Italy referendum: Could a domestic affair threaten to become a euro zone crisis?

Fragile banks, weak growth, and the prospect of more political instability - Italy's referendum on constitutional reform takes centre stage this weekend.

In what could be viewed as a crisis of his own creation, Italian Prime Minister Matteo Renzi has turned the referendum in to into a de facto confidence vote by offering to resign if the vote fails.

Polls have been banned for the last two weeks, when the NO vote appeared to be in the lead. Meanwhile the high percentage of undecided voters -- up to 30 percent -- in some surveys also make this a tough call. Then you've got the estimated 5 percent of Italian voters living abroad.

The atmosphere here in Rome suggest that people are shy over admitting voting yes, a vote for the establishment – rather than against it as we saw with Brexit and the US election.

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So could this vote still turn out to be 2016's third political shock at the ballot box? Perhaps, but its complicated!

It should have been an entirely Italian affair: The country votes this weekend on whether to reduce the size and powers of the senate, leaving the process of government formation to the lower house.

This is where the electoral law change comes in. As of this year, any single party winning the most votes in an election gets boosted to a full majority of seats. Previously a coalition could claim the extra seats and that's generally what happened.

When this idea was initially being discussed, Renzi's Democratic Party was riding high in the polls, his hope was to win an election - put aside the coalitions of old and usher in an era of more stable governments. While some Italian's fear the prospect of a more powerful leader given the country's history, the government argues that these concerns are groundless.

As Paolo Gentiloni told CNBC earlier this week "saying that there is a risk of an authoritarian regime in Italy where obviously the risk is of a bureaucracy, non-functioning, too slow process of legislation."

"We all know what are the risk of the country. The only one that we don't have is the risk of an authoritarian regime. It's ridiculous."

But the situation has changed for other reasons - now the Five Star movement has also dramatically gained support. This new electoral law raises the likelihood they could also form a majority government at some point in the future.

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The Five Star movement is calling for snap elections if the referendum vote is a no. But under the current mix of old and new electoral laws they'd still struggle to rule because they are unwilling to form coalitions with established parties.

Investors are now wondering if this could ultimately mean a referendum on euro membership at some point in the future. The key here is that Italy's constitution as It stands does not allow referendums on international treaties. And current events prove how tough it is to change it.

The additional kicker here is that the constitutional court will rule of the legality of the new electoral law after this referendum so things could change again anyway. We could even go back to the old system - and likely not in the Five Star movement's favor.

For now there are far more pressing concerns. What happens on Monday morning if Italians vote No this weekend? Renzi has promised to resign. The President must then ask someone to step in. The government have indicated that this would happen quickly to try and limit any potential market instability.

In this case, watch the banks as the outlet for investor fears - even though the banking sector is already down 48 percent so far this year. Finance Minister Pier Carlo Padoan has suggested that even if the No vote wins, Renzi's pledge to tackle the issue of non performing loans and recapitalise stricken lender Banca Monte Paschi dei Siena with the help of private investors could go ahead. But will reluctant investors still want to take part?

Whether it's a technocrat or someone from the current government, the next leader will also then be tasked with completing the budget for 2017, finalising the electoral law, and preparing the country for fresh elections next year.

If the Yes vote wins and Renzi stays, I doubt the plan will change too much, even if elections are pushed back to 2018. Investors will probably lose interest in this event quite quickly.

So what does this all mean?

Well the good news is that Italian chief executives and business leaders have told me numerous times in the last five years, this country adopts a carry-on-regardless attitude to political instability. I wonder if the same holds true today.

The bad news is - in either scenario, further economic reforms in Italy will take a back seat.

And while a government change won't help investor confidence in the short-term, It's fair to say those arguing for a bolder, more comprehensive solution for the Italian banking sector will be saying exactly the same after this referendum as they were before. Meaning little additional support unless the market forces it. No matter who wins.

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