Italy's number-three bank, BMPS, has taken a hammering on the stock market this week after the European Central Bank told it to slash its bad debts, its shares plunging 14 percent on Monday and by nearly 20 percent on Tuesday.

But expectations that a solution may be underway boosted them by 14 percent early Wednesday, and a ban by the stock market regulator on speculation also helped the rebound.

With gross bad loans amounting to €46.9 billion ($52 billion), BMPS, is at the forefront of concerns about the fragile balance sheets of Italian banks, which are weighed down by €360 billion in bad debt.
   
The situation has come to a head as Britain's shock vote to leave the European Union has reduced expectations for growth, and thus the ability of Italian banks to handle their debt burdens.
   
The demand by the ECB has raised the heat on BMPS, but Europe's banking regulator is expected to release its health checks on banks later this month and which could mean other Italian lenders will have their feet to the fire.
   
A huge bad debt burden is poison for the economy as it restricts the amount of money that banks can lend to businesses, thus holding back growth.
   
The Italian economy has been ticking along with tepid if any growth the past few years, failing to recover much ground lost following the global economic and eurozone crises.

Italy has tried

Italy has been trying to tackle the bad debt issue but it poses political as well as economic difficulties for the government of Prime Minister Matteo Renzi.
   
He has been hamstrung by new eurozone rules with restrict bailing out banks with public money without requiring investors to also bear part of the burden.
   
That is particularly difficult in Italy as bonds issued by banks have been popular among small investors looking for interest income given the ultralow rates.
   
An effort to restructure four banks angered small investors who lost part of their funds.
   
The government then organised the creation of the €4.25-billion Atlante fund backed by private funds to take bad loans off banks.
   
When banks sell bad loans, they usually do so at a fraction of the original amount, thus forcing them to realize a huge loss and usually requiring investors to pump more capital into the bank so it can meet regulations to resume lending.

German block

Given the poor economic outlook, finding willing investors can become difficult. As the value of Italian bank shares have fallen by over half since the start of the year, existing investors have to pump in large sums or see their existing stakes diluted considerably.
   
Renzi has sought an exemption to allow a state bailout of banks, but Germany has opposed rewriting the rulebook every time there is a new problem.
   
Italy is in negotiations with the ECB and the European Commission to find a way forward and avoid taking the path that eventually led Spain to seek an EU bailout for its banks in 2012.
   
The Italian daily La Repubblica reported Wednesday that under a plan that Rome and Brussels have been discussing for days would “see the Commission give a green light to Italy to take advantage of the exemptions … to be applied in the case of systemic risk and in the wake of Brexit.”
   
The newspaper said the existing Atlante fund plus others and another to be created, would relieve BMPS of a good chunk of its €47 billion euros in bad debt and inject €5-6 billion euros of fresh capital into the lender.
   
The business daily Il Sole 24 Ore said the solution would involve state guarantees on the capital invested into the banks.
   
“That's how the state intends to come to the rescue of BMPS, in a move that, if necessary, may be useful for other institutions too,” said the newspaper.
   
Renzi has a lot at stake as a failure to avoid a banking crisis would not only endanger the economy, but complicate his effort to have constitutional reforms approved in an October referendum.
   
He has threatened to step down if voters reject the measures that aim to make Italy more governable, and Renzi's departure could open the way for further electoral successes for populists who want a vote on abandoning the euro.
   
An Italian banking crisis also risks rippling throughout the eurozone.

'Eurozone banking crisis'

“This has the potential to go beyond Italy given the linkages throughout the system,” said Michael Hewson, chief market analyst at CMC Markets.

“If EU leaders can't resolve the problems in the Italian banking sector it could bring the whole sector crashing down,” he told AFP.

“Without an early resolution of these problems there is the risk of yet another eurozone banking crisis,” concurred VTB Capital economist Neil MacKinnon.

Hewson was sceptical of a taxpayer-funded bailout of BMPS, noting it has been unsuccessfully rescued twice in recent years.
   
“No point in throwing more money at it,” he said.