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Europe's banks face big test as ECB loan repayment deadline looms

June 29, 2010 | 12:20 pm

The worldwide plunge in stocks Tuesday has had many triggers, but a major one is renewed fear that Europe’s banking system is headed for another severe credit crisis.

The European Central Bank on Thursday is expecting repayment of about $540 billion of one-year loans it previously extended to euro-zone banks, as part of the ECB’s efforts to support the banking system in the aftermath of the 2008 credit crisis.

In place of the one-year loans, the ECB is offering the banks new three-month loans.

The problem: Investors would prefer to see the banks stand on their own legs, and borrow from each other for short-term funding rather than from the ECB, which is supposed to be the lender of last resort.

If the banks’ demand for three-month ECB loans is enormous, it could deepen worries that European financial institutions are reluctant to do business with each other because of solvency concerns that stem in part from the continent’s government-debt debacle. Because many of the banks are big investors in government bonds, the dire fiscal outlooks for Greece, Spain, Portugal and other countries have caused investors to fear that the banks’ finances have been weakened further and could continue to deteriorate.

Mark Grant, a managing director at investment firm Southwest Securities, estimated that demand exceeding $370 billion for the three-month loans could fuel a new round of selling of the euro, European bonds and stocks.

“It will be not only liquidity but solvency that gets called into question if the numbers are large,” he said.

The ECB is expected to announce Wednesday morning how much the banks are asking for.

On Tuesday the euro slid to $1.221 from $1.228 on Monday. European stock markets were hit by heavy selling, with the Spanish market down 5.4%, France down 4% and Germany off 3.3%.

Still, indexes of most major European markets remain above their lows reached in spring.

-- Tom Petruno