Europe's Banks Face a Funding Squeeze

The sovereign debt crisis is making it harder for European banks to borrow money from investors—and each other. Investors are shunning bank debt because they fear the bonds of Greece, Portugal, Spain, and Ireland held by the lenders will plunge in value. European banks held $254 billion in loans to the governments of those four countries at the end of 2009, according to the Bank for International Settlements. Including loans to companies and individuals, the banks' overall exposure to the four countries is $1.58 trillion.

Those numbers have made investors jittery. Bank bond sales slowed in May to the lowest since Lehman Brothers' failure in 2008. The extra yield buyers demand to hold the securities instead of government debt soared to the highest this year, and in early June the cost of insuring bank debt against default nearly matched its record high in March, 2009.

Banks also are wary of each other. Rather than lend excess cash to their peers, banks have been parking it with the European Central Bank. Europe's lenders deposited a record $450 billion in the ECB's overnight deposit facility on June 9, more than in the aftermath of Lehman's collapse. As a result, inter-bank loans with a maturity of more than one month are "rare and expensive," Brice Vandamme, a London-based analyst at Deutsche Bank (DB), wrote in a note to clients on June 9.

That has led banks to rely on the European Central Bank for funding. They tapped the ECB for nearly $150 billion of seven-day cash at its last weekly tender on June 8. "There is a lot of mistrust," said Christoph Rieger, co-head of fixed- income strategy at Commerzbank in Frankfurt. "Banks are trading with the ECB rather than with each other."

Banks' difficulties in raising money will curb their ability to extend loans to companies and consumers, which could threaten the region's recovery, says Morgan Stanley (MS) analyst Huw van Steenis. "Many euro zone countries are dependent on bank lending; thus this is a major issue," he says.

There's no mystery behind the nervousness. The ECB said on May 31 that Europe's banks will have to write down 195 billion euros of bad debt by 2011, on top of the 444 billion euros of writedowns they have already logged, bringing the total to the equivalent of $762 billion. U.S. banks will have written down $885 billion by the end of 2010, the International Monetary Fund said in April.

For banks, "if you're not a quality borrower, you're not going to get funding from the market until you reduce your loan-to-deposit ratio and shrink your balance sheet," says Simon Maughan, an analyst at MF Global in London. "The credit and bond markets are doing their job. Unless you reform, you'll be stuck on government support for the foreseeable future."

The bottom line: Fears about shaky sovereign debt are making it hard for European banks to borrow, potentially harming the region's recovery.

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