FORTUNE — The European economic contagion that began 18 months ago as a sovereign debt crisis is dangerously mutating into a full-blown banking crisis. With Greece in de-facto market default, weak banks within the eurozone have started to fall ill as their investors, trading partners and clients pull short-term funding. The move by central banks on Thursday to provide extended U.S. dollar loans to European banks is only a stopgap measure. A Lehman Brothers-like collapse or a Northern Rock-like bank run still cannot be ruled out at this point for several of the eurozone’s largest financial institutions.
The market has hammered French banks into the ground first, but banks in Italy, Spain, Germany and the United Kingdom face serious funding issues as well. Swift action is needed on the part of eurozone members to shore up confidence in its crippled banking sector. The expansion of the European Financial Stability Facility (EFSF) is a good start, but more money will be needed to ensure investors that it’s all clear to park their cash with European banks again.
The alarm bells were sounded on trading floors in Paris and New York this week. Société Générale, Credit Agricole and BNP Paribas – the three major French banking institutions – have seen their share prices move violently in recent days, ostensibly because of their exposure to toxic Greek sovereign debt. On Wednesday Moody’s downgraded the credit rating of Société Générale and Credit Agricole one notch and kept BNP Paribas on review for a downgrade.
But the violent drops in their share prices seem to go beyond the banks’ exposure to Greece and the credit downgrade. Take Société Générale for example. The bank’s total exposure to Greek sovereign debt, including the amount held by its Greek subsidiary, is around 5 billion euros. That’s equivalent to around 1% of the bank’s balance sheet and around the same amount of money the bank lost at the hands of rogue trader Jérôme Kerviel in 2009.
As punishment for its Greek sovereign investments, the market wiped out 56% off Société Générale’s market value in the last three months up to Thursday. That’s around 3.5 times the value of its exposure to Greek sovereign debt, which is clearly overkill. Some of the extra losses baked in to the market value haircut derive from the bank’s exposure to the private Greek credit market through the bank’s local subsidiary. But the market seems to be sending a signal that it is worried about much more than the bank’s measly Greek exposure. The big fear is that Société Générale, along with its French banking brethren, is extremely undercapitalized and could therefore collapse at any moment.
Echoes of Lehman
Banks fund their activities in many ways and through a myriad of currencies. The most reliable source of funding for a bank is common equity capital, followed by the money received from depositors through checking and savings accounts. But in Europe, especially in France, a large chunk of funding comes in the form of short-term loans from prime money funds, money market accounts and other banks. This short-term funding is rolled over nightly in some cases, making it an extremely unreliable and volatile source of funding. One reason Société Générale may be the first bank in Europe hit hard is because 73% of its total debt has maturities of less than one year, the highest ratio of any large bank in Europe.
The Lehman collapse in 2008 showed the world how dangerous it was to depend on short-term funding. Rumors of the bank’s imminent collapse caused dealers to pull their short-term funding and within days the bank was insolvent. A similar situation seems to be taking place in Europe, but in slow motion. For example, U.S. money market funds have cut their funding levels to French banks by 40% in the three months through August 11th, according to Deutsche Bank (DB). This has forced the French banks to take out U.S. dollar loans from the European Central Bank at a higher interest rate in order to have enough U.S. dollars to fund their capital markets and financing activities.
Société Générale and Credit Agricole’s U.S. dollar-denominated assets represent 19% and 14%, respectively, of their total balance sheet at the end of 2010, according to Barclays. Banks are required to hold a certain percentage of their assets in cash and other liquid securities to protect themselves from funding shortfalls that could be caused by not having enough dollars on hand.
On Thursday the ECB, in coordination with the U.S. Federal Reserve and other central banks, said that it would extend maturities on its dollar loans from seven days to three months. This has helped to quell the violent downswing in French bank stocks, but it is only a temporary measure to give the banks enough time to sell assets and raise permanent capital. It should be noted that the Fed discount window was opened fully to broker dealers after Bear Sterns fell in the spring of 2008. It was widely believed that a liquidity crisis had been taken off the table for all U.S. banks, but it failed to address the root causes of the liquidity crisis that took Bear down to begin with: solvency and confidence. Of course, the Fed discount window was not enough to save Lehman Brothers and this temporary measure by the ECB won’t save European banks either if they fail to build a strong capital buffer.
