Europe's troubled banks face a growing squeeze

AP News
Posted: Dec 15, 2011 5:38 PM
Europe's troubled banks face a growing squeeze

Europe's banks are being squeezed from all sides.

They're holding risky government debt. They're struggling to get loans to operate. They're paying higher rates when they do borrow. And regulators want them to build bigger cushions against bad loans.

The banks share the blame for Europe's debt crisis. They enabled governments to pile up too much debt. But they also provide the grease that keeps an economy running. Without them, there can be no recovery.

A flurry of ominous news for Europe's banks has fueled fears about the ability of some to survive the crisis. Many are also concerned that the banks will choke off money to the continent's economy just as it's struggling to eke out growth.

The credit ratings of five large European banks were downgraded this week. Speculation is rising that Commerzbank, Germany's second-largest bank, might need to be nationalized. Others, like UBS and Credit Agricole, are preparing waves of layoffs.

Last week, leaders from more than two dozen European countries crafted an agreement that would force countries to submit their budgets for review and limit the deficits they could run. The goal is to prevent another debt crisis.

Yet since then, doubts have grown over whether that deal will be effective _ or even enacted. European stocks have slid 2 percent. Borrowing costs for Italy and Spain remain at levels considered unsustainable.

The rising uncertainty about whether the crisis can be resolved is having a direct impact on the banks: They're lending less to one another for fear of never being repaid.

It's a dangerous trend. Once credit between banks dries up, fewer loans would flow to businesses and households. Economies would struggle to grow.

Lending is particularly important to European companies, which are more reliant on banks than their counterparts in the United States are. U.S. companies can more easily raise money by issuing bonds. Europe's so-called junk bond market is only a third the size of America's.

And stock-market declines could even increase European companies' dependence on banks. They would make it harder to raise money by issuing stock.

On Thursday, the rates banks charge one another to borrow dollars remained at its highest level since September. That overnight market is vital to banks. Regulators require them to hold a set level of cash at day's end, to satisfy customers who want to withdraw their money. To pay those customers, banks often have to borrow from one another overnight.

A tightening of overnight credit tends to rattle regulators and investors. It was Lehman Brothers' inability to access short-term loans that sped its collapse into bankruptcy in September 2008. Global credit froze as banks feared that others might be vulnerable too.

The rates that banks charge each other for overnight loans has been ticking up. On Thursday, the rate known as LIBOR was 0.1505 percent _ the highest since September.

The European Central Bank has stepped in to lend to banks when no one else has. It supplied banks with euro615.3 billion ($801 billion) to operate their businesses averaged over the three months ending Nov. 8. That's up euro99.1 billion ($129 billion) from what banks needed in the previous three months.

Government bonds of wealthy European countries were long considered safe assets. But as the debt loads of European countries grew, investors began to doubt whether their governments could repay the loans. So they began charging more to lend to those countries.

That fed a vicious circle. The more that governments had to pay to borrow, the more difficulty they had paying it back. Eventually, Greece had to admit it couldn't repay all its loans. That eroded confidence in other eurozone countries. Would Italy renege? Would Spain? France?

Since then, European leaders have struggled to reassure investors that they'll repay their debts and never again succumb to a debt crisis. The ECB has tried to calm markets by offering unlimited loans to banks for up to three years.

But the ECB has so far resisted the one step that many say it must take to prevent a catastrophe: buy government bonds aggressively, to drive down their yields so governments can borrow more cheaply.

The bank's president, Mario Draghi, again rebuffed that idea Thursday. He said governments must take the tough steps to balance budgets.

In the meantime, the value of government bonds keeps sliding. And much of them sit in Europe's banks.

"European banks remain the nexus of most European problems," analyst Huw Van Steenis wrote in a Morgan Stanley research note.

Van Steenis noted that the pressure on the banks ripples through economies. Until the debt crisis erupted, banks used government debt _ traditionally considered their safest assets _ to secure their loans. Now that debt is considered the shakiest assets on their books.

That's making it hard for banks to borrow from each other and lend to homeowners, consumers, businesses. The ECB's October survey showed that banks expected to further tighten lending to businesses through year's end.

Draghi explained this week that the central bank's new offer of three-year loans was meant to encourage lending to the wider economy.

It's unclear whether it will. If nothing else, the move to make credit available to the banks for up to for three years reflected the extraordinary pressure the banks are under. The central banks of the world's wealthiest countries also said this month that they'd make it cheaper for banks to borrow dollars.

That step, though helpful in the short run, hardly provides a long-term solution.

"The systemic support doesn't replace the normal operation of the banking system and the interbank market," said Nicolas Veron, a senior fellow at the Brussels-based economic think tank, Bruegel.

Banks must still produce collateral to secure a loan from the ECB. And while the central bank has relaxed its rules, some banks might be unable to qualify, Veron said.

European regulators want banks to raise more cash and clean up their balance sheets so they can better withstand an economic downturn. The problem is that banks' balance sheets consist mainly of government bonds.

The uncertainty about eurozone governments has sent their bond prices falling and their borrowing costs surging. Few expect the countries to actually default on that debt. But the mere threat of default reduces the value of these assets. So banks are forced to build a bigger cushion of cash. Ultimately, they can't lend as much.

The new rules also force the banks to account for the lower prices on the bonds they hold in determining how much more safe capital they must raise. Veron says this has led banks to sell their bonds cheaply, thereby further driving down their prices. The cycle can then repeat itself.

"What do we see now? Pretty much a repeat" of the buildup to the Lehman collapse, said Christian Hellwig, a professor at the Toulouse School of Economics.


Gogoi contributed from New York. Associated Press writers David McHugh in Frankfurt and Juergen Baetz in Berlin also contributed.