So far the economic effects of Britain's Brexit vote have been pretty localised. The pound and business confidence have plummeted and economists have slashed their forecasts for UK growth next year. But there are few signs of contagion from the UK to the rest of the world. The indicators of financial stress which were flashing red in 2008-09 following Lehman's failure, or in 2010-11 at the time of the euro crisis, are at low levels. Brexit is a huge political shock, but it is not a global economic shock.
Around Europe the strongest signs of financial stress come not from the UK but from the Italian banks.
Italy offers a case study in what can go wrong in a banking system. The financial crisis and its aftermath left Italian banks nursing 360 billion euros of non-performing loans – debts on which creditors have not made payments in more than 90 days. Italy's levels of non-performing loans are three times the EU average. If, as is usually the case, most of these non-performing loans are written off it will leave a gaping hole in the banks' balance sheets.
Talk of bank balance sheets and non-performing loans may sound a bit obscure. But, as Lehman's failure in 2008 proves, when banks get into trouble the consequences for the economy can be devastating.
In Italy's case the nightmare is a re-run of the financial crisis – with bank insolvencies, financial instability and a credit crunch triggering a renewed recession. A shrinking economy, in turn, makes it harder for creditors to repay their debts, adding to the banks' mountain of non-performing loans. In the financial crisis the spiral of bank losses weakening the economy was broken by the banks bringing in fresh capital to shore up their balance sheets. Some of the capital was raised from investors, through issuing shares and bonds, but much came in the form of taxpayer bailouts.
Most major economies sustained damage to their banking systems during the financial crisis. What has made Italy's problems acute is the country's low and declining growth rate. Italy's economy is smaller today than it was in 2000. Weak growth has led to a long decline in house prices and fueled non-performing loans in the construction, real estate and consumer sectors. Italy's legal system has added to the banks' problems. It can take years for banks to recover anything from borrowers who stop making interest payments and foreclosures on mortgages can take more than a decade.
In terms of exposure to bad debts, Italy's third largest lender and the world's oldest bank, Monte dei Paschi di Siena, seems to be in the biggest pickle. More than a third of Monte dei Paschi's loans are non-performing. Its share price has dropped more than 50% since Britain's EU referendum. In the European Banking Authority's latest stress tests of 51 European banks released last week Monte dei Paschi was at the bottom of the resilience league table.
The Italian government's solution to the banks problems is to provide a taxpayer-funded injection of capital. But EU rules introduced since the financial crisis allow state bailouts only in conjunction with a 'bail-in' of investors – this forces those who own the debt of banks to suffer losses on their investments. The rules are tough on investors to discourage banks from reckless risk-taking on the basis the state will bail them out if things go wrong.
In Italy bank debt is held not just by big financial institutions but by millions of households as a form of saving. Bailing in such investors would deal a blow to the consumer sector and would cause a political storm.
The timing could hardly be worse for Prime Minister Matteo Renzi's Democratic Party government. It faces a growing challenge from the anti-establishment, eurosceptic 5 Star Movement (M5S), founded by the comedian Beppe Grillo. Having started as a protest movement M5S is now Italy's second largest political party. Following a bruising midterm defeat to M5S in recent local elections, Mr Renzi has staked his leadership on winning an October referendum on constitutional reform.
With the referendum approaching and the growing threat from M5S Mr Renzi is keen to keep voters onside. He wants to get the banking system working and he wants to do it without bailing in millions of ordinary Italian savers. He has seized on the UK's Brexit vote to make the case for relaxation of EU rules on the grounds that Italy's financial stability is at risk. But EU leaders are wary of breaking their own rules lest it be seen as evidence of dysfunction in the EU's institutions and processes.
The stakes are high, and not just for Italy. Some of Germany's biggest lenders have significant exposures to Monte dei Paschi. Market turmoil caused by a financial crisis in Italy could spread to shares in other European banks or to government bonds in nations with high debt levels.
Italy is hoping to keep on the right side of the EU rules by buying bad debts with money from private and state-backed institutions, rather than injecting state money into the banks.
Italy's banking system certainly needs fixing and this could do the trick. Low growth, a weak banking system and political risk are a very challenging combination. Italy, and the euro area, need to get this right.
PS - Most UK surveys, including our own CFO Survey, show that the EU referendum vote hit business confidence hard. The question is whether this represented a lasting or a more temporary shock to confidence. The only survey I've heard of that has been run twice since the referendum is Lloyds' business barometer. Its headline index crashed to a four-year low of six after the referendum vote, but in the latest survey the index has jumped to 29. This is still well below the five-year average, but the bounce suggests that at some of the damage to business confidence wrought by Brexit is likely to be transient.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.