Since 2008, banks have beefed up this buffer, known as Tier 1 capital, but the French banks have been slow to do so, making them more vulnerable to a short-term funding blip. Credit Agricole is the worst performer of the large banks in Europe in this regard, increasing its Tier 1 capital ratio from 8.1% in the first half of 2007 to just 8.9% in the first half of 2011. Société Générale has increased its Tier 1 ratio from 6.4% to 9.3% over the same period, but it remains at the bottom of the pack. In contrast, Suisse banking giant UBS has increased its Tier 1 ratio from 10.8% to a whopping 16.1% over the same period.
There is no magic number when it comes to the amount of Tier 1 capital a bank should hold. It just needs to be high enough in which investors feel confident that the bank can withstand future losses.
The sovereign debt crisis has evolved into a crisis of confidence, with the French banks being served up as whipping boy, but they are certainly not going to be the last if left unchecked. In Europe, nearly all the major banks have large eurozone sovereign debt holdings. They also hold fewer deposits in relation to their outstanding loans compared with U.S. and Asian banks.
Barclays found that nine of the largest 14 European banks have illiquid net loans held for investment that exceeded the amount of deposits on hand, making them dependent on volatile funding from the capital markets. Société Générale had a loan-to-deposit ratio of around 130%, making it dangerously dependent on outside funding. But it was far from the worst offender in the group. Italian banks Intesa Sanpaolo, with 160%, and Unicredit, with a 149%, along with the UK’s Lloyds, also with 149%, had worst ratios, equating to an absolute deficit of deposits to loans amounting to 139 billion euros, 185 billion euros and 214 billion euros, respectively.
In August, Christine Lagarde, the head of the International Monetary Fund and the former French finance minister, said in a speech at a banker conference this August in Wyoming that European banks were in need of “urgent recapitalization.” “This is key to cutting the chains of contagion,” she said.
It is unclear how much the funding shortfall is at this point. A leaked IMF report last week suggested that European banks would need around $275 billion. Money managers tell Fortune that their models suggest somewhere around $500 billion, which is derived by essentially adding up all the peripheral sovereign debt held by European banks. Whatever the number, it will need to be really big to bring confidence back. The Troubled Asset Relief Program (TARP), set up in 2008 to recapitalize the US banking sector, was $700 billion. In Europe, the European Financial Stability Facility (EFSF) will be 440 billion euros or around $600 billion, once its enlargement is ratified by the parliaments of all 17 members of the eurozone.
Now, the EFSF isn’t exactly TARP, as its mandate is to recapitalize profligate governments, not banks. But once the nation receives the cash, they can then turn around and inject it into their troubled banks. So Greece could use the cash to pay its loans and fill its budget deficit while France could inject cash into Société Générale.
The fear is that the market is already pricing in passage of the EFSF. If so, then it is sending a clear signal to European finance ministers that $600 billion is not enough to restore confidence in the system. Treasury Secretary Timothy Geithner, one of the architects of the TARP program, is in Poland today attending an informal meeting of European finance ministers. He could be there to help the Europeans see the benefits of using the EFSF as a vehicle to restore confidence in the eurozone. If the fund is repackaged in that way, it may help to ease investor fears.
To be sure, a TARP-like EFSF will not solve the European sovereign debt crisis, just as TARP has done little to fix the U.S. housing crisis. The program will only serve to restore confidence in order to avoid a run on the banking sector and to give all parties some breathing room to get their houses in order. Eventually, real structural changes will need to take place to fix the troubles of the eurozone.
Europe has the opportunity to devise real structural changes to the eurozone that would prevent another sovereign debt crisis, namely the centralization of the zone’s fiscal and monetary policy. It remains to be seen if there is strong enough will in the 17 capitals of the eurozone to take such a bold step. Failure to do so could put the continent right back where they started in just a couple years time.