A cold wind is blowing from the City of London to the shores of Frankfurt's Main River—and it has nothing to do with winter. Instead, the chill sweeping across the Continent's financial capitals owes to Europe's worsening economy, as analysts and policymakers revise downward their estimates for 2009 and banks come under renewed suspicion over the health of their balance sheets.
The devastation in just the past few days—especially in Britain—has been nothing short of breathtaking. On Jan. 19, British Prime Minister Gordon Brown unveiled a new program to provide banks with unlimited insurance against further multibillion-pound losses and a £50 billion ($73 billion) fund to buy high-quality but illiquid securities. Yet if anything, the latest bailout plan seems only to have made investors more skittish: Shares in giants such as Barclays (BCS) and the "new" Lloyds (LLOY.L), formed by the government-engineered merger of Lloyds TSB and Halifax Bank of Scotland (HBOS), have since tumbled by 40% and 56%, respectively.
Financial institutions on the Continent are also suffering from increased investor anxiety. Germany's stalwart Deutsche Bank (DB) is off more than 27% since it announced on Jan. 14 that it would post an unexpected 2008 loss of $6.3 billion from winding down exposure to risky financial investments. France's top bank, BNP Paribas (BNPP.PA), is down nearly 30% over the same period. And even Spain's thriving Santander (STD) is off 12% in the past week.
The common theme provoking the banking meltdown is increased worry over the European and global economy. To be sure, there are still concerns over exposure to bad American debt—everything from risky hedge funds to monies parked in the alleged pyramid scheme run by banker Bernie Madoff. But now, with European gross domestic product in decline, unemployment rising, and market sentiment on the skids, investors are increasingly nervous about homegrown issues: the danger of local loan defaults, asset writedowns, and continued sluggish lending.
Not Near the End
"Last year, it was the banks that almost brought down the economy. Now, it's the economy that's threatening the banks," says Pete Hahn, a fellow at City University's Cass Business School in London and a former managing director at Citigroup (C). "We are no way near the bottom of this problem yet."
Nowhere is the situation worse than in Britain. Last October, British banks got a £50 billion (now $69 billion) cash injection from the government. But now the country is entering its third consecutive quarter of negative growth and most economists expect GDP to contract by at least 2% this year. Unemployment has jumped by two percentage points, to 6.1%, over the last 18 months, home prices fell 16% in 2008, and consumer confidence is at a 30-year low.
For banks, that's translating into renewed balance-sheet risk. Nonperforming loans are on the rise and dozens of businesses are folding each day. No institution has been harder hit by such concerns than the Royal Bank of Scotland (RBS.L), which was flying high just a year ago when it anchored a joint takeover of Holland's ABN Amro. On Jan. 19, RBS—now 70% owned by the British government thanks to an emergency rescue last year—announced annual losses that could hit £28 billion ($38.6 billion), the largest in British corporate history.
Investors weren't reassured by the government's backing and drove RBS shares down 66% in a single day. The bank is now worth just $6.8 billion, compared with $80 billion a year ago. "U.K. domestic banks are high-risk stocks at the moment," says analyst James Irvine at brokerage Dresdner Kleinwort in London.
Ireland's Banking Crisis
The same certainly applies in Ireland, which was one of the euro zone's economic success stories over the past decade but has recently hit a wall. The economy there is now expected to contract 4.6% this year (compared with a 6% jump in 2007), and unemployment could skyrocket to 12%, up from 4.6% at the end of 2007. The downturn is whacking Irish banks. On Jan. 15 the government was forced to nationalize Anglo Irish Bank (ANGL.I)—the country's third-largest lender—after the tumbling domestic real estate market left the bank highly exposed to now-illiquid international money markets.
The country's two biggest banks, Allied Irish Banks (AIB) and Bank of Ireland (IRE), have also received state aid of $2 billion and $2.5 billion, respectively. Yet since the government nationalized Anglo Irish, both banks have subsequently lost more than half of their market value on fears that politicians may have to rescue them as well.
Continental banks are faring better but still feeling pressure. On Jan. 21 the French government announced a $13.6 billion cash injection into the domestic banking sector, taking total state aid to the French financial-services industry since last year to $27.2 billion. So far, only SociÉtÉ GÉnÉrale (SOGN.PA), France's second-largest bank, has agreed to a further $2.2 billion recapitalization, although analysts expect the country's other major institutions, BNP Paribas and CrÉdit Agricole (CAGR.PA), to accept similar bailouts.
"The [French] government's capital injection is not intended to compensate for weakness or failures. Rather, it is to head off any potential future problems," Bank of France Governor Christian Noyer told a conference in Abu Dhabi on Jan. 21.
In Germany—Europe's largest economy—those problems have already started to hit. Munich-based Hypo Real Estate Bank (HRXG.DE), which has been battered by its investments in subprime loans, disclosed on Jan. 20 that the German government's Financial Markets Stabilization Fund has granted it an additional $15.4 billion in loan guarantees. The move brings the total aid the bank has received to $54 billion.
In addition, Frankfurt-based DZ Bank (ENEA.F), which acts as the central institution for the nation's cooperative banks, said on Jan. 20 that it lost $1.3 billion in the fourth quarter because of its exposure to troubled Icelandic banks and insolvent U.S. investment firm Lehman Brothers. The cooperative institutions that own DZ Bank have pledged $1.3 billion in fresh capital to keep the bank afloat.
Coming just a week after Deutsche Bank announced its unexpectedly large loss, the new revelations fueled fears that Germany's banking crisis is more severe than previously thought. A study by Germany's bank regulator estimates that banks there could be carrying as much $300 billion in bad debt on their books that may need to be written down, in addition to the $100 billion they have already reported. A spokesman for the regulator said the study is confidential and couldn't comment.
The Chill Is Just Settling In
How much worse could it get? In Britain, at least, the specter of potential nationalization looms just over the horizon. The government has already taken over two failed mortgage lenders, Northern Rock (NRKX.L) and Bradford & Bingley (BBP.L). Now the City is rife with rumors the government might pick up the 30% of RBS it doesn't already own—another reason the bank's shares have cratered.
In the view of Cass Business School's Hahn, the British government would like to avoid further nationalizations but may have to bite the bullet. Public officials won't necessarily run the banks better; they'll simply provide safer cover for debt. "You can't ask civil servants to manage complex financial instruments," Hahn says. "The government would be getting into uncharted territory."
True enough, but further drastic measures could be in the cards if the economies of Britain and its European counterparts continue to worsen. Economists now figure the global downturn will last well into 2010 and that banks will write down billions more in questionable assets between now and then. The chill could be here for a while.