It is estimated that the banking sector in Italy has about €200 billion of gross non-performing loans. Experts say that it will require about €40 billion to recapitalise the banks and put them on a sound financial footing. At first sight, this does not look like a lot of money compared to the recent Greek bailout costing €86 billion. Italy is a larger and far stronger economy and €40 billion is less than 2.5% of GDP.

Italian Prime Minister Renzi wishes to recapitalise the banks with a state bailout and sort the problem. However, in 2015, the Eurozone introduced new rules, the Bank Recovery and Resolution Directive [BRRD]. This seems to rule out Mr Renzi’s simple and painless approach.

According to BRRD, any government funding is conditional on ‘burden sharing’ where the stakes of shareholders would have to be wiped out or cut. That presents a unique problem for Italy where more than one third of all bank bonds are held by retail investors. Any attempt to impose burden sharing on retail held bonds would very likely send shock waves across the entire domestic deposit base.

It is important for Mr Renzi that this problem be solved soon because he is facing a constitutional referendum which he would be more likely to lose if he fails to deal with his banks. In addition, the problem might move from being just an internal Italian bank problem to becoming a full blown Eurozone crisis.

The BRRD is the Eurozone response to the 2008 banking crisis when Ireland and others entered its bailout. Then there were no structures in place to allow banks to fail. To prevent contagion, Irish taxpayers were saddled with debt in order to protect the Eurozone. Ireland, which accounts for just 0.4% of the Eurozone economy, took on 42% of the total debt. Other Eurozone governments were determined that never again would their tax payers be exposed to such a catastrophe.

Despite the rules, sorting these problems is a political issue and loopholes will undoubtedly be found to enable the Italian government to do the right thing.