World's oldest bank BMPS in trouble — Here’s what you need to know

Adam Jeffery | CNBC

It is the oldest lender in the world and it has been making headlines for several months amid concerns it doesn't have the financial firepower to cover its bad debts.

The European Banking Authority said last July that it would have the greatest difficulty among all European banks in covering its toxic loans.

As a result, Monte dei Paschi di Siena announced in November it would seek 5 billion euros ($5.4 billion) in fresh capital during the month of December to improve its capital position. But the plan is currently at risk, following the government's defeat in a recent referendum, sparking broader concerns over the fragile banking system.

Why is the Italian government considering stepping in?

BMPS bond holders could flock to Italy's far right parties: Analyst

Investors have become more skeptical about recapitalizing Italian banks in the wake of Sunday's referendum. They are concerned over the increased political instability, as the Italian prime minister prepares to resign, and a potential slowdown of the economy.

In an attempt to reassure investors, media reports on Tuesday suggested that the Italian government is preparing to participate in the 5 billion euro recapitalization.

Reuters reported, citing anonymous sources, that the Italian government is planning to take a 2 billion euro controlling stake of BMPS using taxpayers' money.

The bank's shares were up almost 8 percent at 10 a.m. London time on the news.

However, a potential state participation could go against European rules and bring further problems to the Italian authorities.

Why is a state intervention controversial?

European rules dictate that bank bailouts should firstly be at the expense of investors and not at the taxpayers.

If Italy opts for injecting taxpayers' money, the European Commission – which oversees competition rules – could fine Italy for illegal state aid.

Apart from rising problems with Europe, a state bailout could spur anti-establishment and anti-European sentiment among Italian voters at a time when support for Eurosceptic movements is on the rise.

Other Italian banks could be at risk

BMPS is a loss that has to be assigned: Strategist

BMPS needs funding and its recapitalization process has to take place quickly to avoid a potential collapse of the third-largest bank in Italy and contagion to other banks.

The Italian banking system has been for a long time a drag in the country's economy due to its high level of non-performing loans.

"With the economy turning around, nonperforming loans (NPLs) appear to be stabilizing at about 18 percent of loans, one of the highest in the euro zone," the International Monetary Fund said in a report issues last summer.

"High NPLs are adversely affecting profitability—profit margins are among the lowest in Europe—and weighing on banks' ability to extend credit," the IMF added.

Credit Ratings agency Fitch said in a note on Tuesday that the referendum result could also damage plans for recapitalization of other Italian banks, including UniCredit.

That would "have negative implications for the broader banking sector, whose attractiveness with investors has already reduced significantly during 2016. The sector's ability to access the institutional markets for funding and capital, which has become more difficult and expensive this year, could deteriorate further," Fitch warned.

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