INVESTORS around the world are extraordinarily nervous. Yields on ten-year Treasuries fell to their lowest-ever level this week; buyers of 50-year Swiss government bonds are prepared to accept a negative yield. Some of the disquiet stems from Britain’s decision to hurl itself into the unknown. The pound, which hit a 31-year low against the dollar on July 6th, has yet to find a floor; several British commercial-property funds have suspended redemptions as the value of their assets tumbles. But the Brexit vote does not explain all the current unease. Another, potentially more dangerous, financial menace looms on the other side of the Channel—as Italy’s wobbly lenders teeter on the brink of a banking crisis.

Italy is Europe’s fourth-biggest economy and one of its weakest. Public debt stands at 135% of GDP; the adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion ($400 billion) of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.

Not surprisingly, investors have fled. Shares in Italy’s biggest banks have fallen by as much as half since April, a sell-off that has intensified since the Brexit vote. The biggest immediate worry is the solvency of Monte dei Paschi di Siena, the world’s oldest bank. Several attempts to clean it up have failed: it is now worth just a tenth of its book value, and could well come up short in a stress test by the European Central Bank later this month (see article).

Size alone makes Italy’s bank mess dangerous. But it is also an exemplar of the euro area’s wider ills: the tension between rules made in Brussels and the exigencies of national politics; and the conflict between creditors and debtors. Both are the consequence of half-baked financial reforms. Handled badly, the Italian job could be the euro zone’s undoing.

Hang on lads, I’ve got a great idea

Italy urgently needs a big, bold bank clean-up. With private capital fleeing and an existing bank-backed rescue-fund largely used up, this will require an injection of government money. The problem is that this is politically all but impossible. New euro-zone rules say banks cannot be bailed out by the state unless their bondholders take losses first. The principle of “bailing in” creditors rather than sticking the bill to taxpayers is a good one. In most countries bank bonds are held by big institutional investors, who know the risks and can afford the loss. But in Italy, thanks in part to a quirk of the tax code, some €200 billion of bank bonds are held by retail investors. When a few small banks were patched up under the new rules in November, one retail bondholder committed suicide. It caused a political storm. Forcing ordinary Italians to take losses again would badly damage Matteo Renzi, the prime minister, dashing his hope of winning a referendum on constitutional reform in the autumn. Mr Renzi wants the rules to be applied flexibly.

But politics is also in play in the euro zone’s creditor countries. Germany rightly says that Italy’s troubles are largely of its own making. It has been unforgivably slow in getting to grips with its crippled banks, perhaps because its regional lenders are bound up in local politics. Any system that allows member states to pick and choose which rules to comply with is bound to unnerve voters in Germany. Just as Mr Renzi has a lot to gain from watering down or suspending the rules, clemency may have a political cost in Germany, where elections are due to be held next year. “We wrote the rules for the credit system,” said Angela Merkel, in response to Mr Renzi’s appeals for leniency. “We cannot change them every two years.”

If they planned this jam, they planned a way out

Nonetheless, the Italian prime minister is right. The market pressure on Italy’s banks will not ease until some confidence is restored, and that will not happen without public funds. If the bail-in rules are applied rigidly in Italy, the outcry from savers will both damage confidence and leave the door to power open for the Five Star Movement, a grouping that blames Italy’s economic troubles on the single currency. The feeling will grow that Italy is getting scant benefit from the supposed pooling of risks across the euro zone, but is damaged by the many constraints it is under—by its inability to devalue its way towards stronger growth, by a fiscal compact that shackles its budget, and now by bail-in rules that came in after other countries had bailed out their banks. If Italians were ever to lose faith in the euro, the single currency would not survive.

There is no point in following rules to the letter, if doing so leads to the demise of the single currency. So the correct response is to allow the Italian government to plump up the capital cushions of its vulnerable banks with enough public money to quell fears of a systemic crisis. Such a rescue should come with conditions: an overhaul of the Italian banking system that forces tiddlers to merge and slashes overheads by closing the country’s profusion of branches. To give the European bail-in directive a greater chance of being implemented in future, it should be changed so that retail investors who already hold bank bonds are explicitly shielded.

Some sort of fudge is more likely. There is already talk of a handy clause in the bail-in rule book that would allow a temporary capital injection for Monte dei Paschi. That may be enough to put a floor under stock prices so that Italy’s other banks, such as UniCredit, are able to raise private capital. Europe would doubtless hail such an outcome as an example of rules-based solidarity. But if history is any guide, it would neither return Italian banks to full health nor resolve any of the bloc’s underlying problems. One lesson of Brexit is that glossing over the concerns of voters is not a sustainable strategy. The euro zone’s jerry-built financial architecture does so twice over, by sidestepping the fears of those in creditor and debtor countries. That will not work for ever—which is why investors are right to be so worried.