Italy has rejected the idea of setting up a “bad bank” for fear that it will focus market attention on the exposure of Italian banks to a rising level of non-performing loans and put the country’s credit rating at risk.

“Letta [Enrico Letta, Italy’s prime minister] believes the idea of a bad bank may be counterproductive for Italy, and fears this will speed up the process of a further downgrade by rating agencies in the next months,” a government official told the Financial Times.

One industry source said the decision not to face up to the problem was creating a “zombie” banking system where lending to the economy has all but stalled as banks seek to hoard capital.

The government’s opposition to a “bad bank” comes as the governor of the Bank of Italy warned over the weekend that Italy’s economic recovery remained “weak” and “uncertain”.

In a downbeat speech to Italy’s top bankers, Ignazio Visco said lending to Italian companies, particularly smaller firms, had fallen 9 per cent over the past two years.

Moreover, in a sign the Italian government’s opposition to a bad bank is not shared by Italy’s bankers, Mr Visco made the case for Italy’s requiring a bad bank arguing that “more ambitious interventions” were not to be excluded as a means of cleaning up non-performing loans to help free up lending.

Analysts argue Italy could do with a state-sponsored bad bank worth €9bn-€12bn, which Spain and Ireland both introduced after the crisis, to free up lending to Italy’s small and mid-sized enterprises crippled by a long economic crisis.

Gross non-performing loans in Italy reached nearly €150bn in November, rising 22 per cent year on year, according to the latest data from Italy’s banking association.

Internal bad banks are designed to help to wind down non-core assets while encouraging investors to focus on the strengths of the remaining operating business.

Italian banks, including Italy’s largest by assets UniCredit and Intesa Sanpaolo, have already taken moves to clean up their non-performing loan portfolios instead of a state-sponsored solution.

Distressed debt funds, including KKR, are in preliminary discussions with Italian banks, including UniCredit and Intesa, about buying some of their liabilities, according to industry sources. The banks declined to comment.

Intesa Sanpaolo is also considering plans to become the first Italian lender since the financial crisis to set up an internal bad bank by setting aside a chunk of its €55bn of gross non-performing loans, according to people informed of the discussions.

Senior bankers are concerned the absence of a state-sponsored solution for Italy’s rising numbers of bad loans will put its banks in the spotlight during the European asset quality review and stress tests later this year.

In lieu of a “bad bank”, the Bank of Italy is putting pressure on Italy’s banks to post heavy provisions over the next quarters, according to banking sources. Several banks, including Monte dei Paschi, Banca Popolare di Milano and Banco Popolare, are due to raise capital to shore up their balance sheets.

Among these the €3bn recapitalisation of Monte dei Paschi, Italy’s third-largest bank by assets which is the subject of a state bail out, is considered key to ensuring sovereign stability, according to banking sources.

Additional reporting by Anne-Sylvaine Chassany in London

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