Something truly scary might be about to take place in Europe. OK, I know what you’re thinking – isn’t something scary already happening in Europe? Greece is heading for a default as politicians and bankers bicker over the terms of its second bailout. Pressure is growing on Italy as its borrowing costs rise. Stocks have been slammed. The euro zone economy could be sinking into a recession. Yes, bad news everywhere. But on top of all that, a new risk is emerging: The intensifying sovereign debt crisis could be expanding into a wider financial sector crisis.
We can see that in how the health of Europe’s banks has become a major concern of investors and policymakers. Bank shares in Europe have been hammered as fears erupt that they are too weak to take the body punches dished out by the euro zone government debt crisis. And once again, the jitters have been exacerbated by a lack of action from both politicians and bank managers across Europe, who continue to insist that no problem exists. If such denial and delusion persists, Europe could end up facing not just a hard-to-solve debt crisis, but also an expensive, destabilizing banking crisis.
The concerns about Europe’s banks have been simmering in the background for some time. Economists have warned that at the core of the euro zone crisis is an unstable support system: Poorly capitalized banks were holding up poorly financed governments, which in turn were expected to back the poorly capitalized banks. As the sovereign debt crisis has escalated, sucking in giant Italy, those fears have only inched closer to becoming reality. Many influential voices have proclaimed that Europe’s banks just don’t’ have the level of capital necessary to withstand a one-two punch of slowing growth and widening debt crisis. They could end up taking a massive smack from losses on their holdings of European sovereign debt. The IMF said recently that Europe’s banks could face more than $400 billion in losses due to the debt crisis. What needs to get done is a major recapitalization of Europe’s banks. Christine Lagarde, managing director of the IMF, made this very point recently:
(European) banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.
We can see that starting to happen. European banks, especially French banks, are having trouble getting financing. Lenders around the world simply don’t want to take on more exposure to a European banking sector burdened with potential losses from weakening euro zone government bonds. These financing problems are what convinced Moody’s to downgrade two French banks this month. If this continues, it could become a big deal, with some serious fallout. Just take a read of PIMCO’s CEO Mohamed El-Erian on the problem:
The rapidly burning fuse is in the European banking system, particularly in France, and Europe is getting very close to yet another tipping point…Private institutions around the world, and even some public ones, have sharply reduced short-term lending to French banks…If it persists, the banks would have no choice but to delever their balance sheets in a very drastic and disorderly fashion. Retail depositors would get edgy and be tempted to follow trading and institutional clients through the exit doors. Europe would thus be thrown into a full-blown banking crisis that aggravates the sovereign debt trap, renders certain another economic recession and significantly worsens the outlook for the global economy.
There is some realization in Europe about the dangers the European banking sector is facing right now. In mid-September, five central banks, including the European Central Bank and the Bank of England, got together to offer dollar loans to Europe’s banks to stabilize the situation. The ECB is expected to extend this program. France’s two largest banks, BNP Paribas and Société Générale, plan to sell assets to shore up their balance sheets. But overall, the response has been insufficient. Yes, they have put their banks through “stress tests,” with the aim of building confidence in their strength, but those tests were widely seen as not tough enough to truly judge the health of European banks. Both policymakers and bank chiefs insist that the banking sector doesn’t require recapitalization.
We can only speculate as to why Europe’s leadership won’t admit to their banking problem. Perhaps they are just hoping statements of confidence will create real confidence among investors (but that never works). Perhaps Europe’s governments don’t want to spend more money bailing out banks. Perhaps corporate managers don’t want to dilute their shareholders.
Whatever the reason, if Europe’s leadership fails to fix their banks, the debt crisis will become an even bigger threat to the global economy. As my colleague Stephen Gandel showed the other day, American banks could take a hit if Europe’s banks falter. Plus, there is no shortage of examples of the dangers economies face when banking-sector ills are not addressed in a timely fashion. Just ask Japan, still suffering two decades after its financial meltdown, in part because politicians failed to tackle its banking problem for half a decade after the country’s financial crisis began. Or look at what became of the U.S. financial sector when American policymakers didn’t react to the looming subprime time bomb. Europe runs the same risk today.