A nun walks under the Bernini colonnade in St. Peter's Square at the Vatican, Friday, Feb. 15, 2013. Pope Benedict XVI signed off on one of the last major appointments of his papacy Friday, approving a German lawyer and financier to head the Vatican's embattled bank. (Alessandra Tarantino/AP)

Inside a 13th-century monastery in a sleepy village north of Rome, the Rev. Salvatore Palumbo was allegedly serving more than one higher authority. Italian prosecutors say a Ferrari-driving lawyer who defrauded insurance companies used the priest as a frontman, with Palumbo stashing the illicit cash inside the secretive Institute for Works of Religion.

A.k.a. the Vatican Bank.

The arrests over the past six months of Palumbo and the 34-year-old lawyer, Simone Fazzari, highlight one major source of the scandals and power struggles that observers say contributed to Pope Benedict XVI’s historic resignation this week — the murky world of Vatican finances.

With ATMs offering transactions in Latin and a castle-like headquarters protected by spear-toting Swiss Guards, the financial arm of the Vatican has never been a run-of-the-mill bank. But a sense of crisis has been building around it and other Vatican financial dealings.

Last month, Italy barred its own banks from doing business in the Holy See, citing a lack of transparency by the city-state’s financial apparatus that has routinely declined to release data on accounts held there by church bodies, clergy, foreign embassies and lay entities related to the Vatican. The move cut off credit card processing at Vatican commercial sites including the Sistine Chapel, effectively forcing them to go cash-only. This week, plastic was finally welcomed again in Vatican City, but only after church authorities cut a deal with a Swiss firm that is not subject to European Union banking laws.

The quickest papal election since 1903 was in 1939 for Pope Pius XII, with only three rounds of voting over two days.

That followed a series of Italian money-laundering investigations, including one that led to the 2010 seizure of nearly $30 million worth of Vatican Bank holdings kept outside the Holy See.

Evidence suggests the outgoing pope sought to shed light on the dark Vatican books, but that effort yielded even more controversy. The former president of the Vatican Bank, Ettore Gotti Tedeschi, was forced to resign in May, alleging he was fired for getting “too close to the truth.” Last year, other documents leaked by the pope’s butler and other sources revealed the depth of the internal tug of war over financial transparency, with Vatican reformers pitted against traditionalists who appeared to believe the church should answer only to a higher power.

On Friday, the pope backed a decision by a commission of cardinals to name Ernst von Freyberg to head the Vatican Bank. The German-born lawyer and member of the ancient Knights of Malta was selected, the Vatican said, because of “his vast experience.” However, Italian commentators were quick to question why the choice was not left to the incoming pope.

“It seems like an attempt to force the situation, not to leave the new pope an option,” said Massimo Franco, author of “The Crisis of the Vatican Empire” and a columnist at Corriere della Sera. “I find it quite strange that this is the last major act of the pope.”

Vatican officials and the pope have cited age and declining health for the first voluntary resignation of a pontiff in several centuries. But in the end, Vatican observers believe a steady barrage of scandals — not the least of those over financial transparency — took a toll on a formidable theologian, who came to the throne of St. Peter on a mission to reinvigorate the church.“It is very clear that Benedict suffered a lot from the revelations of scandal, from the infighting and intrigue at the Vatican Bank and within the Roman curia,” or the Catholic Church’s governing body, said John Thavis, author of “The Vatican Diaries” and a longtime correspondent for the Catholic News Service. “Did that affect the pope’s decision? A lot of people inside the Vatican believe it did.”

Little from Vatican

The day after Benedict’s triumphant return from a historic visit to Britain in September 2010, he was greeted with unwelcome news at the Vatican. Italian authorities had seized nearly $30 million worth of Vatican Bank funds that the Holy See was seeking to transfer out of Italy’s Credito Artigiano bank.

With $8.3 billion in assets, 33,000 accounts and a distribution network in more than 100 countries, the Vatican Bank often moved funds from one destination to another. Yet officials familiar with the case said they were struck by the size of the transaction and demanded to know where the money had come from.

But the Vatican wasn’t telling.

Financial scandal at the Vatican was nothing new. In the 1980s, Banco Ambrosiano, a financial institution largely owned by the Vatican Bank, became embroiled in a money-laundering scandal related to the Sicilian mafia. In June 1982, Ambrosiano’s former chairman, Roberto Calvi — dubbed “God’s banker” by the Italian media — was found hanging from London’s Blackfriars Bridge in a death that was ruled a homicide and has yet to be solved.

There have been more recent cases of alleged criminality related to the Vatican Bank, including that of Palumbo, who is awaiting trial and has denied charges of using the institution’s secrecy to veil a money-laundering ring. But more frequent have been what Italian prosecutors describe as a haughty resistance to European Union laws forcing banks to prove the legitimacy of funds.

Letters of inquiry, prosecutors said, have often been sent to the sovereign city-state only to go unanswered or be tersely rejected. In the case of the $30 million, for example, Italian government officials say they have spent almost three years seeking evidence that the funds are legal.

“It's a matter of fact that the collaboration between the anti-money-laundering authorities of Italy and Vatican City have been interrupted, and requests for information have not received useful answers,” Rome Deputy Prosecutor Nello Rossi said.

In December 2010, however, Benedict took a landmark step toward transparency, issuing a motu proprio, or papal letter, forbidding money laundering and the financing of terrorism. More importantly, for the first time, he established an independent Vatican watchdog, the Financial Intelligence Authority.

Yet subsequent events seemed to undermine his mission. Tedeschi, the Italian economist appointed president of the Vatican Bank in 2009 and who claimed to be an anti-corruption crusader, was fired in May by the bank’s board because of negligence. The banker also became the target of Naples prosecutors investigating money laundering, allegations Tedeschi has denied.

Last June, an explosive dossier from his time at the bank was seized by Italian authorities and leaked to the news media. In it, according to Corriere della Sera, Tedeschi wrote of a power struggle inside the bank over reform, citing deep resistance “when I asked for information about bank accounts that did not belong to priests.” Referring to the 2010 seizure of the $30 million, he wrote that he had been in favor of releasing data to Italian authorities but had been blocked by powerful forces within the bank.

Last year, in a cache of documents leaked by the pope’s butler, fresh details emerged of the broader quest to clean up administrative corruption within the Vatican. The incident showed how difficult it has been for the Holy See to maintain its traditional airtight secrecy in an age of voracious media, digital or otherwise.

‘Encouraging’ signs

Yet even as scandal swirled, the Vatican has also appeared to take genuine strides toward transparency. In September, it hired Rene Brulhart — a wunderkind Swiss lawyer who helped clean up the dodgy reputation of Liechtenstein’s banking system — as a special adviser, quickly promoting him to the head of the Financial Information Authority. Under his direction, the agency is thought to be formulating a series of major directives aimed at pushing the city-state toward a deeper embrace of international banking norms, with announcements expected in the coming weeks.

In a report by an E.U. commission last year, the Vatican Bank was also found to be mostly compliant with anti-money-laundering standards and was praised for coming “a long way in a very short period of time.” However, the committee said, the bank lags in monitoring suspicious activities and carrying out sufficient due diligence.

“We have informed everybody very well of the path that we are following to be a part of the international system of controls on money laundering, and we have been doing so for two full years,” said the Rev. Federico Lombardi, the Vatican’s spokesman. He called the E.U. commission report “encouraging,” adding that “they’ve also signaled the points we need to improve, and we’re working on that.”

Stefani Pitrelli in Rome and Eliza Mackintosh in London contributed to this report.