Eurozone disarray deepens crisis

Investors panic as politicians and regulators fail to agree on timeline for recapitalisation of European banks

European politicians and regulators are locked in a dispute over the pace of recapitalisation of the continent's fragile banking sector.

Reports surfaced this week that the eurozone officials are planning to accelerate the injection of new equity into the financial sector of the single currency bloc.

But that has since been denied by the European Banking Authority (EBA) in a move that threatens to throw financial markets into further turmoil. In July, the EBA released the results of a stress test of 90 European banks: nine institutions failed and 16 came close to failing. The EBA gave national authorities until 31 October to set out plans to recapitalise those institutions and said that it would publish a report on implementing those plans by June 2012.

However, this slow timetable has panicked investors in recent weeks, resulting in some banks finding it increasingly hard to access funding. And despite a call on Friday from Christine Lagarde, the head of the International Monetary Fund, for European governments to "act now" to recapitalise banks, the EBA has stated there are "no changes" to its timeline. The IMF has accepted the market verdict that the EBA's test was not credible.

The IMF also released an explosive analysis in advance of its annual meeting in Washington this weekend that identified a $200bn hole in the European banking system. The IMF researchers did what eurozone banking regulators have refused to do: they calculated how much banks could lose if European periphery states default on part of their sovereign debt.

Researchers reached the $200bn figure by calculating the write-downs on eurozone sovereign debt of Greece, Ireland, Spain, Italy, Portugal and Belgium implied by movements in the Credit Default Swaps market (the cost of insuring those bonds) since 2009. They then applied those implied write-downs to the stock of holdings of European debt held by European banks. According to the IMF, some European banks have made provisions for these losses. But many are valuing these bonds as if they are going to be paid off in full.

When Ms Lagarde first argued that the banks needed urgent recapitalisation, at a meeting of central bankers in August, she provoked a furious response from policymakers. She was forced into a partial retreat at the G7 meeting in Marseille earlier this month. But this week Ms Lagarde has returned to her initial robust position, stepping up the pressure on eurozone policymakers for urgent action.

A new report from the European Central Bank added to the pressure for recapitalisation this week. It said that national supervisors "should co-ordinate efforts to strengthen bank capital, including having recourse to backstop facilities, taking also into account the need for transparent and consistent valuation of sovereign exposures".

Of the nine banks that failed the EBA stress test and the 16 that were judged to be close to the danger zone, no French banks were found to be lacking in capital, despite the fact that the sector holds some €9bn in Greek sovereign debt. On Friday, the credit rating agency Moody's downgraded eight Greek banks. Two of them, the Emporiki Bank of Greece and General Bank of Greece, are majority-owned by France's Credit Agricole and Société Générale respectively. The head of France's markets regulator, Jean-Pierre Jouyet, admitted on Friday that "there is indeed a problem with the capitalisation of banks".

The package agreed by eurozone leaders at a Brussels summit in July agreed that the $440bn European Financial Stability Facility (EFSF) should have the power to recapitalise banks. But the extension of the EFSF's powers cannot come into effect until it is ratified by eurozone parliaments, a process that will take until next month at least.

In the meantime, investors fear further volatile trading this week. In the UK, the FTSE 100 lost 5.6 per cent or £78bn of value on the week, the second biggest fall this year and one of the sharpest since the financial crash three years ago, while the US Dow Jones index fell 7 per cent on the week.

The slowdown in the US economy, weak manufacturing data from China, as well as worries over the euro, are behind the latest selling. However, institutional investors say it will take more than the emergency statement from the Group of 20 nations at the end of last week to restore confidence.

Six of the G20 countries had signed an open letter to the G20 president, France's Nicolas Sarkozy, urging eurozone countries to act swiftly over fears that some of Europe's banks are teetering on insolvency if Greece were to default. The Chancellor George Osborne also warned that time was running out to tackle the eurozone debt crisis.