An employee enters the headquarters of French bank Societe GeneraleJOHN SCHULTS
The central bankers have spoken: There will be no repeat of Lehman Brothers Holdings Inc. in Europe.
Greece can't pay its bills, and Portugal may be next. The euro currency is under strain. Nobody is quite sure what would happen to major lenders such as Société Générale and Crédit Agricole should Greece or Portugal default. Politicians are bickering about how to fix the situation.
The global tables are so turned that once poor countries such as the BRICs – Brazil, Russia, India and China – are mobilizing to extend help for Europe.
But one problem the continent won't have, five of the world's most powerful central bankers have declared by taking a firm and early stand this week, is a sudden collapse of a large bank because of an inability to get the funds needed to keep its daily operations going.
On Thursday, the Federal Reserve, the European Central Bank, and the central banks of Japan, Switzerland and the U.K. banded together to offer unlimited funding to European banks through the end of the year. That will buy breathing room to find a fix for Greece, which may include an orderly national bankruptcy, and to try to fix the balance sheets of the banks, without having to worry about a bank suddenly failing.
After weeks in freefall on concern about funding, shares of companies like SocGen and Crédit Agricole soared.
The timing was coincidental, but still it rang with symbolism. It was almost three years to the day that Lehman vaporized because nobody would lend it money amid fears about what was on its balance sheet.
European banks were able to secure funding in recent weeks, but with increasing difficulty. Most cash was available only on an overnight basis. Longer-term bond markets have been closed for months, with investors unwilling to take the chance that they won't be repaid in five or 10 years.
In that environment, big European banks must scramble every day to renew loans. Banks such as SocGen, BNP Paribas and Deutsche Bank were adapting to what the CEO of SocGen called a "new world since the summer." It was an unstable situation with little margin for error and huge risk of a blowup should investors lose faith in a bank.
"Interbank liquidity is very tight, except for overnight," said Matthieu Debost, the Paris-based head of European equities for the investment banking division of Bank of Montreal. "Nobody wants to lend more than 24 hours. That has been the case since early August."
Funding in the form of loans is the oxygen of banking. Interbank lending is the daily matchup of financial institutions that have a short-term excess of cash with those that have an immediate need for it. It's a way for lenders to make a quick profit on their extra money.
All large banks rely on the goodwill of dozens of lenders. They get cash from other banks and money market funds that advance short-term loans of a few days or weeks, from investors such as mutual funds and insurance companies that buy longer-term bonds, and from depositors.
But as soon as that goodwill evaporates, the funding disappears, and a bank can no longer function. At best, it happens gradually, and the bank must stop new loans and call or sell off old ones. On a wide scale, this outcome can cripple economic growth. At worst, there's a run on the bank and the result looks like Lehman.
Key indicators show the stress in Europe has been steadily rising.
Longer-term financing hasn't been available on terms banks are willing to accept. European banks have sold less debt in the third quarter so far than in any quarter since 1996, according to the Financial Times.
The price of a three-month loan between banks, adjusted for interest rate expectations, is at the highest since early 2009, when markets were facing the waning days of the first phase of the credit crisis.
That, of course, assumes there was actually someone willing to provide that loan. U.S. money market funds, for example, had lent as much as $1-trillion to European banks as of mid-summer. However, as investors pulled money out of money market funds on concern about that exposure, fund managers were beginning to cut back on lending to banks such as SocGen.
To be sure, the situation was nowhere near as bad as in 2008. The use of short-term funding by French banks, while more prevalent than in other countries, was significant but "not off the scale,' Barclays capital analyst Jeremy Sigee said in a recent note. And access to U.S. dollar funding is "at the low end of the range, although no worse than that." Banks were not lining up for central bank cash.
However, the trend was disconcerting. With the other problems facing Europe, the funding situation was a bomb that had to be defused.
So the central banks stepped in. Their offer is for unlimited loans in U.S. dollars to any institution that needs it, and that can provide collateral. The program is open for three months, taking banks through the crucial year-end period, when interbank lending has tended to dry up as banks reduce risk in preparation for releasing their annual results.
That gives the central banks three months to focus on the next most pressing problems: fixing the balance sheets of European banks. Unless the bank balance sheets are fortified with enough capital to survive hits from sovereign defaults, confidence will never fully return and the funding problems will always haunt Europe.
"This [central bank action on liquidity]addresses but a single symptom of the broader problem," said RBC foreign exchange strategist Stewart Hall. "The provision of liquidity is the 'easy' part. Recapitalization is the thornier issue."
BNP Paribas has $27-billion of exposure to bonds from Greece, Spain, Ireland, Italy and Portugal, according to figures from Barclays Capital. Crédit Agricole has $10-billion. SocGen has $5.6-billion.
The banks need to raise billions of dollars of capital to absorb the potential hits. There are calls for a European version of the TARP program that solidified U.S. banks at taxpayers' expense. The need for recapitalization is "urgent" and may require governments to force banks to take capital, à la TARP, according to Christine Lagarde, the former French finance minister who now leads the International Monetary Fund.
"If there is a restructuring or default of Greek debt, most European banks, especially on the continent, will have to raise equity," said Mr. Debost of BMO. "They will have to do that to restore confidence, and meet capital requirements."
For shareholders who bid up European bank stocks this week, that means the outlook remains cloudy. Banks may be forced yet again to sell shares at cheap prices, or governments may have to step in and provide money. The chief executive officer of SocGen, Mr. Oudea, suggested at a Barclays Capital conference that injections of French government cash via preferred shares could be an option.
In other words, long term pain for common shareholders is an unfortunate possibility. But at least sudden death is off the table.