Italian banks Banco Popolare and Banca Popolare di Milano are in advanced talks to merge, raising the prospect that a consolidation of Italy’s mutual bank sector urged by regulators for 20 years may finally take place.

The talks come as analysts predict Italy’s bank sector faces a tough year with non-performing loans worth 21 per cent of gross domestic product built up during a three-year recession weighing on profitability and lending. This is despite forecasts Italy’s economy could grow 1.4 per cent.

Concerns are especially acute regarding Banca Monte dei Paschi di Siena, Italy’s third-largest bank by assets, and smaller bank Carige, the two worst losers of 2014’s European bank health check which have acknowledged they cannot remain independent. Market regulator Consob banned short selling in both banks this week after sharp share price falls.

Italy’s government set the scene for consolidation of the popolari mutual banks more than a year ago, passing a law which forced the 10 largest banks — with assets worth about €500bn in tangible equity — to convert into joint stock companies by the end of 2016.

The aim of the law, which eradicates the banks’ archaic one shareholder, one vote governance structure, was to spur consolidation to create a third-largest banking group to rival Italy’s biggest banks UniCredit and Intesa Sanpaolo and better the sector’s governance to boost lending to small businesses hit by the recession.

Italian officials also reckoned that spurring popolari consolidation could create buyers for Monte dei Paschi and Carige.

However, despite initial enthusiasm from investors, progress has been slow as the management of the popolari, which are rooted in their local communities, have opposed ceding their positions.

According to people with direct knowledge of the matter, talks between Banco Popolare and Banca Popolare di Milano which began before Christmas are gaining traction as the banks agree crucial points of governance.

In particular, Banco Popolare’s chief executive Pierfrancesco Saviotti, 73, is open to stepping aside to allow Banca Popolare di Milano’s regarded boss Giuseppe Castagna, 53, to take on the role of CEO of the merged bank. A merged bank headquarters would remain in Milan.

Both banks have a market capitalisation of about €4bn, and the parity in market value was also helping the merger talks as the banks were keen to undertake a “merger of equals”, according to people familiar with the matter.

Gary Paulin, co-founder of brokerage Aviate, said Banca Popolare di Milano “remains one of our highest conviction longs within the Italian banking sector along with Mediobanca, Intesa Sanpaolo and UnipolSai”.

Mr Paulin said recent numbers showed improving trends in its core business, even “before the big catalyst – consolidation”

Shares in Banco Popolare were up 5.8 per cent in mid-morning trading. Banca Popolare di Milano was up 4 per cent on market expectations a deal may be close.

Mr Castagna has said he wants to announce a deal by mid-February, allowing him to gain European Central Bank approval ahead of a meeting to convert into a joint stock company in June.

Nonetheless, in a sign of the brinkmanship which bankers expect will continue up until the first merger deal is signed, Banca Popolare di Milano executives on Wednesday were also due to meet top management from larger Brescia-based rival UBI Banca with whom they have held on-off talks for months, according to two people.

Bankers predict once one merger deal is struck, others will follow. “The whole of Italy’s banking sector is about to explode, we are coming to that moment. Once the first guys move you are going to see a scramble for the other assets,” said a senior banker.

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