Italian bank stocks slump after defeated Renzi resigns

Italian banks are drowning in bad debt
Italian banks are drowning in bad debt

The euro swung wildly against the dollar and bank stocks in Italy slumped as the country appeared headed for a period of political and financial turmoil.

Prime Minister Matteo Renzi said Monday that he would resign after his program of constitutional reform was rejected by Italians in a referendum, with the 'No' campaign winning nearly 60% of the vote.

The prospect of instability in the eurozone's third biggest economy saw the euro initially drop about 1% against the dollar to its lowest level in 20 months. But it bounced back strongly in early U.S. trading.

Italy's main stock market index fell by about 1%, but European stocks were otherwise trading slightly firmer and U.S. stock futures were also positive.

Related: Italy's Renzi to resign after referendum defeat

Global market reaction was relatively muted, perhaps because Renzi's defeat was expected.

"No‎netheless, Italy's financial markets, its underfunded banks and its overall economy could suffer unless Italy resolves its political crisis fast," noted analysts at Berenberg bank.

It's unclear what happens next in Italy. Renzi's party may be asked to form a new government, perhaps in coalition with the center right. If all else fails, there may be early elections in 2017.

An extended period of political uncertainty would trouble investors for several reasons.

Bank bailout?

The most immediate concern is a potential banking crisis. Some of Italy's banks are drowning in bad debt -- a legacy of years of economic stagnation -- and urgently need to raise new funds.

The world's oldest operating bank, Monte dei Paschi (BMDPF), is the weakest link. It needs 5 billion euros after failing a test of its financial health earlier this year.

"Due to a likely deteriorating sentiment, some of the ongoing bank recapitalization plans might be more difficult and could be postponed, opening a period of high volatility," wrote Deutsche Bank analyst Paola Sabbione in a report on Monday.

sick european banks

If investors won't back capital increases, then some banks may need a government bailout.

Shares in Monte dei Paschi fell nearly 4% -- they've lost about 86% of their value this year -- while Unicredit (UNCFF) dropped nearly 6%. Shares in Banco Popolare di Milano fell 7%.

Unicredit said Monday it was in exclusive talks to sell its asset management arm to Amundi of France -- a deal that could bolster its finances.

Risk of recession?

Italy's economy, which has been stuck in neutral for decades, is also likely to suffer. Renzi's government had embarked on a series of reforms aimed at boosting growth and prosperity.

Many of those are incomplete or still in the pipeline, and progress is now likely to stall. New elections could take place, but they may be many months away. Economists expect growth to weaken sharply next year, and some say a return to recession is possible.

Related: A nightmare scenario in the heart of Europe

And if they happen, those early elections could prove ultimately to be the biggest headache for investors.

Risk for the euro?

The chief beneficiaries are likely to be populist parties that have capitalized on anger over the sluggish economy and high unemployment -- such as the eurosceptic Five-Star Movement.

The party, founded by comedian Beppe Grillo, could campaign on a promise to hold a referendum on Italy's continued membership in the euro.

The week to come in markets

Investors see Italy as the biggest risk to the future of the eurozone, and they've been selling the country's bonds in recent weeks.

Still, the likelihood of one of the European Union's founding members abandoning the euro is very remote. There are significant constitutional and political obstacles to such a move.

The European Central Bank, which meets Thursday, could announce even more aggressive measures to support Italy and the wider European economy.

-- Charles Riley and Nina dos Santos contributed to this article.

CNNMoney Sponsors