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The oft-times tortuous path of democracy, which can be underestimated, has been fully on display as Greece and now Italy grapple with enormous burdens of government debt.

Signs of European bank sector stabilization dissolved rapidly as the ensuing chaos from continuing protests, political machinations and government turnover added new risks and outright uncertainty. Newly installed technocratic governments in Greece and Italy offer only the hope of apolitical process to address budget deficits, expenditure cuts and other austerity focused measures. While the uncertainty has mitigated, risks to the successful navigation of democratic process and importantly implementation of these measures remain significant – the proposed plans have yet to be implemented.

Last week’s anticipated stabilization of the banking sector has evaporated, undermined on a number of fronts and increasingly self-reinforcing to the downside. While the sector’s capital raising requirements are manageable (€76 billion in new money – see here), the political backdrop has all but created an outright buyer’s strike. With only pockets of capital raising possible, broad access to capital markets is currently questionable and deeper pockets such as sovereign wealth funds are unlikely to be coaxed in.

Consequently, to meet the 9% core Tier 1 ratio requirement, banks are focusing on risk weighted asset reduction – either credit reduction or outright asset sales. Top of the list of asset sales is European peripheral sovereign debt, though simultaneous national pressure is likely forcing these same institutions to purchase domestic sovereign debt. Savvy households behaving rationally are shifting deposits out of weakened banking systems, exacerbating bank funding problems and asset-liability mismatches. This year through the end of August, Greek households have withdrawn €13.5 billion (12%) in deposits – this trend has likely accelerated since then.

In this environment, banks themselves continue to be leery about lending to each other – overnight indexed swap spreads to both LIBOR and EURIBOR have reached Jul 2010 highs and are climbing. Weakened political machinery is increasing cost of new debt funding and piling on fiscal pressure. Credit rating agencies appear poised to continue de-rating EU sovereigns with France fully in the cross-hairs. Against a backdrop of weakened global economic growth, none of this is contributing to reversing or even stabilizing the downward trend.

Viewed as a continuing game of chicken between Germany, France and ECB vs Europe’s periphery and the markets, political risk appetite is notably high. Badly needed instead is political stability and rational decision-making. Cooperation and complimentary actions between EU governments and the ECB are key. The multitude of political voices and opinions already makes for a complicated landscape and benefits from pruning or at least more coherence.

Also importantly, since the flexibility of even a few weeks ago is gone, EU governments need to increase their respective cash funding in the European Financial Stability Fund – current levels are meager and attempting to leverage these is absurd, particularly in current markets. Plainly, EU governments need to take a page from their own playbook – better back-stop their own risks first before passing out the hat to other governments. It cannot be stressed enough that this should be done before there are too few solvent governments left to fund the EFSF. These measures would enable markets to make more reliable assessments of risk. Against this backdrop, evidence of regulatory forbearance is a welcome and needed response for the financial sector.

Positive market reaction to the manageable capital shortfall in the European banking system was short-lived, undermined by political instability. In this current environment, there is no meaningful way to invest in European financials. Externalities are key drivers, reflected in the sharp increase in volatility. A focus on strong franchises offers only partial relief as both market rallies and downturns are mostly indiscriminate. U.S. and emerging market banks continue to offer better prospects.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.