The euro zone is no stranger to bailouts with Ireland, Greece, Portugal and Spain all given varying degrees of financial aid since the financial crisis in 2008. Problematically for euro zone leaders, however, Italy is seen as "too big to bail out" and its funding needs too great.
It already has massive public debt pile at 132.7 percent of gross domestic product (GDP), second only to Greece, and only recently recovering economic growth (forecast to be 1.1 percent in 2016), according to the European Commission.
As such, investors are worried that any Italian bank collapse could cause an economic crisis in Italy, a country already facing political upheaval; Prime Minster Renzi has called a referendum on constitutional reform which will be held in October and has said he will resign if he loses the vote, meaning new elections will have to be held.
Stuck between facing the anger of Italian voters (and potential financial chaos) of bailing in depositors to save the banks (as per EU rules) and the anger of Europe if it uses public finances, Italy was "in a bind," according to analysts at Rabobank.
"If Italy does manage to get a green light for the recapitalization, the funds required to reinforce the Italian banking system may well be coming from Italy's public finances. And this is where the real pain could come from," Richard McGuire, Lyn Graham-Taylor and Matt Cairns said in a note on Wednesday.
"Although the extra funds that the government is planning to provide to the financial sector are relatively small in terms of Italian GDP, these could be the straw that breaks the camel's back. With only tepid growth since the global financial crisis, and with an already mountainous debt burden, adding even more debt to this debt pile might very well be a trigger for rating agencies to consider a downgrade of Italy's credit ratings," they added.
"Italian ratings are already at 'BBB-' for S&P (and) if these ratings start to come under pressure from the agencies, this could lead to speculation that Italy may eventually fall out of the investment grade bucket," they said, warning that this would have a "major impact" on the country, particularly if the political scene is thrown into disarray.
"If Renzi were to lose this vote in October, this could cause a period of uncertainty, harming the Italian economy … and adding more stress to the banking sector. Moreover, new elections might very well be won by the anti-establishment Five Star Movement, which is campaigning to pull Italy out of the euro zone. With the Five Star Movement only trailing Renzi's Democratic Party by a small margin in recent polls, the prospects of new elections and the very uncertain outcome could send Italy into a tailspin," they added.
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