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For this summer’s euro zone crisis, head to Italy

It wouldn't be summer without a crisis in the euro zone, and following the U.K.'s vote to leave the European Union, we are likely to have a second, this time with an Italian flavour.

Italy's banks were once the foundation of the modern banking system – but now, weighed down by bad debts and a dismal economy, those foundations are at risk of crumbling. In his efforts to resolve the problem, Prime Minister Matteo Renzi must walk his own tightrope between sticking to EU rules and discontent at home.

The numbers are bleak. Italy's economy is unlikely to return to pre-crisis levels for close to a decade, according to the International Monetary Fund (IMF). And swilling around at the bottom of that economy are around 360 billion euros ($394 billion) of non-performing loans, 200 billion euros worth of which are deemed insolvent, are still on banking balance sheets.

In the flurry of financial markets action that surrounded the U.K. referendum on EU membership (and can it really only have been a month ago?) Italian banks were among the biggest losers as a sector. Intesa Sanpaolo, Mediobanca and Unicredit lost around a third of their value within days of the vote, and, while they have regained some ground since, are still down significantly on their pre-referendum value.

Stress tests this Friday, July 29, are unlikely to reassure investors. While the Italian banks facing the tests won't "fail" per se -- the test won't have a pass/fail mark -- they are expected to show plenty of cause for concern and add to calls for a systemic reform of the country's banking system. But we shouldn't expect this any time soon.

When it comes to bad loans, the convolutions of the Italian legal process mean that it can take years to recover anything from borrowers who can no longer pay – for example, foreclosures on mortgages can take more than a decade. And the banking sector is stuck in a vicious, ever-decreasing circle with the economy. Banks can't lend to fuel the economy, the economy gets worse, and the chance of banks getting anything back from their bad debts shrinks even further.

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Andy Sacks | Getty Images

Renzi wants a good, old-fashioned taxpayer bailout, to the tune of $45 billion, but he may have come to that decision too late. EU rules introduced since the credit crisis mean that such a bailout can only happen if investors are on the hook first. However, in Italy, this is more likely to impact ordinary people as there is a relatively high level of retail investment in banks. Renzi's colleagues elsewhere in the EU have been inflexible on this plan so far.

With a growing threat from his own eurosceptic front, the Five Star Movement, and a referendum in October on key constitutional reforms, Renzi needs to keep the people onside. If the banking system cannot help fuel economic recovery, particularly an eye-watering 37 percent rate of youth unemployment, Italy's chapter in the history of banking will become a page turner for all the wrong reasons.

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