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The Financial Crisis Returns: Europe's Attention Shifts to Its Ailing Banks

Sovereign bonds were once considered among the safest of all investments. Yet with Greece teetering and several more euro-zone countries on the watch list, the Continent's banks are in trouble. The European Union is struggling to come up with an antidote. By SPIEGEL Staff

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The mood was decidedly somber last Thursday as Jean-Claude Trichet put in his last appearance as the president of the European Central Bank (ECB) following a meeting of the institution's governing council. There was no farewell gift and no bouquet of flowers -- only a few words of praise from Jens Weidmann, the president of Germany's central bank, the Bundesbank.

Trichet briefly acknowledged that he was "deeply moved" by the tribute from his German colleague. Then the Frenchman, who will be replaced by Italy's Mario Draghi at the end of this month as the head of Europe's currency watchdog, turned to the latest casualty of the euro crisis: The banks.

Three years after the collapse of the Lehman Brothers investment bank in September 2008, the crisis is heading toward a new peak. The banks no longer trust each other and, during the past week, prices of insurance policies to protect investors in the event that credit institutions go bankrupt have soared to the highest levels ever observed. Only the central banks are considered safe havens and are flooded with money from financial institutions.

Even US President Barack Obama is anxiously watching as events unfold in Europe. He recently stated publicly that the events transpiring on the other side of the Atlantic currently represent the greatest threat to the American economy. "You must act fast," he told the Europeans, adding that there needs to be a "very clear, concrete plan of action that is sufficient to the task."

Back in 2008, the threat came from America. At the time, the US government allowed Lehman Brothers to go bankrupt -- and unleashed a financial tsunami that drove large parts of the global economy into a recession and cost millions of jobs.

Extremely Precarious Situation

Now, it has become apparent that the danger from the heart of the financial world has not yet been eliminated. This time, though, it is emanating from Europe. With leading politicians and economists saying that the cash-strapped Greeks will soon require substantial debt relief, Europe's financial institutions find themselves in an extremely precarious situation.

Many banks still hold billions of euros in government bonds from Greece and other debt-stricken European countries. If these securities tumble in value, the institutions involved could face bankruptcy themselves. In the financial sector there is a growing fear of a chain reaction -- and of a second meltdown in the banking sector. The supply of money to business and industry could soon dry up, sparking a new credit crunch.

As a precautionary measure, ECB President Trichet has turned on the money pump again. Over the coming months, the banks will have access to virtually unlimited liquidity from the ECB.

Furthermore, European heads of government are debating a new radical program. It has become apparent that a number of European banks will have to be nationalized and plans call for the money to finance this move to come, at least in part, from the European Financial Stability Facility (EFSF), the temporary euro backstop fund.

It was only in early September that Christine Lagarde, as the new head of the International Monetary Fund (IMF), was heavily criticized after she suggested that European banks would need some €200 billion ($267 billion) in additional capital. Now though, following a meeting with German Chancellor Angela Merkel and World Bank President Robert Zoellick last week in Berlin to discuss the banking crisis, it is clear that everyone agrees on the gravity of the situation.

Zero Risk?

The problems are immense. The European debt crisis involves a type of investment long considered to be one of the soundest available -- government bonds issued by European countries. It is a situation which has taken politicians by surprise as well, as can be seen by existing regulations regarding the assessment of risk posed by sovereign bond investments. When determining how much equity capital banks need as a buffer, the risk of financial loss associated with government bonds is considered to be zero.

In the middle of the year, many banks were already forced to write off 21 percent of their Greek bonds due to the impending debt reduction, known as a "haircut." That, though, likely won't be enough. Greek bonds may soon lose half their value -- if not more.

German financial institutions would likely be able to absorb such losses. The country's 13 largest banks have reduced their Greece-related risks to €5.6 billion.

But what if other European countries are affected by the turmoil? Currently, Italian and Portuguese government bonds are only being traded at a steep discount. If Greece were to default on its loans, the market value of these bonds would plummet even further.

US investment bank JP Morgan suggests a scenario in which Greek bonds have to be written down by 60 percent, Portuguese and Irish bonds by 40 percent and Italian and Spanish bonds by 20 percent on bank balance sheets. Due to these writedowns alone, JP Morgan says that European banks require an extra €54 billion. Analysts at Morgan Stanley even recommend up to €150 billion more in capital.

Signs of Trouble

French banks are particularly vulnerable, as demonstrated by last week's collapse of the troubled Belgian-French bank Dexia. After being bailed out in 2008, it now has to be rescued a second time with public funds from France, Belgium and Luxembourg. The Dexia Group holds €21 billion worth of sovereign bonds from ailing euro-zone countries. BNP Paribas also has more than €20 billion in Italian government bonds on its books while Spain owes the French bank some €2.5 billion. Furthermore, BNP and Dexia together constitute Greece's leading foreign creditor with approximately €4 billion.

France's banks are now showing signs of trouble. The venerable commercial bank Société Générale has lost 50 percent of its share value since the beginning of the year. It, along with Crédit Agricole, was recently downgraded by the US rating agency Moody's. To make matters worse, both banks have Greek subsidiaries that have been dragged down by the crisis.

On top of that, the French will find it increasingly difficult to raise money on a daily basis to meet their ongoing obligations. They are much more dependent than other European financial institutions on cash injections from powerful US money market funds. These investment funds, which manage a total of $1.5 trillion, are specialized in such short-term transactions.

Such lenders, however, immediately cut all lines of credit if any doubts arise over whether they will be repaid. According to the Fitch rating agency, the funds are setting increasingly tighter deadlines. Nearly 30 percent of the French securities traded by the 10 largest US money market funds only have terms of up to seven days. Dexia's rapid collapse shows what happens when the cash flow suddenly stops.

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