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On Sunday, Italians vote in a referendum to decide whether an amendment to the Constitution proposed by the government should be implemented or not. The vote is not about any financial or economic issue, but its timing and its potential implication for political stability are such that a negative outcome could trigger some financial instability.

Italian banks are still bearing the burden of a significant load of non-performing loans (NPLs). We have discussed the issue of NPLs in the Italian banking sector several times before (see e.g. and ), and there is not much new on this front. As of September 2016, the Bank of Italy was that the total of bad debts in the system was €198.9bn, down from €200bn in August. Table 1 shows updated 2016Q3 gross NPL ratios for some of the biggest Italian banks, showing that the situation is diversified. While some initiatives (such as the guarantee scheme ) have been taken recently, these will likely take time to bear fruit.

The elephant in the room is obviously Monte dei Paschi di Siena (MPS), with its 35% NPL ratio, and a capital raise operation looming at the end of the month. I have discussed the specific problematics of a potential MPS resolution - particularly highlighting the point that 65% of MPS’ total outstanding subordinated debt is held by retail savers, making a bail-in focussed resolution within the BRRD framework potentially very painful. Back in July 2016, I had argued that the best solution for MPS would have been a precautionary recapitalisation with burden sharing for junior debt, protection of senior creditors and a credible reimbursement scheme for those who were wronged due to unlawful practices which should have been better prevented.

The choice was different, specifically to go for a disposal operation on NPLs which hinges on a capital raise of €5bn from private investors. The fear of a potential political backlash from a bail-in of subordinated retail debtholders possibly played a role in this decision, in view of the planned referendum. The fact that the capital increase was scheduled for December 2016 - after the referendum - is probably further evidence in support of that. But this choice now puts the bank in a very difficult and uncertain situation, for a number of reasons.

To put things in perspective let’s first note that a capital increase of €5bn is big in itself: it  amounts to almost 10 times the value of the bank’s current market capitalisation (which is around €600m). To this, the bank is adding a €4.3bn debt-to-equity swap offer, which will run from 28 November until 2 December The bank reportedly communicated to Consob - the Italian public authority responsible for regulating the Italian financial markets - that it expected a take-up of this offer for about €1bn, 25% of the total.

A second problem is timing. The operation is supposed to be initiated right after the referendum, and this has become risky, in view of the uncertainty mounting on the outcome of the vote. Opinion polls now point increasingly to a victory of the NO camp. If this were to happen - especially if NO were to win by a significant margin - the Prime Minister would likely resign and the opposition parties would be strengthened. After amendment of some aspects of the new electoral law - which was drafted in tandem with the constitutional amendment on which Italians are voting - new elections would be held.

The potential consequences of such a situation for financial stability are twofold. First, there would be a transition period that could drag on for a long time. All parties would likely try to pull the amendment of the electoral law in a direction that benefits their electoral prospects. During this period any reform effort would essentially be frozen, and in a country like Italy this is hardly good news.

Second, the outcome of the ensuing elections - with a strengthened 5 Star Movement and possibly a comeback of the centre-right - would heighten political and economic uncertainty. For starters, the idea of a referendum on Italy’s membership of the EU or Euro would probably be central to the 5 Star Movement’s campaign and possibly for the Northern League as well. Contrary to what many seem to believe, such a referendum is not something that can happen overnight. Article 75 of the Italian Constitution in fact states that the ratification of international treaties cannot be subject of a referendum. The Constitution can be amended - we are seeing it now - but it requires gathering a considerable majority in the Parliament and in the country.

Yet, the fact remains that this would be a complicated and uncertain situation, and in this context investors’ interest in the MPS operation could evaporate (and the success of the NPL dismissal operation with it). Attracting foreign capital in politically uncertain circumstances could be already difficult, and the prospect of a potential surge of the 5 Star Movement could complicate things even further, as the prevalent opinion among its members is that MPS shoudl be nationalised. The bank is to have communicated to Consob that there is “no plan B” under study. And admittedly it is hard to see what alternative option would be there, aside from the one discussed this summer.

So the solution to the MPS issue may in fact be back to the option that was available but not taken six months ago, although this “tactical” delay would not be inconsequential. Uncertainty may in fact create spillover effects on other Italian banks, whose NPL situation is also not yet resolved and who are part of a strongly interconnected system. As a matter of fact, interconnection has increased further recently, due to ventures such as the bank-funded Atlas fund that has been acting as a underwriter of last resort in the capital raises of several troubled small banks and that we have discussed at length . Incidentally, one of the early proponents of the Atlas fund has recently that in hindsight it would have been better not to participate.

So, in conclusion, almost six months after the most recently released ECB’s stress tests, the situation of the Italian banking system looks still very uncertain. In the case of a NO victory in the referendum, the success of the planned recapitalisation of MPS is at risk. At that point, the solution to the MPS problem may - somewhat ironically - be back to the one that was available six months ago. But this time there would be the downside of having to take action in a context of heightened political and economic uncertainty. This could create significant spillovers for the rest of the banking system. For now, all we can do is wait until Sunday, and see.