March 27 (Bloomberg) -- Were it not for some shady derivatives trades carried out by the world’s oldest bank, Banca Monte dei Paschi di Siena SpA, Italy’s most recent parliamentary elections might have produced a government.

When Bloomberg News on Jan. 17 broke the first details of derivatives transactions that the bailed-out Monte dei Paschi made to hide losses, the election campaign was in full flight. Many Italians were planning to vote for Pier Luigi Bersani’s center-left Democratic Party, tired of the endless conflicts of interest and political corruption that former Prime Minister Silvio Berlusconi had come to represent.

Yet the Democratic Party ran the philanthropic foundation that, in turn, controlled Monte dei Paschi. The foundation for years had chosen the bank’s top executives, meddled in investment decisions and determined how the bank’s largess, via dividends, should be distributed in Siena. As more revelations followed, the Monte dei Paschi affair seemed for many Italians proof that their entire political system was rotten. Bersani’s sizable lead began to evaporate, and by election day no party had enough support to form a government.

The story of Italy’s 88 bank foundations that Elisa Martinuzzi lays out in the May issue of Bloomberg Markets magazine is one of good intentions gone awry. The foundations were in many ways virtuous. They were meant to help move the country’s banking system from state to private control. Foundation ownership meant that bank dividends went to philanthropic causes.

The banking system that resulted did a decent job as far as the wider society was concerned. Italy spent slightly less than 0.3 percent of annual gross domestic product recapitalizing its banking sector from 2008 to 2011, compared with 2.5 percent of GDP in Germany and 40 percent of GDP in Ireland, according to data from the European Commission.

Still, the foundation system proved susceptible to the weaknesses that hobble Italy’s political economy, namely patronage and corruption. Some foundations, such as Fondazione Monte dei Paschi di Siena, held onto their bank shares, partly because they offered too useful and lucrative a political tool. No wonder former Treasury Minister Giuliano Amato, who drew up the 1990 law that set up the foundations, recently called his creations Frankensteins.

Italians voted against their political system in February. Beppe Grillo’s Five Star Movement, which calls for erasing the entire political structure, won a quarter of the vote. Grillo then ruled out supporting any of the traditional parties in government, forcing a period of gridlock. Italy’s economy is too fragile for such uncertainty, which is helping to choke off desperately needed flows of bank credit.

More than a month after the elections, negotiations to form a government continue. Time is running out for Bersani. Grillo should play a positive role by pledging Bersani enough votes in the Senate to control it (the Democratic Party already has a majority in the House), in exchange for commitments to a handful of Five Star Movement demands such reforms to the electoral system. Achieving that alone would earn Grillo a place in Italy’s history books.

There are alternatives, but they’re less attractive. Fresh elections might produce more votes for Grillo, but quite possibly no clear majority again, meaning an extended period of uncertainty. A grand coalition between Bersani’s left and Berlusconi’s right would involve the kind of horse-trading within the old political elite that Grillo and many Italians want to end.

Whatever shape the next government takes, it can go a small way toward restoring confidence in the system by ensuring that local governments and party officials can no longer appoint foundation directors, and by forcing foundations that still have large bank stakes to sell them. Italy needs to complete the transition to private ownership that its financial sector began more than 20 years ago.

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