A perfect storm is brewing for Italian prime minister Matteo Renzi. The once golden boy of European politics is now facing the strongest political and economic headwinds since coming to power two and a half years ago.

The most pressing concern are Italian banks, and more specifically the €360 billion of bad loans weighing on their books.

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Italy's prime minister Matteo Renzi has staked his career on winning October's constitutional referendum. (Photo: ec.europa.eu)

They are mostly a legacy of Italy’s record double-dip recession between 2008 and 2014, and they have limited lenders’ capacity to offer new loans to businesses and households, throttling Italy’s timid economic recovery.

On the back of these concerns are Italian bank sector share prices which have been falling strongly since the start of the year. In the wake of Britain’s vote to leave the European Union, this has turned into panic selling, focusing especially on the world’s oldest lender, the 500-year-old Monte dei Paschi di Siena (MPS).

In the two weeks since the 23 June Brexit referendum, MPS shares have lost 50 percent of their value, and are now worth less than €0.27, their lowest level ever. The fact that a little more than two years ago, stock in the Siena-based lender was worth almost €9 gives a measure of its spectacular fall from market grace.

MPS has long been the weak link among major Italian banks – it has required two state bailouts and several recapitalisations since the 2008 financial crash – but investors are now fleeing from it because the European Central Bank (ECB) has asked it to cut down its bad loans baggage – worth almost €45 billion – by 25 percent over the next two years.

“We are working intensely with the authorities to quickly find a structural and definitive solution for non-performing loans,” MPS chief executive Fabrizio Viola said Thursday (7 July), after a board meeting that discussed the ECB demands.

Collision path with Brussels

“Our people are working with even more intensity and vigour to overcome also this difficult moment and once again attest our credibility,” he added.

The difficulty for MPS is that getting rid of bad loans quickly means selling them at reduced prices, exposing the bank to major losses that would leave it short of capital.

In its current state, few private investors would dig into their pockets to back a recapitalisation, leaving the onus on the Italian government, which already owns a 4-percent stake in the bank.

This sets Renzi on a collision path with Brussels, as the latest rules put shareholders and creditors on the first line in case of a bank's rescue, rather than taxpayers - a bail-in rather than a bailout. This has been done to avoid a repetition of what happened after the 2008 financial crash, when European governments – but not Italy – spent hundreds of billions of euros to rescue banks.

Echoing arguments already used by Rome to navigate around EU deficit targets, Renzi says he does not want to break the bail-in rules, but is seeking flexibility in their application.

The sticking point is not whether Italy can extend public aid to banks – this is allowed under extraordinary circumstances, and MPS’ plight easily qualifies as extraordinary – but whether banks’ creditors should lose some of their money as a contribution to the rescue, as foreseen by the regulation.

Political dynamite

This would be political dynamite for the Italian premier, especially after the experience of last autumn, when bail-in rules were applied for the resolution of four regional banks and their bondholders lost all their investment.

One of them was a pensioner who then committed suicide - the government took opposition flak for that death and it was probably the turning point in Renzi’s political fortunes.

Last month, Renzi’s Democratic Party (PD) suffered embarrassing local election defeats, losing mayoral races in Turin and Rome to candidates from the Five Star Movement (M5S).

In recent days, two polls have suggested that the PD was on course to lose the next general elections against its populist, eurosceptic opponent.

With a crucial a referendum on constitutional reforms looming in October, the prime minister cannot once again be seen to be putting ordinary Italians’ savings at risk for the sake of rescuing banks.

Renzi has staked his career on a referendum win. He promised to quit politics if voters reject the reforms his government has proposed, and warned that the country would slide back into political chaos if they were rejected.

Pressure is on to resolve the Italian banking imbroglio before 29 July, when stress tests by the European Banking Authority are expected to expose the frailty of MPS and perhaps of a few other lenders.

'Italy could go under'

Analysts say Italy’s approach will likely be two-pronged, with capital injections in stricken banks and an expansion of a private bank rescue fund that could help MPS and others by buying their bad loans.

With typical bluster, Renzi says he is on top of it all, and has even tried to turn the tables on Germany.

At a press conference in Rome with his Swedish counterpart Stefan Lovfen on Wednesday, he said the issue of non-performing loans in Italy “has to be resolved, can be resolved and is being resolved”. But he added that it was 100 times smaller than the derivatives problem “of other, important banks” – a pointed reference to Deutsche Bank.

Nevertheless, the financial and political heat is on Rome, rather than Berlin, amid widespread perceptions that the banking problem in the eurozone’s third-largest economy could escalate into the next big crisis after the Brexit shock.

“A solution should be found quickly or the world’s oldest bank could fail and bring down the rest of Europe’s embattled banking sector with it. The EU needs to show flexibility or Italy could go under,” Neil Wilson of British trading firm ETX Capital warned on Wednesday.