Dexia may be the spark that ignites Europe

October 4, 2011, 10:19 PM UTC

FORTUNE — Dexia is a little-known Belgian bank that has recently made headlines because it is struggling with funding problems, meaning that investors are reluctant to loan the bank the short-term money that it needs for day-to-day operations. It’s a problem that several of Europe’s banks have been facing, but the situation has gotten so bad for Dexia that it may need a government-sponsored rescue — its second since 2008.

“Dexia is the first casualty of the inertia over Europe’s sovereign debt crisis,” writes Otto Dichtl, director of financials at Knight Capital. Dichtl adds that France and Belgium have guaranteed all of Dexia’s existing debt and could completely restructure the bank in response to funding pressures.

Despite the government guarantees, bond investors are abandoning Dexia as well as France and Belgium sovereign debt. French and Belgian bonds were trading lower than the German benchmark, and credit default swaps on both countries have widened. Meanwhile, investors are dumping Dexia shares.

Clearly a Dexia rescue isn’t a solution, but the beginning of a larger problem. For starters, a government bailout and restructuring could actually impair the bank. “The key problem for Dexia in this respect is the likely significant difference between book values of many of its assets compared to actual trading levels,” Dichtl writes. This means that selling assets right now could crystallize losses and threaten Dexia’s solvency.

And rescuing Dexia is the start of a larger, painful acknowledgment that governments may no longer be in control of Europe’s debt issues.

If we’ve learned anything from 2008, it is that government acknowledgement of severe problems — even in the form of intervention — will make investors even less willing to fund other institutions that are perceived as troubled. It begins with a lack of faith in one institution, not unlike what we saw when the markets forced Bear Stearns into the arms of JPMorgan. And then you see a chain reaction of liquidity problems and government rescues as investors shun a wider circle of intertwined lenders and borrowers. In Europe, this could mean that the markets force radical (and unwieldy) restructurings of both banks and of sovereign debts.

In the case of Europe’s banks, we could easily see problems at financial institutions swamp the balance sheets of Europe’s governments, an event that the fragile global economy is ill equipped to absorb. For example, Dexia’s total liabilities alone mount to 1.5 times Belgium’s gross domestic product and 1.2 times Belgium government debt, according to Knight Capital. Banco Santander’s total liabilities equal 1.1 times Spanish GDP.

Societe General’s total liabilities are equal to 58% of French GDP and BNP Paribas’ total liabilities equal 97% of French GDP. Total liabilities at SocGen, BNP, and Credit Agricole amount to 2.4 times French GDP and 2.6 times French government debt.

The point, as Knight points out, is that Europe’s banks could soon be a terrible liability on these sovereign economies; and we won’t see confidence restored without a comprehensive policy response that addresses both financial sector and sovereign risk. Without that radical policy response, Dexia could be the spark that turns Europe’s long-smoldering banking problems into a conflagration.