The European tendency to wait until the last minute may prove to be too late.

The Financial Times warns today that the big Italian bank domino that observers have been watching most closely, Monte dei Paschi di Siena, will go critical this Friday if (more likely when) it fails the bank stress test. The non-trival problem is that implosion would be so large as to exhaust what is left of Italy’s rescue funds. Yet the ECB and European competition authorities have so far refused to give Italy a waiver under the new banking rules so that it can avoid subjecting small savers who were duped into buying bank bonds to bail-ins. Prime Minister Renzi has had a good bank/bad bank resolution plan ready to go since early this year, but using state funds to support such an approach as an alternative to bail-ins is verboten under the news rules.

So how are the Italians proposing to finesse this mess? A “private sector rescue”. That means having the less sick banks prop up the really diseased Monte dei Paschi. The net effect is to increase systemic risk, since it knits the banks together even more than before. We saw a variant of that in the US financial crisis, when bank regulators had the barmy idea of encouraging banks to buy other banks’ subordinated instruments, creating a major impediment to resolving mid and larger sized banks, since wiping out those instruments would produce losses at other banks, potentially a cascade of failures.

However, the healthier banks have nixed a straight-up equity purchase. As you’ll see, the latest plan looks unworkable, since it calls for more fresh capital via a rights issue. And who pray tell will stump up for that?

From the Financial Times:

Italy was last night racing to secure a privately backed bailout of Monte dei Paschi di Siena, the most exposed of the country’s troubled lenders, including a plan to raise €5bn of fresh capital so as to avert nationalisation, according to bankers and European officials…. People directly involved in the Monte Paschi discussions say they are aiming for a private rescue of the bank to be announced before the stress test results are published after US markets close on Friday. But they admit that the negotiations could go down to the wire or run into or beyond the weekend. This raises the prospect of shares in Monte Paschi and other Italian banks coming under renewed pressure when markets reopen on Monday, which many fear could prove lethal. Any such rescue would be under EU rules, which would mean a so-called bail-in, where junior Monte Paschi bonds would be converted to shares, and compensation given to retail investors… The privately backed plan, which is still under discussion and could change, would involve a multi-layered deal to rid Monte Paschi of €10bn of net non-performing loans and recapitalisation worth up to €5bn, say people involved in the talks…. Instead, Intesa Sanpaolo and UniCredit have agreed to put an additional €160m into Atlante, a privately backed fund, alongside pension funds and CDP, the state bank, to put a total of about €3bn into Monte Paschi bad loans. To clean up the lender, at least €10bn of its NPLs would be spun off into a special purpose vehicle. This would then be securitised, with shareholders taking the more risky junior tranche of debt and Atlante taking the mezzanine tranche. The least-risky senior tranche would be backed up to €7bn of bridge loans from a pool of banks likely to include JPMorgan of the US and Mediobanca, the Italian investment bank. The longer term aim would be for the senior tranche to be guaranteed by a government-backed scheme, known by the acronym GACS. To boost its capital, Monte Paschi would launch a rights issue of up to €5bn, its third in three years and worth more than five times its current market value. However, analysts believe this fund raising would be difficult given the bank’s reputation for scorching investors capital.

Mind you, Italian banks are full of bad loans. Italy was seeking authorization to use €40 billion in state funds to rescue its banks. An analyst cited in the Financial Times piece thinks it will take a mere €30 billion. Either way, even if the authorities manage to cobble together a scheme to keep Monte dei Paschi going, the bank failing its stress test would put even more pressure on Italian banks and Eurobanks seen as fragile, such as Deutsche Bank.

The plan in Italy seemed to be to try to hold the banking system together until the constitutional referendum in October. Renzi earlier said he’d resign if it failed but recently he’s tried retreating from that position. Commentators believe that if Italy were forced to resort to a bank bail-in, voters would take their revenge on Renzi in the polling booth. If his referendum failed, Renzi’s government may fall regardless. The pro-exit Five Star movement is the leading party in Italy right now, and it has promised it would have a referendum on leaving the Eurozone. So the political and economic stakes are extremely high.

The death watch over Monte dei Paschi has a Lehman-esqe feel. The powers that be were hoping they could hold off a financial crisis until after a key election, yet they were also deeply committed to not doing any bailouts. The Europeans may be about to learn that their “kick the can down the road” strategy has taken them to the brink of a precipice.