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Europe's worst case scenario: 'negative spiral for banks' Add to ...

There's trouble for banks on both sides of the balance sheet in the sovereign debt crisis in Europe. While most of the focus has been on the asset side -- what will happen if banks have to take haircuts on the bonds they hold -- a more immediate concern may be the liability side.

It's been two months since the markets closed to bond issuance by regional European banks, according to a note from RBC, and at some point, the "drought" in funding is going to cripple banks ability to finance.

Bank bonds are sold at interest rates that are based on a spread over the government bonds of the country in which the banks are based. If the underlying government bond yields rise, banks yields float up too. For banks in countries like Greece and Spain, there yields are so high that there's no appetite to issue bonds and raise cash. No cash, no lending, and that's how the economy starts to stall.

"Unfortunately, the action of bank managements as well as banks’ fundamentals are being subordinated to the macro concerns afflicting the European economies and public accounts," RBC analyst Carlo Mareels wrote. "Independently from what banks do, their spreads will continue to be driven to a large extent by the sovereign in which they are based."

"A prolonged funding drought is more dangerous and remains, in our view, potentially one of the main transmission mechanisms between the sovereign debt crisis and an impact on the real economies," he added.

Already, there's evidence that banks are starting to shrink their balance sheets because they can't get the capital they need to fund lending.

The analyst pointed to Spanish lender Banesto, which reported that its assets fell by 16 per cent over the past year and lending dropped 5.7 per cent.

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