Banking crash hits Europe as ECB loses traction

Source: Telegraph

By Ambrose Evans-Pritchard
Last Updated: 10:37AM BST 30 Sep 2008

The Dutch-Belgian bank Fortis, Britain's Bradford and Bingley, and Iceland's Glitnir, were all partially or fully nationalized after failing to roll-over debts in the short-term money markets, while the French state pledged support for the Franco-Belgian lender Dexia after the share price collapsed on reports of a capital shortage.

"The European financial sector is on trial: we have to support our banks." said French President Nicolas Sarkozy. He has reportedly ordered the state investment arm Caisse Des Depots to shore up Dexia, even though the bank is based in Belgium.

Germany's Hypo Real Estate, a commercial property lender, was rescued with a €35bn lifeline from a consortium of local banks. The lender has $560bn in liabilities, almost as much as Lehman Brothers.

Hypo Real's share price crashed 74pc, setting off a masse exodus from financial stocks in Frankfurt. Commerzbank fell 23pc and Aareal Bank was off 43pc.

Anglo Irish Bank was down 44pc in Dublin on wholesale funding fears.

Europe's credit markets have come close to seizing up as three-month Euribor jumped to a record 5.22pc and OIS spreads rocketed to 113 basis points.

"The interbank market has collapsed," said Hans Redeker, currency chief at BNP Paribas.

"We're now seeing a domino effect as the credit multiplier goes into reverse and forces banks to cut back lending to clients," he said.

Mr Redeker said the latest alarming twist is a move by banks to deposit €28bn in funds at the European Central Bank in a panic flight to safety. This has jammed the mechanism used by the authorities to shore up the financial system in a crisis.

"The ECB is no longer able to inject liquidity because the money is just coming back to them again. This is extremely serious. If monetary policy is no longer working, there is a risk that the whole system will blow up in days," he said.

The euro plunged on Monday as the wave of bank failures hit the newswires, dropping 2pc to $1.43 against the dollar. It recovered slightly as the US Federal Reserve flooded the markets with $630bn of dollar funding with fellow central banks in the biggest liquidity blitz in history.

Analysts say German finance minister Peer Steinbrueck may have spoken too soon when he crowed last week that the US would lose its status as a superpower as a result of this crisis. He told Der Spiegel yesterday that we are "all staring into the abyss".

Germany - over-leveraged to Asian demand for machine tools, and Mid-East and Russian demand for luxury cars - is perhaps in equally deep trouble, though of a different kind.

The combined crises at both Fortis and Dexia have sent tremors through Belgium, which is already traumatized by political civil war between the Flemings and Walloons. Fortis is Belgium's the biggest private employer.

It is unclear whether the country has the resources to bail out two banks with liabilities that dwarf the economy if the crisis deepens, although a joint intervention by The Netherlands and Luxembourg to rescue Fortis has helped Belgium share the risk. Together the three states put €11.2bn to buy Fortis stock.

This tripartite model is unlikely to work so well in others parts of Europe, since Benelux already operates as a closely linked team. The EU lacks a single treasury to take charge in a fast-moving crisis, leaving a patchwork of regulators and conflicting agendas.

Carsten Brzenski, chief economist at ING in Brussels, said the global crisis was now engulfing Europe with devastating speed.

"We are at imminent risk of a credit crunch. Key markets are not functioning properly. The Europeans thought the sub-prime crisis was just American rubbish that the US should clean up itself, but now they are finding out that it is their rubbish too," he said.

Data from the IMF shows that European banks hold 75pc as much exposure to toxic US housing debt as US banks themselves. Moreover they have mounting bad debts from the British, Spanish, French, Dutch, Scandinavian, and East European housing markets, where property bubbles reached even more extreme levels that in the US.

The interest spread between Italian 10-year bonds and German Bunds have ballooned to 92 basis points, the highest since the launch of the euro. Bond traders warn that the spreads are starting to reflect a serious risk of EMU break-up and could spiral out of control in a self-feeding effect.

As the eurozone slides into recession, the ECB is coming under intense criticism for keeping monetary policy too tight. The decision to raise rates into the teeth of the crisis in July has been slammed as overkill by the political leaders in France, Spain, and Italy.

Mr Sarkozy has called an emergency meeting of the EU's big five powers next week to fashion a response to the crisis.

Half of the ECB's shadow council have called for a rate cut this week, insisting that the German-led bloc of ECB governors have overstated the inflation risk caused by the oil spike earlier this year.

Jacques Cailloux, Europe economist at RBS, said the hawks had won a Pyrrhic victory by imposing their hardline monetary edicts on Europe. "They have won a battle but lost the war. The July decision will hardly go down in history books as a great policy decision," he said.
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