In a surprise move on Tuesday, Italy approved a one-off 40% tax on the profits banks make from higher interest rates.
The move comes as a sharp rise in official interest rates has resulted in double profits for Italian banks.
The proceeds from the tax will be used to reduce taxes and offer financial support to mortgage holders.
Even so, Italian banks say the 'windfall' tax will have a significant negative impact on the sector.
The sudden move was approved by members of Prime Minister Giorgia Meloni's cabinet during a meeting yesterday.
They pledged to invest the funds raised to help households and businesses struggling with borrowing costs.
The tax will be applied to the net interest income that comes from the gap between loan rates and bank deposits.
Around €2 billion is reportedly expected to be generated from the levy, which will be used to fund support for families hit by higher interest rates.
The Italian Parliament now has 60 days to pass the tax decree into law.
As a result of the action, Italian banking stocks suffered a sharp decline on Tuesday (European session), with BPER Banca falling 10% and Banco BPM down 9%, while Intesa Sanpaolo and Finecobank each fell over 8% and UniCredit fell over 6%. .
The impact was also seen outside Italy, where Germany's Commerzbank fell around 3.2% and Deutsche Bank traded 2% lower.
To reduce the impact, the government stipulated that the tax would not amount to more than 0.1% of the lender's total assets.
