Could Europe be on the cusp of a Lehman moment?

August 23, 2011

By Kathleen Brooks. The opinions expressed are her own.

The euro zone debt crisis has now spread from the sovereigns – after the ECB came in and purchased Italian and Spanish debt – to the banking sector. Although the EU authorities put in place a short-selling ban, which has another week to run, the banking sector is back at the pre-ban levels or in some cases even lower.

Europe’s banks are by and large less capitalised than their U.S. peers. They are also exposed to Europe’s sovereign debt and European loan books. Even if a member state manages to avoid a default, growth is now slowing and we could be in line for another recession that would most likely increase bad debts and further erode banks’ profits.

As if that wasn’t enough, German Chancellor Merkel and French President Sarkozy announced a proposal for a financial transactions tax – a Tobin tax – to pay for bailouts to Greece, Portugal and Ireland. This will be discussed at the next EU summit in September, and if implemented would only make it harder for banks’ to boost their capital bases going forward.

The Basel three global regulatory standards for bank capital adequacy requires the world’s largest banks to boost their Tier 1 capital ratios and to hold higher quality capital as a buffer in case of financial shocks in future. These rules were introduced this year and since then Europe’s banks have been in a rush to raise capital. Pressure was ramped up after stress tests that were released in June showed that 24 banks needed to raise extra capital. Eight banks failed the test, while 16 had core tier 1 capital ratios below the 6 percent threshold.

So the banking sector in Europe was already exposed even before growth started to slow and the sovereign crisis spread to Italy and Spain. If markets get a hint of trouble in the banking sector the rumour mill can go into overdrive. This has driven stocks like Unicredit and Societe Generale lower by 30 percent and 40 percent respectively since the start of August.

Earlier this week there were rumours that some banks had to borrow dollar-based funds from the U.S. Federal Reserve’s swap facilities for foreign banks. This is considered the lender of last resort when you can’t raise money from the inter-bank market. The sums were fairly minimal – EUR500mn and EUR200mn – however, they suggest that some European banks are in trouble and a liquidity crunch could be in the wings.

Rumours and a sharp deterioration in sentiment led to the collapse of Lehman Brothers in 2008, so if the current conditions persist it is not a major stretch of the imagination to see a European financial institution go the same way.

However, we need to keep things in perspective. Back in 2008 Euribor –the inter-bank lending rate – spiked higher threatening to bring down the global financial system. Although the Euribor rate has been rising recently it remains well below the peak of three years ago.

So we may be some way off a full blown liquidity shock in Europe’s banking sector, but the current environment is worrying. The banking sector is the glue that holds an economy together; if it starts to come unstuck the consequences can be severe, as we found out in 2008.

Image — Chocolate bars in Euro banknote design are on display at a candy shop in Vienna, August 19, 2011. REUTERS/Heinz-Peter Bader

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