Europe's Bank Scare

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CONTAGION: Markets are slammed as panic spreads from Wall Street to Europe

Warren Buffett, the legendary American investor, likes to say that it's only when the tide goes out that you find out who's been swimming naked. In the long-sheltered world of European banking, the tide has gone out very fast in the past few days — and it's exposing some stark truths: a worrying number of banks are overstretched or have taken outsized risks, and the system of banking regulation that is supposed to watch over them is too narrowly focused for comfort.

On Sept. 29 alone, governments from Germany to Iceland rushed to prop up five ailing financial institutions with huge cash infusions or full-blown nationalization, making it one of the grimmest days in the history of European finance. Among the high-profile casualties were Fortis, Belgium's largest bank; the venerable British mortgage lender Bradford & Bingley; and Germany's Hypo Real Estate, which has a massive $560 billion balance sheet and is a big player in the domestic securities market. As the governments stepped in, the message they sent to the public was supposed to be reassuring: Don't panic — your money is safe. Most European nations have some sort of deposit insurance that would reimburse account holders, at least up to a point, in the event of a default — although by their rescue actions the authorities sought to make it clear that it wouldn't come to that.

But a lot more convincing still needs to be done. Financial stocks plunged on news of the bailouts, and Datastream's index of European bank stocks has now fallen by 45% in a year. Even shares of some of the biggest and seemingly most solid financial institutions such as Royal Bank of Scotland have been mauled. Some depositors have taken fright, too. A day after the U.K. Treasury announced the nationalization of Bradford & Bingley and the sale of its branches to Spain's Banco Santander, Kusum Patel, a 50-year-old chef from Ilford, a gritty commuter suburb 9 miles (14.5 km) northeast of central London, withdrew all her savings and closed her account, as did several other customers. "They say it's going down. I've been hearing it on the radio," Patel fretted. "I haven't got a great amount of money, but the little bit I have is enough to make it scary."

Fortunately, that sort of panic — which brought down British lender Northern Rock a year ago — was the exception. But the loss of confidence underlying it is every banker's worst nightmare — and every bank regulator's, too. At Bradford & Bingley, staff were given forms to hand out to customers explaining what had happened and why their money was safe. Elsewhere, it was national authorities who sought to reassure, most notably in Ireland, where the government announced an unprecedented $560 billion guarantee to cover the deposits and debts of the nation's six biggest banks for the next two years.

While calming the general public is critical, nobody has yet figured out how to deal with a fundamental cause of this crisis: banks' loss of confidence in each other. They are so nervous about so-called "counterparty risk" — the possibility of not being repaid — that they have stopped lending to one another, bringing credit markets to a grinding halt. "We know who the strong banks are, but we don't know who the strong banks are exposed to," explains Simon Maughan, banking analyst at MF Global in London. In this treacherous environment, a bank doesn't just worry about its counterparty, he adds, but about its "counterparty's counterparty." The European Central Bank, working together with the Federal Reserve and other central banks, has reacted by making hundreds of billions of dollars readily available to financial institutions, but so far that hasn't broken the vicious circle, and interbank lending remains gummed up. "It's like pushing on a string," says Maughan. He points out that banks are hoarding the money they can borrow overnight from central banks rather than using it to lend to others; as a result, "You're not really achieving anything at all."

The troubles were exacerbated when the U.S. House of Representatives rejected a $700 billion rescue package for banks across the Atlantic on Sept. 29. For all the difficulties the Bush Administration has encountered as it tries to push through that package, there's a crucial difference between the U.S. response and the European one: in Washington, Treasury Secretary Hank Paulson has been working closely with Fed Chairman Ben Bernanke to craft a systemic response to what has turned into a systemic crisis. In the 27-nation European Union, by comparison, there is no single bank regulator and no mechanisms by which to craft a comprehensive solution that crosses national borders. The result is what Daniel Gros of the Centre for European Policy Studies calls the "balkanization" of European banking, with national authorities struggling on their own — or, at best, with one or two neighbors, as in the case of Fortis — to put together piecemeal local solutions. Gros and many others want a more comprehensive, pan-European regulatory framework to be put in place, a plan the European Commission in Brussels is eager to promote. Among other measures, the Commission is proposing a reform of banking-capital requirements.

It's still too early to know if Europe's patchwork regulations will be transformed — Hans Martens, chief executive of the European Policy Centre, for one, says the current crisis could actually push governments in the opposite direction, toward more national intervention: "I don't think the mood is for more Europe."

(See the ten steps to the financial meltdown here and TIME's photos of the global financial crisis here.)

(See TIME's Pictures of the Week here.)

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