Europe’s debt mess has been festering for so long it sometimes feels more like a chronic condition than a life-or-death crisis. But as negotiations to prevent a Greek default drag on, investors and lenders increasingly are concerned that a banking crisis could break out, dragging down the Continental economy before Greece even has a chance to default. On Sept. 21 the International Monetary Fund estimated that Europe’s banks face more than $400 billion in losses and said that weak banks need to raise capital quickly.
The core of the problem? As the charts on these pages show, some European banks are in peril of losing what they need most: cheap funding. Banks profit by borrowing money for short periods—rolling over some of their debt as often as nightly—to fund long-term loans at higher rates. As concern about their exposure to a sovereign default grows, European banks are paying more to borrow.
Doubt about banks can quickly become self-fulfilling if worried depositors and lenders yank out their money. Remember: Lehman Brothers went from O.K. to dead in less than a week in 2008, when hedge funds and other banks concluded that the company couldn’t pay its bills.
Indicators of stress on European banks have risen sharply since midsummer. The eight largest U.S. money-market funds halved their lending to German, French, and U.K. banks over the past 12 months and stopped financing Italian and Spanish banks, according to data compiled by Bloomberg. Some Italian banks are so desperate for funds that they’re selling bonds to retail customers for five times the interest they offer on savings accounts.
Quarterly financial statements aren’t timely enough to show what’s going on. The smart money pays attention to market indicators that monitor European banks’ health daily—or even minute to minute. One measures the premium banks pay for unsecured three-month loans from one another vs. the superlow overnight rate controlled by the central bank. That signals a growing mistrust among banks. Another is the price of credit default swaps—insurance that pays out if a bank fails to pay its debts.
One arcane but critical sign of distress is the cost of a “basis swap”—a measure of how much European banks pay when they raise dollars by trading euro-denominated loans for dollar loans. The price of basis swaps has risen from 28 basis points (0.28 percentage points) of the deal value in mid-July to 98 basis points on Sept. 20. When the spread exceeds 150 basis points, “we are in large European bank failure zone,” says Conor Howell, head of exchange-traded funds trading at Christopher Street Capital in London.
“There is a vicious cycle,” says Yves-André Istel, a businessman and investment banker who often speaks with high government officials in Europe. “The doubts make the banks pull their horns in, which affects the real economy. As the real economy flattens out or worse, the revenue to the sovereigns is put into question, and the whole cycle heads downward.”
Sovereign debt may be the underlying problem, but “the fuse is shorter on the banks,” so they have to be shored up immediately, says Istel, who is deputy chairman of Swiss luxury goods company Richemont and a senior adviser to investment bank Rothschild. He says each nation should raise a rescue fund that would be available to invest in preferred shares and warrants of that nation’s banks. They should recruit private investors to participate in the funds, Istel says. The mere existence of the funds could shore up confidence while work proceeds on a sovereign-debt fix, he argues. What the indicators are saying is that there’s little time to waste.