European officials defend banking systems

Top European officials defended the health of the continent’s financial system Monday, trying to stem concerns that Europe’s slowing economy and high levels of government debt may cause some of its banks to fail.

In separate statements European Central Bank President Jean-Claude Trichet and European Economic and Monetary Affairs Commissioner Olli Rehn said banks within the 17-nation euro currency zone have been steadily raising the amount of capital set aside as a cushion against losses and will not face the sort of cash crunch that helped trigger the recession in 2008.

Their comments come amid gathering evidence of an economic slowdown that threatens to knock Europe’s crisis response further off course and spark a new round of global economic turbulence.

With growth stalling, there is mounting fear that struggling countries like Greece, Spain and Italy could miss their targets for reducing their public debt and further undermine the confidence of international investors, who are already demanding higher interest rates in return for lending to them.

The remarks were also a rebuff to Christine Lagarde, head of the International Monetary Fund, who warned during the weekend that weakness in European banks posed a key risk to the economy.

Speaking at a conference of central bankers and economists in Jackson Hole, Wyo., Lagarde, a former French finance minister, said the banks needed “urgent recapitalization.” She said the euro zone’s financial system had to prove it could withstand the impact of an economic slowdown and possible losses arising from investments in the government bonds of heavily indebted nations.

The dispute among prominent European officials reflects a divide over solutions to Europe’s problems. Despite calls, including those from the Obama administration, for more dramatic action, Europe’s unwieldy and often cautious politics have led to a stepwise approach that has yet to allay concerns that the monetary union may crack apart.

At a meeting Monday of the European parliament’s Economic and Monetary Affairs Committee, Trichet and Rehn offered reassurance about the health of the banks.

Trichet explained that the ECB has guaranteed open-ended lending to any European bank that needs cash, removing any liquidity threat to the firms or the wider economy.

“There cannot be a liquidity problem for the European banking system,” Trichet said, noting there are about $700 billion in loans outstanding from the ECB and a further willingness to lend whatever banks need.

The ECB in recent weeks also has been buying large sums of government bonds issued by Italy and Spain to help keep down their borrowing costs. (The interest rate on bonds tends to decline as demand increases.) Last week, the central bank increased its holdings of government bonds by another $7 billion.

As in the United States, banks in Europe were hard hit by the financial crisis, which began in 2007, and subsequent recession. While Europe’s financial industry has gone through a major reorganization, the process is not as far along as in the United States. The consolidation of Europe’s banking sector is incomplete, with more closures and mergers considered likely, particularly in troubled economies like that of Greece.

On Monday, Greek officials announced that two of the country’s largest banks were merging, with the hope that the combined firm could withstand the hazards in the economic climate.

Although Rehn acknowledged “deterioration” in Europe’s growth prospects — and the possibility that problems in the financial industry could drag down the broader economy — he also said the region’s banks were getting stronger. European banks “are significantly better capitalized now than they were one year ago,” and weaker ones are being required to raise more capital, Rehn said.

In her weekend remarks, Lagarde said public funds should be used, if necessary, to shore up the continent’s banks. Otherwise, she warned, even strong economies like Germany and France could suffer bank failures or face a “liquidity crisis” if financial firms stop lending to each other out of fear.

Her comments underscored the growing concern about how Europe’s challenges may affect its banks and their ability to support economic activity through loans.

The root of the problem is government bonds issued in struggling countries. Large investments in these bonds, which were considered secure when they were made, are now in doubt. As the European economy slows, this could lead to an increase in defaults and reduced profits for the banks. As concerns grow about the health of banks, their ability to raise new cash, either through issuing their own long-term bonds or taking out short-term loans, is becoming more constrained and more expensive, according to IMF and other reports.

Lagarde's call for a quick and broad recapitalization plan is aimed at breaking that dynamic. The aim would be to restore investor confidence in the banks — and the confidence of banks in each other — by injecting enough new money to make clear they could weather both an economic slowdown and losses on their government bonds.

But this approach would face stiff political resistance in much of Europe for several reasons. After using tens of billions of dollars in taxpayer funds to prop up banks in recent years, European leaders are reluctant to pump in more. The proposal would be especially controversial in stronger countries like Germany, which could be obliged to provide money to help banks elsewhere, for instance in Spain.

Moreover, European leaders over the past year have agreed to ante up for emergency loans to Greece, Ireland and Portugal. Expanding this program by making bailout funds available to banks across the euro zone could prove difficult for national leaders to justify.

Addressing the danger posed by holdings of government bonds would also require leaders to jettison the assumption that these bonds would never default. Current regulations do not force banks to set aside capital against possible losses on their holdings of government bonds, unlike other types of investments.

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