Fears grow as Europe's ailing Dexia bank aided

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Fears of a European banking crisis are haunting financial markets, heightened by the strife at one of the continent's major lenders.

If the strains persist, it would become increasingly challenging for the region's banks to meet their funding needs. And with the U.S. subprime debacle still fresh in the minds of investors, worries over a fragile European banking system would only serve to roil jittery markets further.

Tuesday, France and Belgium moved to prop up Dexia, a Franco-Belgian lender that was among the first banks to be bailed out in 2008. That news came as Deutsche Bank AG, Germany's biggest bank, announced it is cutting 500 jobs, abandoning its profit forecast and taking fresh writedowns on the Greek bonds it holds.

European banks hold about €3-trillion ($4.2-trillion) in European sovereign debt, representing about 8 per cent of their total assets. But there is a lack of transparency about exactly what each specific bank owns, sparking worries of further writedowns. That has prompted North American money market funds and lenders to reduce their exposure to European banks, making it even harder for those banks to gain access to funding. This is playing out just at the same time that low interest rates and weak economies are taking a toll on the banks' bread-and-butter lending businesses.

The challenges for Europe's banks will become that much tougher if troubles refuse to ease, the Institute of International Finance said in a report. As of the end of 2010, the 90 banks that were stress tested had €4.8-trillion of wholesale and interbank funding that expires either this year or next, more than 12 per cent of their total liabilities and shareholders' equity.

The worsening situation is causing the market to lose faith in the ability of policy makers to deal with the mess. Dexia passed the latest stress tests that were conducted by the European Banking Authority this summer, tests that were widely viewed as insufficient.

"The inability to resolve the problems, whether it's Greece of whether it's the spillover in Italy, is becoming more evident," said Royal Bank of Canada chief executive officer Gordon Nixon. "And the European banks are having a very hard time financing."

He noted that many of these lenders are still highly profitable. "But what people are worried about is the consequences of Europe falling apart," Mr. Nixon said.

Europe's troubles again upset global markets Tuesday, although New York stocks climbed back on a report by The Financial Times that the finance ministers of the European Union, who met in Luxembourg, were studying ways to shore up their banks and prove to investors that their institutions are sound.

Charles Geisst, a financial historian and professor of finance at Manhattan College in New York, said he believes there will be another banking crisis.

"It's very similar to the inbred mortgage-related problem we had in this country," he said, noting that European banks have massive exposure to the continent's economies and sovereign debts through their business operations as well as the assets they hold. (U.S. banks, in comparison, hold less than 1.2 per cent of their total assets in U.S. sovereign debt, according to the IIF).

"There is another Lehman Brothers out there some place, for slightly different reasons," Mr. Geisst said. "And that alone is going to spread fear."

As with the crisis of 2008, the broader risk is the ripple effect in the global financial system. Mr. Geisst expects that the European situation will spill over into areas such as credit default swaps.

"The biggest concern is the contagion in terms of economic growth and confidence, and to some degree fear in the marketplace," Mr. Nixon said. "The markets are trading right now on fear, confidence and liquidity, as opposed to rationale."

Royal Bank of Canada, the country's largest bank, has had a joint venture with Dexia since 2005 that serves institutional investors with services such as pension administration and securities lending. In the past three quarters, Dexia-related revenue amounted to $557-million for RBC or about 2.5 per cent of the bank's total revenue, according to TD Securities analyst Jason Bilodeau.

European authorities have suggested that Dexia's troubled assets will be ring-fenced through the creation of a so-called "bad bank," while some of its healthier operations could be sold. Barclays analyst John Aiken said he does not expect Dexia's problems will have a direct impact on the joint venture with RBC, although the Canadian bank could find itself having a new joint venture partner.

Leo de Bever, CEO of Alberta's pension fund manager, Alberta Investment Management Corp., said he remains optimistic that European authorities will deal with the situation by recapitalizing banks. "If you let Greece go bust and you let the cost hit the pension plans and the banks, you'd have to recapitalize the banks," he said. "But that's not money you lose, it's money that you have to lend to keep the lights on."

European banks have raised more than $410-billion of equity capital since 2008, according to the IIF.