ITALY was left feeling especially hard done by on October 26th following the results of the European Central Bank’s asset quality review. Of the 25 institutions that failed its stress tests, nine were Italian, including the worst performer, Monte dei Paschi di Siena (MPS). Italy's central bankers immediately said that they thought the results confirmed the overall solidity of the Italian banking system. The review was based on out-of-date data from the end of 2013, they pointed out. Once capital injections in early 2014 worth €11 billion ($13.9 billion) were taken into account, only two still faced shortfalls: MPS, Italy’s third-largest bank, and the much smaller Banca Carige.

Markets, however, disagreed with this overly-rosy assessment. On the morning of October 27th the value of shares in both Banca Carige and MPS fell by double-digit percentages. Although they were both widely expected to fail the stress test, the scale to which they did was greater than initially expected. The banks have been given two weeks to come up with plans to plug their holes. Banca Carige needs to find €814m and has announced it plans to issue €500m in new shares to cover some of this. MPS, meanwhile, will have a tougher time covering its shortfall of €2.1 billion.

Although only two banks technically failed, many of Italy’s smaller lenders remain weak. Italy's banking system has been “petrified” for the last 20 years, says Alberto Gallo of Royal Bank of Scotland, “built not to be profitable but for social interests” and closed “like a medieval castle” to foreign investors. The system as a whole is in need of a shake-up to become more efficient. With a total of 680 banks, Italy boasts more branches per person than pharmacies or restaurants. At the end of 2012 there were 54 bank branches per 100,000 people, compared with the average in the European Union of 39.



This fragmented market structure could be soon to change. When the ECB takes over supervision of Italy's banks on November 4th, it is unlikely to allow the protection of old business models to be continued. Until recently, many regional governments and charitable foundations with localist agendas had large shareholdings in some Italian lenders. The influence of these owners in the past has made potential aggregations especially difficult, and highly political, analysts say.

Although it is still unclear how governance rules will change as the result of banking union, it is likely that something will need to shift. A flurry of mergers in the Italian banking sector may be encouraged by the new regulators, particularly among the banche popolari, which are mid-sized mutual banks that are closely tied to Italy’s regions. Ultimately, it could be the move towards European banking union, rather the ECB's stress tests themselves, that can shake up Italy’s troubled banking sector for the better.