OREANDA-NEWS. If Italian banks make additional voluntary contributions to the country's deposit insurance fund, this will strengthen our view that weaker Italian banks represent a contingent liability for the country's larger banks whose financial condition is still sufficiently strong to be able to provide support, says Fitch Ratings.

Contributions to the Fondo Interbancario di Tutela dei Depositi (FITD), though modest in absolute terms, will weigh on the sector's already weak profitability. We have taken a number of negative rating actions on Italian banks since mid-2015.

According to media reports, voluntary contributions of EUR700m (up from the current permitted maximum of EUR300m) would initially be used to support small, failing savings banks owned by foundations with limited resources to recapitalise them. The voluntary contributions would avoid the resolution and likely bail-in of bondholders. Increasing the maximum permitted amount requires parliamentary approval, which the press reports will be sought in mid-June.

These banks are very small and typically might be allowed to fail. However, in Italy it is not uncommon for retail investors to subscribe to senior and subordinated bonds issued by banks, and bailing these in could have a negative impact on domestic financial stability.

Four banks representing 1% of sector assets were put into resolution in November 2015, and to comply with burden-sharing principles, subordinated debt issued by these banks was written down. We believe this may have contributed to a loss of confidence in some of the country's weaker banks and triggered deposit outflow during the closing months of 2015 and early 2016.

The authorities have a tough job finding a solution for Italy's failing banks without disrupting financial stability. But bank rescues, even of small players, can be costly in Italy. Resolution costs associated with the four small banks reached EUR4.5bn, borne largely by the country's largest banks. The banking sector also contributed up to EUR300m into a solidarity fund to reimburse retail subordinated bondholders in the four banks. In addition, Italian banks contributed into Atlante, a fund that invests in bank equities and some impaired loan securitisations.

According to the Italian Banking Act, and similar to deposit insurance funds in other countries, FITD can intervene in a bank's restructuring and resolution to prevent its failure - in other words, it can do more than simply pay out depositors on liquidation.

FITD was frequently used in this way to recapitalise ailing banks in the past. But in December 2015, the European Commission ruled that capital provided by FITD to Banca Tercas, although not mandatory and agreed on by a large majority of the fund's members, constituted state aid. This is because FITD's discussions and rescue proposal had been undertaken in conjunction with the Bank of Italy.