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Markets worry as Italian banks face the perfect storm

A rocky 2016 has gotten worse on the Brexit vote, and now bank bailout funds may have to grow bigger.

Italy's bank bailout fund might not be enough to beat back the Brexit. More key Italian financial services firms are under pressure and face the potential need to raise capital, leaving Italian government officials and its banking system trying to steer clear of a crisis.

As Italian bank bonds and share prices are seeing their value slammed in the face of rising uncertainty, banks with substantial bad loans are facing greater pressure, with rates around the world slipping into negative territory. It's an anxiety some in Italy and throughout the European Union may have been hoping would be eased by the Brexit vote last month — but then the U.K. referendum delivered the opposite outcome from the one they had sought.

"Market volatility following the U.K.'s EU referendum result hit the Italian bank sector particularly hard because it is one of Europe's weakest," Fitch Ratings analysts said in a July 4 report. "Asset quality pressure is a main driver for the negative outlooks on several large and medium-sized Italian banks."

The Brexit vote, which calls for the United Kingdom to abandon a European Union that has careened for years from one crisis to another, could hasten weak Italian banks' downfall. It was widely expected that European and U.K. banks will suffer the brunt of the vote in late June, and while British banks have been hard hit by the news which brings with it tremendous regulatory uncertainty EU banks have suffered as well.

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Many banks in Italy, including its largest, UniCredit SpA, have seen share prices pounded; its stock is down more than 60 percent so far this year. A staffer at UniCredit could not provide comment when contacted.

Already, Italian officials and executives appear to be pulling out all the stops to stave off banking sector contagion. The lingering question for banks is whether they can continue to support lending operations at a time when creditors face potential losses and as some of the country's leading financial services firms could be subject to shotgun M&A marriages by regulators.

Italian financial services firms earlier this year established a multi-billion dollar fund called Atlante to buy non-performing bank loans. But the fund, which is in the 4-billion euro to 6-billion euro range ($4.43 billion to $6.65 billion), one analyst said, is far too small to cover all the non-performing loans held by major Italian banks. However, the fund could still be leveraged in order to support loan purchases.

"The authorities need to get banks to remove a large portion of soured loans from their books so they can loan more," said Julien Jarmoszko, senior research manager at S&P Global Market Intelligence. "If investors fear more Italian banks, this will raise their cost of capital and reduce lending as a result."

It's still possible the Atlante fund could grow, Fitch analysts say. It would need to be substantially larger if a figure referenced Monday by the Wall Street Journal holds true: That estimate, which says that 17 percent of Italian banks' debt is bad, translates into roughly $400 billion in exposure.

"An increase in the size of Atlante, a vehicle to participate in bank capital increases and invest in impaired loans, is also possible," the analysts wrote July 4.

Another possibility is that Italian government officials would try and stave off crisis by channeling capital toward the country's banks. That, however, appeared to be met with push-back from other EU regulators, according to one report.

"[I]t seems to be a murky area," said Hugo Cruz, Italian banks analyst at Keefe, Bruyette and Woods. "The EU's state aid rules say that the state could intervene if there is a serious disturbance in the economy. The question then is, 'what is a serious disturbance,' and who decides it."

This week, the market may get its answer.