MILAN — The spotlight is on Italy's troubled banks as regulators prepare to release the results Friday of stress tests of EU lenders that will show how much money the country's financial sector, the most troubled in the region, needs to avoid rekindling a eurozone crisis.
Banks in several countries could be shown to be financially weak, but Italy's are under particular scrutiny as they still lumber under 360 billion euros ($400 billion) in loans that aren't being repaid.
Of the five big Italian banks being tested by the European Banking Authority, Monte dei Paschi di Siena is most notably expected to come up short. On the eve of the stress test, Monte dei Paschi's board confirmed that it had rival proposals to save the world's oldest bank. They reportedly involve the sale of non-performing loans and raising capital. Shares soared 7 percent to 0.31 euros on opening Friday.
Concern over Europe's banks has grown since Britain's vote to leave the European Union has increased market jitters. In particular, the potential economic impact of a British exit suggests central banks will keep interest rates lower for longer — something that weighs heavily on the earnings of banks, which rely on higher rates to make money when lending.
The outcome of Friday's test is likely to shape the terms under which Italian Premier Matteo Renzi can rescue the banking system. The issue is important because rescuing failed banks has overwhelmed the public finances of some eurozone states before, leading to bailouts, such as Ireland's.
With Italy ranking as the third-largest eurozone economy, any crisis of confidence over the state's financial health has the potential to rekindle concerns about the overall currency's integrity.
The European Central Bank and other banking supervisory bodies will have the weekend to digest the results before issuing any recommendations for any capital increases. Investors can also plot their next move.
Unlike previous tests of banks' financial health, the European Banking Authority will not declare on Friday passing or failing grades. Rather, the oversight agency will assess whether banks would prove financially resilient in case of an extreme economic drop and market volatility.
Italian banks have been hard hit by market speculation this year, much of that since Britain voted to leave the EU although there has been a rebound since the early sell-off. The pressure has forced major strategic and structural changes at Italy's biggest bank, UniCredit, where the new CEO Jean Pierre Mustier has moved quickly to sell assets and reshuffle the organizational structure. He has promised a new strategic plan by the end of the year.
Whatever the ECB's recommendations, Renzi will have to take into account new European Union rules when devising a strategy to protect Italian banks. The EU is blocking the use of public money to rescue the banks, following new rules to block bailouts. Taxpayer money can now only be used after bank creditors, including bondholders, take a loss first — a measure to make sure bank rescues don't overwhelm state finances.
But in Italy even that rule carries risk for Renzi's government since about one third of bank bonds are held by small retail investors. Renzi's has called for a temporary suspension of EU rules, something EU executives have been hesitant to grant.
Lorenzo Codogno, an analyst at consultancy LC Macro Advisors LTD, said the most likely response will be a combination of public and private interventions, but he expressed concern that possible measures were still under debate five years after the eurozone sovereign debt crisis "gripped Italy's lenders and produced a quasi-credit crunch."
"The situation of Italian banks may well be manageable, but there is need for bold policy action to stop the collapse in confidence and the spreading of uncertainty, which can result in a self-fulfilling prophecy," Codogno said. "Repairing balance sheets and raising capital remain key to facilitate new lending and provide support to economic grow."