Europe's Banks Need Government Life Support

Further write-downs in structured credit and more trading book losses; a marked deterioration in loan quality given the economic recession; continued downward pressure on earnings because of a serious decline in business volume-these are the ills still dogging European banks as they embark on the long and arduous road to recovery.

It is a recovery that experts like Sam Theodore believe lies quite a ways off in the future and is certainly not on the horizon for 2009.

"This year, all the banks are going to care about is survival," said Theodore, the former head of European bank ratings at Moody's Investors Service and Canadian rating agency DBRS, now manager for the banking sector at the Financial Services Authority (FSA) in London. "In the longer term, the current challenges call for banks to change their business models and become more conservative, but in the short to medium term, this is a tall order, even if it is a necessary one."

Indeed, it's going to take a long time for Europe's banks to go back to doing business as they used to. Many have been exiting business lines that were once profitable and, in an effort to survive, extreme prudence has become the order of the day. Many expect regulation to become more stringent. Consolidation-most of it forced-is certainly on the agenda for this year, and those banks that can are desperately trying to shore up their coffers through new retail accounts.

But it is slow going, and in the near to medium term Europe's banks will continue to be highly reliant on governments to support them-something that's necessary not only from a financial point of view, but also needed to shore up investor confidence.

"The main challenge is getting investors to trust banks again, so governments need to be around for a few more years to make that happen, and we need to hope they don't lose too much money in the meantime," Theodore said.

According to a recent report released by Fitch Ratings in London, weaning banks off their dependence on government funding will be critical to restoring normality in the banking sector. Of course, government schemes that guarantee bank debt and provide funding to challenged institutions have helped a great deal in reducing the impact of a full-blown, systemic banking sector problem, but in the long term, it will be absolutely key for banks to lessen their dependence on governments, said Julia Peach, managing director in Fitch's financial institutions group.

Yet another tall order? Yes, says Peach. "And I don't think it is going to happen anytime soon, because the markets are unlikely to return to normality until we see a return in confidence in our banking systems. And that will be a protracted process."

So government involvement, at least for now, is necessary, and the good news is that it will be forthcoming, Peach said.

Learning To Lend Again

But even as the public sector moves to provide reassurance and aims to encourage bank lending, banks are still striving to protect their exposures and capital needs by reducing new lending volumes, said Alexandre Birry, director in Fitch's financial institutions group. And this serves to further accentuate the crisis the entire global economy is facing. As a result, we may see more direct government intervention to force banks to lend again.

There has been a clear reduction in corporate lending, as banks have focused on deleveraging and enhancing capital ratios. However, the gap in lending to corporates, which is exacerbating the global economic slowdown, is also to a large extent the result of a dearth in international interbank lending. This is particularly prevalent in the United Kingdom, Peach said.

With less credit to spare, banks are choosing to lend to those corporates with which they have relationships, but even in relationship banking, it's clear that there are cutbacks. "We're seeing an overall move toward decreased lending and attempts to cut the undrawn facilities for some names," Peach said.

Banks everywhere have been repairing their capital bases and otherwise deleveraging, and this, as the Fitch report states, is a step in the right direction. However, this alone won't get lending to pick up, particularly on the subinvestment grade side, where there has been virtually no activity at all.

The good news, though, is that the high yield bond and equity markets seem to be picking up, so there is a venue through which leveraged corporates could perhaps access funds, said Christopher Kandel, co-head of the bank finance group in law firm White & Case's banking and capital markets group in London. Indeed, after the triumphant success of a recent high yield bond issue by Fresenius, sources say there are a few more new issues in the works that could come to market soon.

"The fact is that there is a huge refinancing need, but there's also a large gap between those requirements and bank lending capacity," Kandel said. "It looks as though in a number of cases the gap can be met by high yield, mezzanine and equity, so I think that's going to be the flavor of the lending market for the next few months."

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