Italy: Europe's next domino to fall?

Prime Minister Renzi on risk to Italian banks
Prime Minister Renzi on risk to Italian banks

The world's oldest bank is in deep trouble.

Shares in Italy's Banca Monte Dei Paschi Di Siena (BMDPF) have crashed 45% in 10 days, forcing regulators to temporarily ban short-selling in the stock. The bank has been given until Friday to come up with a plan to reduce its bad loans by 40% by 2018.

It's not alone. Other Italian bank stocks have fallen by about 30% since June 23, when the U.K. voted to leave the European Union. Italian officials are trying to find ways to shore up the country's financial system.

Italian banks have been choking on bad debt for years, but the U.K. vote has thrown their problems into sharp relief. Here's how Brexit could turn Italy into Europe's next crisis:

An economic slowdown

Economists have slashed their U.K. growth forecasts for this year and next. Uncertainty over the EU's first divorce may also depress growth across Europe, and that's the last thing Italy needs.

The Italian economy has barely grown since the country adopted the euro in 2002. GDP rose by just 0.3% in the first quarter, half the rate of the eurozone as a whole. Retail sales have fallen for six months in a row, and last month suffered their worst slump since November 2013.

Related: Italian bank crisis may be collateral damage from Brexit

A slowdown puts even more pressure on the banks, because people and businesses are more likely to default on their debt. Italian banks are already being crushed by problem loans worth €360 billion ($396 billion).

Weaker bank profits

A weaker economic outlook could prompt the European Central Bank to push record low interest rates even lower.

That would be bad news for banks. "Rate cuts by the ECB could make Italian banks even weaker in the short term," said Jack Allen, an economist at Capital Economics.

Related: 7 cities that could steal business from London

Banca Popolare (BPXXY) shares have fallen 28% since the Brexit vote. Unicredit (UNCFF) is down 34% and Intesa Sanpaolo (IITSF) down 30%.

The Italian government is considering injecting billions of euros into the banking system, but its options are limited. EU bank bailout rules require investors (shareholders and bondholders) -- rather than taxpayers -- to shoulder the burden of any rescue.

Political upheaval

An Italian banking crisis, together with the Brexit vote, could inflame anti-European sentiment.

Italians are already losing faith in the euro, and the clamor for a referendum on the currency is getting louder.

Prime Minister Matteo Renzi is at risk of losing a vote this fall on constitutional reform. If he does, he may be forced to resign, leading to new elections at a time when Italy's anti-euro party, the Five Star Movement, is gaining ground.

"The traditionally very pro-European country has become more euro-sceptic after years of economic stagnation and painful fiscal repair," wrote Holger Schmieding at Berenberg bank. "The risk of domino effects across the [European Union] and the eurozone looms larger than before."

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