Italy's banks have made steady progress in reducing their exposure to bad loans in recent months, but the potential for further inroads is likely to rest on the outcome of the upcoming general election, UBS analysts have said.
The euro zone's third-largest economy has been hamstrung by a sizeable pile of non-performing loans (NPLs) over the past decade. This unwelcome legacy has spiraled to such an extent that Italy not only has the biggest exposure to NPLs of any country on the continent, its bad loans also account for almost 25 percent of the European Union (EU) total, according to the European Banking Authority.
The next challenge for Italy's banking sector looks likely to be the result of Sunday's general election.
UBS analysts suggested the outcome would probably be "broadly neutral" for the banking sector, before adding that there are two outcomes that could spell danger to the industry.
They highlighted the prospect of repeat elections and the formation of a euroskeptic coalition government as potential flashpoints that might derail recent progress among Italian lenders.
"In such cases, a potential increase in sovereign yields would impact banks via higher funding costs and the mark-to-market of government bond holdings," UBS analysts said in a research note published Wednesday.
The European Central Bank's (ECB) massive program of quantitative easing (QE) has aided Italy's economic recovery in recent years, while also providing a platform for the country to make strides in reducing its pile of bad loans.
Nonetheless, an extended period of robust economic growth is essential in order for Italy to make further progress.
The Swiss bank has estimated that the Italian economy grew by 1.5 percent in 2017, lifted by domestic demand and trade. Meanwhile, the rating agency Standard & Poor's upwardly revised its sovereign credit rating by one notch to BBB in October — the unexpected change marked the first such increase for more than three decades.
At the end of January, Italy's former economic development minister told CNBC that the upcoming vote posed a threat to the country's financial stability. Carlo Calenda stressed reducing its heap of NPLs remained the country's "most important challenge."