Banks came under deep pressure Tuesday after Italy's right-wing cabinet approved a 40% windfall tax on profits lenders reap from higher interest rates after reprimanding lenders for failing to reward deposits, in a surprise move that sent shares plunging across Europe.

Sharply higher official interest rates have yielded record profits for banks, as lenders were able to hike the cost of loans while holding off paying more on deposits.

From top Italian bank Intesa Sanpaolo to Unicredit and Monte dei Paschi di Siena, lenders lost between 6% and 8% in early morning trading in Milan on the news of the tax, adopted by Prime Minister Giorgia Meloni's ministers late Monday.

Meloni's government had floated the idea of a windfall tax on banks earlier in the year but appeared to have cooled on the plan.

A senior banking executive told Reuters that lenders had been ready for "the chopping block, but then the axe didn't come down."

Since then, however, bumper first-half results from banks brought the issue starkly into focus once again and prompted the government to act on the eve of the summer political shutdown.

One source said the plan came as a surprise even to some ministers at Monday night's cabinet meeting.

Italy's banking share index plunged 7.4% by 0915 GMT on Tuesday, with Intesa Sanpaolo down 8% and UniCredit down 6.5%. Italian banks dragged the European index down 2.4%, with a Moody's downgrade of some U.S. banks also weighing on bank shares.

The government is "using part of the banks' billion-dollar profits to help families and businesses affected by rising interest rates," Deputy Prime Minister Matteo Salvini said on the messaging platform X, formerly known as Twitter.

Salvini told a news conference in Rome late on Monday that the tax would be levied on banks' "surplus profits" generated by the European Central Bank's (ECB) interest rate hikes.

The rate hike by the ECB has boosted banks' profits but increased the cost of money for households and businesses, he said.

Countries such as Spain and Hungary have already imposed windfall taxes on the sector and others may now follow suit. Spain's left-wing government's move drew criticism from the ECB.

Meloni is also using the tax to raise funds for the draft budget for 2024, in part to counter a surprise 0.3% decline in gross domestic product (GDP) in the second quarter of 2023.

The country's right-wing government had repeatedly criticized banks for failing to pass on to depositors the higher cost of money but took action only after the latest round of record earnings reported by banks at the start of August.

Windfall for the Treasury

Citi analysts calculated the tax could wipe nearly a fifth of Italian banks' 2023 net income. Bank of America estimated proceeds of between 2 billion-3 billion euros for the government.

Sources said the Treasury expected to collect less than 3 billion euros ($3.3 billion) from the measure.

That would be similar to the figure of 2.8 billion euros raised by this year's windfall tax on energy companies.

Italy will apply the tax only in 2023 with banks paying the sums by June 30, 2024. The measure applies to the net interest margin (NIM), a measure of income banks derive from the gap between lending and deposit rates.

Italy will tax 40% of the NIM earned in 2022 or 2023 – depending on which sum is bigger – and above-given thresholds for a yearly increase.

Intesa at the end of last month said it expected to pocket over 13.5 billion euros this year from its net interest margin alone.

All main Italian lenders reported much stronger than expected results for the first six months and upgraded their profit outlook thanks to the boost from higher rates.

Intesa saw its net profit jump 80% to 4.2 billion euros in the first half, while its rival heavyweight UniCredit posted a half-yearly net profit of 4.4 billion euros.

Unlike peers in some other European countries, Italian banks never charged for deposits when official rates fell below zero.

Since rates rose, they have cut current account costs but have refused to reward cash held there saying that money is held there for day-by-day use, not as an investment.

"One has only to look at banks' first-half profits... to realize that we are not talking about a few million, but... of billions," Salvini told reporters late on Monday.

"If (it is true that) the burden deriving from the cost of money has... doubled for households and businesses, what current account holders receive has certainly not doubled," Salvini said.

The government wants to use the proceeds to help those struggling with the cost of living such as mortgage holders.

Salvini described the Italian cabinet's move as "common sense," but Francesco Galietti, from the Policy Sonar consultancy, said it was a "hugely controversial tax."

Parliament now has two months to convert the cabinet's decree into law, during which it can be significantly changed.