European Banks: The Bailouts Continue

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Ireland got the ball rolling on Sept. 30 when the government moved to guarantee all debt and deposits until 2010 at six of the country's banks, at an estimated cost of $578 billion (BusinessWeek.com, 10/1/08). A decision last week in the U.S. to raise the Federal Deposit Insurance Corp. ceiling on consumer bank account protection to $250,000 fueled the trend.

The cat was out of the bag, and suddenly other countries found themselves under pressure to offer comparable protections. Germany's Merkel announced on Oct. 5 that the government would guarantee all private savings, estimated to be worth €500 billion ($679 billion). Authorities in Austria, Denmark, Sweden, and Iceland followed suit with similar plans the next day to assuage consumer fears. Unlike the other plans, Denmark will call on commercial lenders—not the government—to guarantee deposits at an estimated cost of 35 billion kroner ($6.4 billion).

Other European countries are now under pressure to take similar action or risk seeing local depositors move their savings to government-supported foreign banks. Britain alleges this unintended consequence already has distorted competition between Irish and English banks in both countries.

(On Oct. 7, European Union finance ministers meeting in Luxembourg proposed an EU-wide boost in the minimum bank deposit guarantee to €50,000 ($68,460), as well as agreeing to plans to help banks at financial risk.)

Iceland's Overexposure

Perhaps no country has been hit as hard as Iceland. The tiny island's top banks, such as Kaupthing (KAUP.ST) and Landsbanki, had used easy access to foreign capital markets to expand aggressively in recent years. But with the onset of the credit crunch, investors grew wary of Icelandic banks' market exposure, even though they have capital-borrowing ratios comparable to the European average. Only last week, Iceland's government bought a 75% stake in Glitnir, the country's third-largest bank, for $865 million to bolster shareholder confidence.

Now, Prime Minister Geir Haarde has been forced to go further. On Oct. 5 he announced the country's banks had agreed to sell foreign assets and decrease their international activity. The next day, Iceland suspended trading in its domestic banking stocks to protect them from meltdown. It's a question of holding on until the storm has died down a bit, and observers figure Iceland is in the same position as many other countries. "All banks are reliant on short-term funding, and the Icelandic banks no more so than any other," says Richard Portes, professor of economics at the London Business School.

Indeed, all these quick bailout measures and expedited government policy shifts still aren't managing to unclog Europe's frozen capital markets. According to Tower Group's Bob McDowall, uncertainty surrounding future European government action means banks remain wary of loaning cash to other institutions. The London Interbank Offered Rate (LIBOR), the rate at which banks lend to each other, is at a seven-and-a-half-year high—evidence institutions now prefer to hoard cash reserves instead of lending to the market.

Europe's central banks have also failed to reopen capital markets despite injecting billions of dollars of short-term liquidity. On Sept. 29 the European Central Bank announced plans to provide additional capital for banks until the end of the year. The Bank of England similarly said it would offer $72.4 billion in extra three-month funds to financial institutions. Yet these measures have had little effect.

EU-Wide Approach?

European governments can only hope their interventions—and a focus on more traditional retail banking—will generate the confidence needed to bolster Europe's lagging financial-services industry. But the increased state role in Europe's banking sector is also setting off some alarms. Though the underlying political philosophy and motivations are different, nationalizing banks is a throwback to the 1970s and 1980s, when governments often owned or controlled large stakes in domestic financial institutions.

With many European institutions now reverting to state hands, Batstone-Carr of brokerage Charles Stanley worries that the banking sector will become more conservative—and potentially less global. After embracing a myriad of sophisticated banking practices in recent years, banks could now realign their business models, he cautions.

Perhaps it's time, he and other analysts say, for a more EU-wide approach to solving what is quickly becoming a pan-European problem. But with no central financial regulator in Europe, and a tendency by local politicians to focus on domestic financial and economic issues, any such solution seems unlikely soon. The resulting irony could be that even though Old World institutions engaged in less of the risky lending that pulled down so many American counterparts, a European banking recovery could take longer.

Scott is a reporter in BusinessWeek's London bureau .