David Prosser: Europe's banks prepare for a day of reckoning

Wednesday 30 June 2010 00:00
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Outlook It is all very well expecting a recovering patient to stand on his own feet, but kick away the crutches too early and he will simply fall over – and, in the worst case scenario, knock over some otherwise healthy bystanders too. This is the risk that the European Central Bank is taking by refusing to extend its one-year funding programme, which has lent almost €450bn to European banks struggling with liquidity issues.

That programme comes to an end tomorrow. And though it will be replaced by a rolling series of shorter term liquidity facilities, the fear is that many of Europe's financial institutions will once again find it prohibitively expensive, or just downright impossible, to access the funding markets.

The ECB has taken a hard line with banks that have privately complained it is premature to withdraw this support. And you can see its point – this programme, in one guise or another, has been running since the financial crisis of almost three years ago. Eventually, we must start heading back towards normality, not least because of the distorting effects of cut-price emergency support. In any case, the banks have known the 1 July deadline was approaching for many months. They have had the time to make alternative arrangements.

Still, market movements yesterday suggest there is not much confidence that they have done so. A sharp rise in the cost of borrowing between European banks – now at a nine-month high – was the dominant factor in knocking stock markets back so markedly.

The end of the week is likely to be even more treacherous. Spain plans to sell another tranche of government bonds tomorrow too, exposing itself to the scepticism of markets about its ability to stay on top of its debts just as the banks' funding crisis threatens to rear its head once again. We could very well see a new round of speculation about the future of the euro.

At the very least, the withdrawal of the ECB support is another threat to the eurozone's economic recovery (and that of the UK, by extension). Estimates of how much of the support will not be rolled over into the new facilities range from a third to two-thirds, which implies serious shrinkage in bank balance sheets – meaning less lending to businesses and individuals.

It may be that the ECB gamble pays off – that its sickly patients, forced to limp forward unaided, learn to walk and run again (and if not, when might they?). But let's just hope the bank's officials are on hand, ready to catch those that do fall, as the markets appear to expect them to.

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