With serious political risks and the possibility of contagion if left unresolved, a solution to the Italian banking crisis that avoids substantial hits to bank bondholders and creditors is likely. Given the “Brexit” vote less than a month ago, European policymakers are concerned about the future of the Europe project, and a firm application of new rules on bailouts to the problems of Italian banks could stoke populist movements further.

How did the situation reach fever pitch so quickly? In a nutshell, Italian banks’ bad loan problem collided with more stringent rules that came into effect this year, investors’ loss of confidence in bank stocks globally that has seen equity capitalization cut by 23% year-over-year, and tough political choices in Italy that have been made more pressing by the UK’s vote to leave the European Union (EU).

While the bad loan problem is not unique to Italy, the size of the problem is distinct. The European Central Bank’s end of 2014 stress tests of Eurozone banks highlighted Italian banks as trouble spots, and their levels of non-performing loans (NPLs) have only continued to grow, weighing in at approximately €360 billion today, or 18% of total gross loans. Contrast that with Spain, the next highest at 6%, and the size of Italy’s problem becomes clear. Particular banks within Italy have even more NPL exposure, an estimated 30% in some cases.

Further complicating matters are new rules that came into effect this year on how bank bailouts can occur. The EU’s state-aid rules require private sector creditors to first take losses equal to 8% of the bank’s liabilities before the state can provide aid; i.e., before any public money can be injected into a bank in a bailout, there must be a “bail in.” The point of the new regime is to ensure the private sector shares in recapitalizations, resolutions, or restructurings of troubled banks, so that the public sector does not bear the burden alone.

In Italy, retail customers have always been significant holders of Italian banks’ bonds, and the new rules mean that if things go badly, they will suffer losses before any state aid can come to the rescue of the bank. Requiring a bail in of largely retail lenders increases the likelihood of a political crisis in Italy. Italian Prime Minister Matteo Renzi has said he will resign if a package of constitutional changes designed to streamline reforms is not passed in an October referendum, and a bail in would make it more likely that Renzi will lose his referendum. This could open the door to Italy’s populist parties, one of which has already said it would call for a referendum on EU membership.

Earlier this year a concerted effort was made to create a “bad bank” to clean up Italian banks’ balance sheets. Other European countries have already done this, but Italy’s decision to do so was poorly timed, as it decided on a framework for a bad bank at the beginning of 2016, after the state-aid rules had come into effect. A key sticking point is the price at which any NPLs would be sold to the “bad bank,” as a price that’s too low doesn’t help the banks, but a price that’s too high smacks of the state aid that the new rules sought to control. In April, Italy created a new scheme to shore up weak banks: a fund called “Atlas” that has so far provided €3.5 billion in capital to three Italian banks and is launching a project to buy NPLs potentially as soon as the end of this month. However, this scheme likely doesn’t have the scope to fully address Italian banks’ challenges.

Equities of Italian banks have suffered substantial price declines this year and especially since Brexit. This has impacted not only the weaker banks in the country but also the higher quality institutions given the possibility that stronger banks might be called on to buy assets of weaker banks and perhaps take over weak lenders.

To avoid losses by retail investors in any restructurings of banks, Italian authorities might invoke exemption language in the state-aid rules that could shield this class of investors from participation in bail ins. This might mean that these bondholders will have their bond positions converted to equity, and the government could step in to provide additional relief to retail investors.

Next Friday, July 29, the European Banking Authority will publish the results of its latest stress tests. No one expects that the Italian banks will look good in the light of those results, which will put further pressure on Europe and Italy to work out a solution. The political ramifications related to the discussions between Rome and Brussels will likely have far-reaching significance.

Adam Perez is a Senior Investment Director on Cambridge Associates’ Global Investment Research team.