Italy dealt a surprise blow to its banks and sent shockwaves across the sector in Europe by setting a one-off 40% tax on profits reaped from higher interest rates, after reprimanding lenders for failing to reward depositors. Sharply higher official interest rates have yielded record profits for banks, as the cost of loans soared while lenders held off paying more on deposits. European bank shares tumbled on Tuesday. A gauge of euro zone banks fell 4.5%, and was set for its biggest daily drop since the turmoil in the banking sector in March, when Credit Suisse collapsed. Italian Prime Minister Giorgia Meloni’s government had floated the idea earlier in the year, but appeared to have cooled on the plan. Since then, however, bumper first-half results from banks brought the issue back into focus and prompted the government to act on the eve of the summer political shutdown. All main Italian lenders reported much stronger than expected results for the first six months and upgraded their profit outlook thanks to higher rates. Lenders in Italy have passed on to depositors on average 12% of the rise in rates, versus 22% in the euro area, Jefferies has calculated. “One has only to look at banks’ first-half profits … to realize that we are not talking about a few millions, but … of billions,” Deputy Prime Minister Matteo Salvini told a news conference in Rome late on Monday. Italy’s banking share index plunged 7.7% on Tuesday, with sector leader Intesa Sanpaolo\n \n (IITSF) down 8.4% and rival UniCredit \n \n (UNCFF)down 7% “These government interventions in Europe do not help provide the necessary stability to lower the risk premium attached to the eurozone. This is not just an Italian thing, Spain had done the same last year,” said Gilles Guibout, head of equity strategies at Axa Investment Managers in Paris. Analysts at Bank of America estimated the new tax could cost Italian banks between 2% and 9% of their earnings. The fall-out touched other banks in the currency bloc, including Spain’s Banco Santander\n \n (BCDRF) and Germany’s Deutsche Bank\n \n (DB), which both fell more than 4%. For 2023 alone, Italy will tax 40% of banks’ net interest margin, a measure of income banks derive from the gap between lending and deposit rates. The government expects to collect less than 3 billion euros ($3.3 billion) from the measure, sources close to the matter told Reuters. Proceeds from the windfall tax will be used to help mortgage holders and cut taxes, Italy’s deputy prime minister said. “The tax that Italy has levied on the excess profits that banks are perceived to be making has come as a surprise and is likely raising concerns that over countries could follow Italy’s example,” said Stuart Cole, chief macro economist at Equiti Capital. Italy is not the only country to impose windfall taxes or bank-specific duties in Europe. In December 2022, Spain approved a temporary bank levy to raise 3 billion euros by 2024, aimed at measures to ease cost of living pressures.