Danger everywhere: The debt crisis in Europe is draining confidence in banks

Economist
October 8, 2011

“This brutal lack of confidence” is how the chief executive of one of Europe’s biggest banks describes the situation facing his firm and its peers. The catalogue of troubles afflicting the institution (call it Bank X, so as not to punish it for its candour) shows how worrying the outlook has become for big banks, and hence for the real economy.

A bank-funding crisis that started on Europe’s periphery with worries over Greek, Irish and Spanish banks has now infected the core of the West’s financial system. The governments of France and Belgium said this week they would stand behind the debts of Dexia, a perennially troubled lender, while also engineering a break-up of the bank. Across the Atlantic shares in American banks whipsawed on worries about a Greek default and rumours of policy breakthroughs.

For Bank X, the most pressing issue is a freezing of funding markets as investors ponder the potential impact of losses that banks may take on their holdings of euro-zone government bonds. American money-market funds have almost completely withdrawn dollar funding from European banks over the past few months. This is forcing them to sell dollar assets. Some of these transactions will do no harm to the sellers: there are buyers at reasonable prices. But Bank X is also cutting traditional banking activities denominated in dollars. Some of these include critical functions such as trade finance.

A bigger worry is a freeze in euro funding. Institutional bondholders such as pension funds and insurers have refused to buy unsecured European bank debt in any meaningful quantities since early summer, and balk entirely at durations longer than two years. “There are a lot of banks that would be willing to give away assets if they could, just so they don’t have to fund them,” says one investment banker. Bank X is trimming euro assets, accelerating plans to cut the size of its balance-sheet. Other lenders are doing the same. That risks driving down asset prices, forcing lots of banks to mark down equivalent assets and erode capital. Deleveraging also means a reduction in lending activity.

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