The European Central Bank has asked Italy's third-largest lender, Banca Monte dei Paschi di Siena, to slash its bad debts by 40 percent over three years, heaping more pressure on Rome and Brussels to stabilize the Italian banking system.

Monte dei Paschi is the weakest link among big lenders in the euro zone's fourth-largest bank sector and may have to raise capital quickly to meet the ECB's target, given that last month's Brexit vote has hurt investor appetite for bad debts.

The Italian government, mindful that the country's banks rely heavily on retail investors, wants a green light from the European Union to help lenders such as Monte dei Paschi raise capital without triggering bail-in rules that would force bondholders and shareholders to share some of the losses.

Otherwise, ordinary Italians, who according to Fitch rating agency hold about a third of outstanding Italian bank debt, face huge losses as banks are forced to sell assets or shares at heavy discounts.

"The market thinks Monte dei Paschi risks having to launch the umpteenth capital increase, and this time it's quite unlikely that any shareholder will be willing to stump up more cash," said Vincenzo Longo, a banking analyst at IG.

"The government will probably need to chip in, and this seems to be at the heart of the negotiations between Rome and Brussels, which are far from smooth but could have systemic consequences, both for Italy and Europe."