The Italian political crisis has sparked fears about the fate of European banks. Market watchers are concerned that after years of austerity and shoring up capital the institutions are still weak, and failure to unify the region's disparate banking system will result in a financial crisis.
The Euro Stoxx Banks index is down 9.72 percent this week following Italian President Sergio Mattarella's move to block the formation of an anti-establishment government. This week, the country's two largest parties, the left-wing 5-Star Movement and the right-wing League, tried to appoint an anti-European Union politician as finance minister, but it was vetoed by the country's president, who then appointed a new euro-friendly prime minister.
Those two groups reached an agreement to form a new coalition government on Thursday in which the little-known economics professor from the University of Rome, Giovanni Tria, will be the Minister of Finance. The Italian President Mattarella approved the new cabinet, which will be sworn in on Friday.
Last week in Spain, the country's ruling party was found to have been involved in an illegal kickbacks scheme, while a former treasurer and close friend of the president was convicted of fraud and money laundering and sentenced to 33 years in prison. Spanish Prime Minister Mariano Rajoy on Friday became the first leader in Spain's modern democracy to lose a vote of no confidence in Parliament.
While both countries' issues contributed to the recent market turmoil — the S&P 500 is down slightly and the MSCI Europe Financials (EUFN) has fallen by 5 percent in the past week, through May 30 — Italy's issues are far more damaging to the EU's future. Both 5-Star and League want to leave the euro zone, even though they're on opposite ends of the political divide. While a majority of Italian citizens want to say in the EU, with both parties running on anti-union mandates, and receiving large portions of the March vote, an EU exit is certainly a possibility.
A health check on European banks tells the story. While these institutions appear to be in a more stable position than they were in 2016, they still suffer from undercapitalization, the burden of non-performing loans and low profitability.
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A huge balance sheet cleanup remains unfinished with $938 billion of bad loans —a large portion in Italy — still sitting on bank balance sheets, according to the European Banking Authority. That's because institutions are still laden with government debt and their capital buffers are not sufficient to tackle the problem.
Hopes were that European bank fortunes would greatly improve this year thanks to overhauls by the European Central Bank and rising interest rates. But now political winds have shifted.