These have precipitated a wave of populism that has rejected the old establishment and brought in a new guard.

Unfortunately, that has done little to resolve another Italian bugaboo: a massive banking crisis.

European banks have accumulated about $1.2 trillion in bad and non-performing loans (NPLs) that have continued weighing down heavily on their balance sheets. Italian banks are sitting on the biggest pile of bad debt: €224.2B ($255.9B), with NPLs and advances making up nearly a quarter of all loans.

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Source: Bloomberg

As if that is not bad enough, the banks now have to contend with potentially heavy penalties coming from Brussels after Italy's recalcitrant leadership refused to revise the country's fiscal 2019 budget to lower debt and borrowing.The sharks can already smell the blood in the water, and investors have been shorting Italian banking stocks to death. Italian banks hold nearly a fifth of the country's government bonds.

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Source: Reuters

Short sellers have mainly been targeting medium-sized lenders as well as asset manager Banca Mediolanum and investment bank Mediobanca. According to FIS Astec Analytics data, the volume of these banks' shares on loan—a good proxy for short interest—has shot to its highest in 15 months.

Short interest on Mediolanum's shares now stands at 8.7 percent of outstanding shares, while Mediobanca has 15 percent of its shares sold short.

Rome Refuses To Back Down

Investors seem justified in their pessimism on the Italian banking sector - if the latest developments are any indication.

A month ago, the European Commission rejected Italy's 2019 budget on grounds that it flouted EU requirements and Italy's commitment to lower its expanding budget deficit. The latest budget hiked the deficit to 2.4 percent of GDP--way higher than the targeted 1.8 percent this year. Meanwhile, total debt sits at a staggering 130 percent of GDP, the fourth highest in the world. The EC rules are clear: national debt should be maintained below 60 percent of GDP while deficit should not exceed three percent of GDP