EU banks forced to raise cash or face 'debilitating' contagion

“[Competition commissioner Almunia] said he thought we needed to continue with crisis regime if necessary,” she told reporters in Brussels.

Stress tests of EU banks in July revealed that nine banks, mainly smaller institutions, were undercapitalised and would be unable to withstand further financial shocks, while an additional sixteen were in a ‘grey zone’.

In response, these banks must submit plans to the EU banking regulator by 15 October on how they plan to boost their capital base. They then have until mid-2012 to raise cash either from markets or submit requests for aid from their governments.

Commissioner Almunia however had said that other banks than those identified by the stress tests were also in difficult waters. His spokesman on Wednesday insisted his intent was more “subtle” than what had been reported.

“It is possible he didn’t say all banks or which banks possibly other than those identified by the stress tests that might need to be helped in the light of the crisis situation and that’s all he said. And that’s very different from what some of you [reporters] tried to say,” she said.

On Tuesday, speaking in Warsaw, Almunia said as a result of the deteriorating economy, banks were in a worse situation than when the tests took place.

"The worsening of the sovereign debt crisis, its impact on a fragile banking system and the continuing tensions in funding markets, all point to the possible need for further recapitalisation of banks on top of the nine that failed the stress tests earlier this year,” he said.

It was the first time a senior EU official had suggested that the European banking sector was in worse trouble than has been admitted.

As a result, he would be asking his colleagues in the commission to allow the currently relaxed rules on state aid for banks to be extended beyond the end of this year.

He also criticised some banks for “dragging their feet” on making known the true state of their finances and conceded that French banks, none of which failed the stress tests or were in the grey zone, are being hit by “some liquidity tensions that we hope can be solved.”

Last week, Moody's cut the rating on two major French banks, Credit Agricole, one of the biggest in financial institutions in Europe, and Societe Generale, over their exposure to Greek sovereign debt.

The Bank of China has also decided to halt foreign exchange forwards and pulled swap lines with Societe Generale, Credit Agricole and a third French Bank, BNP Paribas.

The banks have also been bludgeoned by large falls in their share prices off the back of their Greek exposure.

Additionally, German industrial conglomerate Siemens, which itself has a banking licence, has withdrawn some €500m from an undisclosed French bank and placed the sum with the European Central Bank for safe keeping and a higher rate of interest.

A series of French banks have put up for sale large portfolios of asset sales in an attempt to shore up their capital cushion.

The banks and the French government have said that they are capitalised sufficiently to withstand eurozone debt shocks.

Standard & Poor’s on Wednesday also downgraded seven Italian banks as a result of related sovereign debt risk, and adjusted the outlook on eight others from stable to negative.

Regarding the wider European situation, Fitch credit ratings agency has also warned "pressure on liquidity, profitability and eventually capital positions will negatively affect banks' credit profiles and ratings."

Until now, EU officials have insisted that European banks are better capitalised than a year ago and that French bank finances in particular were sound, stressing that they have held higher ratings than most other banks and that if there are any worries, they relate solely to liquidity issues rather than those of solvency.

Trouble could quickly spread around the world

But the pressure is mounting globally on European banks to act quickly to prevent a domino effect hitting other financial institutions.

Central banks from around the world last week moved to inject dollars into European banks who are having trouble raising funds in the US currency.

On the weekend, Swedish finance minister Anders Borg and his Spanish counterpart, Elena Salgado, both called for banking recapitalisation.

And the International Monetary Fund on Tuesday in its World Economic Outlook report, warned that European banks were “heavily exposed” to countries with debt servicing issues.

The next day, Jose Vinais, the head of the IMF's monetary and capital markets department, warned that the level of EU bank exposure to sovereign debt has soared to €300 billion.

"A concern is that capitalisation of euro area banks is relatively low, and they rely heavily on wholesale funding, which is prone to freezing during financial turmoil," the report read.

"Trouble in a few sovereigns could thus quickly spread across Europe. From there it could move to the United States - by way of US institutional investors' holdings of European assets - and to the rest of the world."

The global lender’s new chief, former French finance minister Christine Lagarde has also called for an “urgent”, “substantial” and mandatory recapitalisation.

Without such moves, “we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis,” she said.

Former UK prime minister Gordon Brown, speaking at the World Economic Forum in Dailan, China, said that the EU is being hit by a banking crisis, not the debt crisis that leaders believe is ailing their economies.

"The European banks as a whole are grossly under-capitalised: they have liabilities far in excess of American banks. We have now got the inter-play with sovereign debt because we socialised the liabilities," he said, according to the Daily Telegraph.

"It has morphed into a sovereign debt crisis, and is more serious than 2008 because governments then could intervene to sort of out banks. Now both banks and governments have problems," he said.

French bail-out of banks?

Speaking to EUobserver, Costas Lapavitsas a Greek economist at the University of London explained why the crisis has returned back to the banking sector.

“European banks have significant exposure, both private sector and public sector debt, and so the more Europe goes into recession, the worse their situation gets,” he said. “They know their peers are in the same situation, hence the difficulties of obtaining liquidity in the interbank market. They also have trouble meeting their dollar obligations and hence the so-called dollar funding gap among banks.”

“It is a combined liquidity and solvency problem,” he continued. “This is why central banks around the world last week offered support to banks, which lessened the pressure, but did not deal with the underlying solvency problem.”

He said that if Paris were forced to bail out its banks, the results could be very dangerous for the single currency.

“A French state bail out of its banks would probably result in the country losing its Triple-A rating as public debt would escalate. If France were downgraded, the pressures from financial markets on the country would be very heavy.”