EU moves to damp down fears for shaky banks

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European policy makers are trying to quell fears about the safety of the region's troubled banks, saying they're prepared to mount a co-ordinated defence of the sector.

Assurances from European leaders helped spark a broad rally in global markets, which recouped some of the heavy losses of recent sessions as the continent's financial woes escalated. But the relief may be short-lived. A plan to shore up the banks will be extremely expensive, require bank investors to absorb some of the pain and is sure to run into political hurdles, analysts warn.

So far, efforts to backstop the banking sector do not appear to have gone much beyond the talking stage, despite growing pressure from the international community, which fears the spreading crisis could trigger another global credit freeze and plunge the world back into recession.

"Our skepticism is almost as high as our cynicism, because talk is cheap and we've been disappointed in the past," David Ader, head of government bond strategy at CRT Capital Group LLC in Stamford, Conn., said in a report. And whatever plan emerges will have to address "the issue of haircuts, how capital will be raised, who will buy new debt," and how to maintain stability in bond and currency markets.

The International Monetary Fund calculates that up to €200-billion ($277-billion) needs to be earmarked for the urgent bank rescue.

"We have to restore confidence quickly," said Antonio Borges, head of the IMF's Europe department. "The best way to do that is to have a capital increase rather quickly."

But several analysts say that number is far too small to assure the banks can weather the debt storms. "They need to provide a blanket guarantee for all [euro zone]banks," said Arthur Heinmaa, managing partner with Toron Investment Management. "It has to be an eye-popping number."

Fears that Europe's financial institutions are too weak to withstand the fallout from the sovereign debt crisis have sparked heavy customer withdrawals, boosted costs of capital and restricted the banks' access to vital interbank loan, credit-swap and other markets.

This week, France and Belgium stepped in to shore up Dexia, the troubled Franco-Belgian lender, and assure its clients and counterparties that their money is safe. Similar scenarios could play out across the euro zone without strong government guarantees. And those guarantees may well include a caveat that bank bondholders will have to bear part of the cost.

"If there is a common view that banks aren't sufficiently capitalized for the current market conditions," a European-wide firewall will be necessary, German Chancellor Angela Merkel said after a meeting in Brussels.

European banks hold about €3-trillion in European sovereign debt. This accounts for about 8 per cent of total assets. But the banks are not required to write down the value of government bond holdings, unless there is an actual default.

"Nothing tangible has been offered, just policy comments, and it's not clear what signal is being sent," Scotia Capital economists Derek Holt and Karen Cordes Woods said in a report. "Yes, it would be a positive to inject capital into the most pressured banks in order to mitigate" a lending crunch in Europe. "But the horse is already out of the barn in that sense," they commented.

Overnight bank deposits at the European Central Bank have climbed in recent days to their highest level this year, reflecting growing distrust within the financial system over banks' ability to repay their loans. Euro-zone banks would rather park their cash at the ECB at a low interest rate of 0.75 per cent than lend to other banks at the higher interbank rates.

The interbank market is not yet frozen, which occurred at the height of the 2008 credit crisis. But the risks are rising that Europe's bank woes will spill over into the interconnected global financial system.