The Italian lender Monte dei Paschi (BMPS) is racing against time to raise 5 billion euros ($5.4 billion) by the end of the month, with analysts speculating that the issue could potentially effect the future path of politics in the country follow the resignation of Prime Minister Matteo Renzi.
BMPS failed a stress test in July and has to improve its capital position, even if that process might include public money. The main aim is to gather the 5 billion euros from private investors but with an interim government and the likelihood of new elections, many are more reluctant on putting their money into BMPS.
"The most immediate and potentially costly issue from a political standpoint (in Italy) is the recapitalization of BMPS," Fabio Fois, economist at Barclays, said in a note on Monday.
"If the private plan fails and the government decided to refer to the clause in Bank Recovery Resolution Directive (a European regulation) that permits extraordinary financial support, government's popularity could be at risk of severe deterioration," he added.
Reuters reported on Monday, citing a Treasury source, that Italian authorities will intervene with public money if necessary to ensure the continuity of the bank and to protect clients' savings. The source also said that a debt-to-equity swap was being considered.
Italian policymakers and EU officials have been trying to deal with Italy's fragile banking system in recent months, which has been bogged down by non-performing loans (NPLs) estimated to total 360 billion euros ($400.7 billion).
A state bailout, with taxpayer money, could contravene EU rules. Such a solution would stand in contrast to a bondholder "bail-in," but would perhaps protect Italian households which are heavily exposed to the asset class. However, banking analysts in recent weeks have been focusing on the idea that both public money will be used alongside some form of "bail-in" with retail investors taking some sort of hit.
Under European rules, a public recapitalization entails that equity holders and subordinated creditors (owners of high-ranking debt) will have to share the burden and enter a "bail-in" of 8 percent (minimum) before public money is used. The European Commission has suggested that Italy could opt for a public recapitalization but that will require compensating these retail investors.
This option has already been applied in four smaller Italian banks but it still had losses for retail bondholders and took a long time to complete.
"This has still meant meaningful losses for retail investors even if the blow has been softened considerably. Additionally, this option involves months of waiting before cash can finally be accessed," Deutsche Bank said in a report last week.
The problems for BMPS represent problems for other Italian banks with the whole sector in Europe seeing heavy volatility in stock markets over recent months. The banking system has been weak for years as most institutions have failed to deal with the high level of bad debt in the wake of the financial crisis.
UniCredit, the biggest Italian bank in assets, also failed the ECB stress tests last July. It announced on Monday that it was selling its asset management arm Pioneer to the French insurer Amundi for $3.75 billion to improve its capital ratios.
The ability of Italian banks to access markets for funding "has become more difficult and expensive" in 2016 due to the country's political instability and a slower reform implementation, according to credit ratings agency Fitch, adding that such capacity could deteriorate further.
The recapitalization process of BMPS is therefore set to upset Italian voters, which ultimately could punish the main parties in upcoming elections.
"If the 'bail-in' of junior bondholders is not announced simultaneously with a bailout of retail investors, the announcement likely would severely hurt the popularity of the parties belonging to the coalition government," Fois from Barclays said.
This increases the chances of populist parties, such the Five Star movement, in the upcoming election. Even if the 40 percent of voters that supported former Prime Minister Matteo Renzi still stick with his center-left party, chances are that the next Italian parliament will be even more divided, making implementation of much needed reforms increasingly difficult.
"Italy's growth and high political uncertainty are currently a key source of vulnerability for the whole of the euro area. Hence, it should ideally be addressed via a convincing plan including a large backstop," Deutsche Bank added.