The pain from Brexit is being felt most not in London, but in Italy's banks.
Monte Paschi shares sank to the lowest on record on Monday, while other bank stocks in Milan sank are near multi-decade lows. UniCredit, the country's largest lender, trades at a near 80 percent discount to its book value, and Paschi at 90 percent.
Investors have lost confidence in the banks' ability to deal with their 360 billion euros ($400 billion) of souring loans without some form of help.
The Italian government is pushing to start a 40 billion-euro rescue which would spare investors losses. Germany and European Union officials have rebuffed those plans because the banking union set up in the wake of Greece's financial crisis was specifically designed to force losses from future bailouts onto creditors -- not taxpayers.
Italy is, in that view, simply using Brexit as a political excuse -- in part to spare voters who bought junior bank debt. But sticking to a rule book that forces losses on investors will only lead to much larger problems in future. The country needs some flexibility.
The numbers involved for Italy are just too big to ignore: it would cost about 45 billion euros just to mark to market Italian lenders' 210 billion euros of most problematic loans, the sofferenze, according to analysts at Berenberg. With economic growth set to slow and private investors even less likely to jump in after Brexit, simply waiting will make the problem worse.
All this is happening against a backdrop of growing regulatory pressure. Paschi tumbled on Monday after the European Central Bank asked it to draw up plans to cut its souring loans by 40 percent. That may force the lender to raise capital -- something private investors are unlikely to provide. Paschi has erased more than 14 billion euros of market value in the past decade.
The country's largest lenders can't be called on to rescue the whole system, even if they are forced to acquire troubled peers. UniCredit itself is likely to need as much as 5 billion euros of capital.
The last thing Europe needs is an economic crisis in Italy. The country the world's third-largest debtor after the U.S. and Japan -- its public debt of 2.23 trillion euros amounts to more than 130 percent of gross domestic product. Its banks hold some 419 billion euros of sovereign debt. There's a real risk of another systemic crunch for the euro zone if no solution is found.
It's certainly true the country has dragged its feet over past reforms and that Prime Minister Matteo Renzi has his eye not just on financial stability but on his own political future. But a dogmatic approach with Italy risks stoking fires that are too big to control.
The euro zone's history of tackling crises has been one of compromise and eleventh-hour deals -- one more won't hurt. Encouragingly, there are signs Brexit could force a more flexible outlook: the ECB is considering loosening rules for its bond purchases, something which would benefit Italy. And last week, the country was given permission by the European Commission to supply 150 billion euros of liquidity to struggling banks until the end of the year.
But those are not going to be enough to solve the banks' problem loans on their own. With private sources of capital lacking, lenders will need government help -- either to provide capital or remove these loans from their balance sheets. It may be a tall order politically -- but, financially, help for Italy would be help for all of Europe.
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