European bank executives are facing the return of an all too familiar problem: political panic.

After years of slowly healing from past crises, European banks have recently had the luxury of turning their focus to boosting profit and shedding bad loans. But the political turmoil in Italy—home to arguably Europe’s most problematic banking sector—has rekindled fears that the euro’s fragility, and authorities’ failure to unify the region’s disparate banking system, will continue to haunt the industry.

As the political temperature rises in Rome, and to a lesser extent in Madrid, European banks have taken the brunt of the pain.

The Euro Stoxx Banks index is down 5% this week following Italian President

Sergio Mattarella’s

move to block the formation of an antiestablishment government. A coming vote in Spain that could depose its pro-market center-right party from power has also rattled investors.

“The whole banking sector was under attack,” said Vincenzo Longo, a strategist at IG Markets.

If it continues, the uncertainty could delay widely anticipated interest rate rises in Europe, a move that would crimp bank profits. It could also hamper a closely watched cleanup operation at Italian lenders, analysts said.

Italian banks have been at the heart of the selloff. The country’s chronically unprofitable lenders have been steadily wading through deep restructuring and shedding bad loans. Fragile investor confidence in the turnaround has been dented by the latest political upheaval.

The negative sentiment also hit French and Spanish banks, which have sizable exposures to Italian government debt. In Portugal—which like Italy has a huge government debt pile—shares of Banco Comercial Português SA, the country’s largest traded bank, were down 12% this week.

European bank share prices stabilized in early trade Wednesday but the hit to investor confidence in the sector was palpable.

This latest instability comes as the European banking sector continues to lick its wounds from the continent’s last debt crisis.

A huge balance sheet clean up remains unfinished, with €813 billion ($938.3 billion) of bad loans—a large chunk of which is in Italy—still sitting on bank balance sheets, according to the European Banking Authority. Meanwhile, reforms aimed at decoupling the “doom loop” in which banks laden with their local government’s debt are sucked into a downward spiral as their home economy deteriorates remain unfinished.

“Whatever is bad for the Italian economy is going to be bad for its banks,” said

Sony

Kapoor, managing director of think tank Re-Define. “That aspect of the loop you simply cannot break.”

But the political turmoil reminds investors that European banks aren’t going to be making outsize profits soon.

Up until the turn of the year investors had predicted that the combination of an economic rebound, banking reforms pushed through by the European Central Bank and rising interest rates would see European bank profits rise to €120 billion this year, says George Karamanos, an analyst at Keefe, Bruyette & Woods. “Are those expectations realistic now?” he asks, adding it is unlikely.

That optimism was particularly visible in Italy. Up until a few months ago Italian banks were the best performing bank stocks in Europe. Political risk was seen as low and investors were cheering on a reduction in bad loans, which had shrunk to €285 billion from €350 billion in the space of a year.  Politics has now dampened that optimism.

In Italy, two antiestablishment parties, whose attempt to form a coalition government failed last Sunday, had struck an agreement on a joint government platform, which included a number of measures for the banking sector.

The two parties planned to scrap a rule allowing banks to recover debts from retail borrowers without going through the courts, which could slow down the cleanup of banks’ balance sheets. They also hinted at the possible full nationalization of Banca Monte dei Paschi di Siena SpA, of which the government owns a majority stake after partially nationalizing it last year.

While their coalition attempt collapsed, they could come back stronger if new elections are called. Talks in Italy continue on how to overcome the political impasse.

That has raised questions over the future of the eurozone—both parties have flirted openly with the idea of pulling Italy out of the euro—and in turn spooked investors and highlighted a wider problem: EU authorities haven’t yet fully fixed the continent’s banking system.

A plan to package eurozone sovereign bonds together to reduce the riskiness of any individual bond within the pool, for example, has been largely shunned by Germany. The German government and other member states whose banks weren’t as hard-hit by the crisis, have also resisted the creation of an EU-wide deposit-insurance program, which would provide safety for depositors no matter their location. A Germany bank official said last week that EU-wide insurance program “probably won’t happen in my lifetime.”

During the last eurozone crisis banks across Europe shed sovereign exposures to riskier periphery markets. However,​ domestic​ banks in those countries still have large exposure to their ​home sovereign debt, particularly as they are treated as safe assets under bank accounting rules. Currently 10 Italian banks have Italian sovereign debt holdings greater than their capital buffers, according to a study by France’s IESEG School of Management.

After Italian banks, French banks are the second most exposed to Italian government debt with €44.27 billion in bonds, followed by Spain with €28 billion of sovereign debt, according to calculations by the EBA. France’s BNP Paribas SA, which has a large Italian bank, and Spain’s Banco de Sabadell SA are among the most exposed to Italy, analysts say.

However, some analysts have played down the risk of another full blown eurozone crisis engulfing the region’s banks.

“We do not expect a disorderly escalation of the situation into a repeat of the sovereign debt crisis,” analysts at

UBS

wrote in a recent note. Unlike years ago, the eurozone’s economy is growing and the ECB is still buying government and company bonds.

“We aren’t getting any panicked calls,” said one banker at a big European lender. European banks have largely already tapped markets to raise their funding for the year, so the latest upheaval isn’t hitting balance sheets yet.

Some investors are even eyeing deals again in Europe, said one major portfolio manager. “It’s starting to look cheap again,” he says.

Write to Max Colchester at max.colchester@wsj.com, Patricia Kowsmann at patricia.kowsmann@wsj.com and Giovanni Legorano at giovanni.legorano@wsj.com

Appeared in the May 31, 2018, print edition as ‘European Lenders Face New Shock.’



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