Europe's Banks Face New Funding Squeeze

LONDON (Dow Jones)--An extraordinary dry spell in the market for long-term European bank funding is amplifying pressure on policy makers to devise a solution to the continent's banking crisis.

For the past three months, European banks have been largely unable to sell debt at affordable prices to investors, who are wary of the banks' vulnerability to risky euro-zone government bonds and other loans.

At $34 billion , the amount of senior unsecured debt issued by the continent's financial institutions this quarter is on track to be the smallest of any quarter in more than a decade, according to data provider Dealogic . Most of those were bite-sized deals of less than $500 million apiece. Traditionally, issuing such debt has been among the most popular ways for banks to finance themselves over the long term.

Now market observers are worried that the funding freeze is going to continue and--perhaps worsen--heading into 2012, with potentially serious repercussions for the banking industry.

Most banks said they have raised enough money to get through the final three months of the year, and they have access to safety valves such as central-bank liquidity to ensure they can meet their day-to-day funding needs.

Yet analysts have estimated that the banks face a mountain of debt, totaling nearly EUR800 billion ( $1.08 trillion ), that comes due in 2012. Much of that will need to be replaced with new debt. If banks can't raise this, they might have to shrink their balance sheets by selling assets or curbing lending.

"This is about the time of year you'd want to be prefunding for next year," said Simon Samuels , an analyst in London with Barclays Capital . The funding lockout "obviously can't go on much longer" without damaging the industry.

Until recently, much of the concern about the deteriorating conditions in Europe's banking system focused on strains in the short-term funding markets. Traditional lenders to banks, such as U.S. money-market funds and fellow banks, have become wary of lending except for extremely short periods of time. This has sowed fears that large European banks could encounter life-threatening liquidity problems.

While those jitters still exist, they have eased somewhat because of the European Central Bank's willingness to serve as a lender of last resort to banks that can't get short-term funding elsewhere. Analysts said this largely eliminates the risk that a big bank will suddenly keel over.

Now, however, analysts, investors and some bankers said they are increasingly anxious about the inability of banks to issue medium- and long-term debt.

Renewing next year's waves of maturing debt is likely to be especially tricky because nearly 25% of it had benefited from government guarantees that won't exist for new debt, according to CreditSights Ltd. analyst Simon Adamson .

If conditions persist, it could force banks to drastically reduce their lending and other activities, which could undermine the broader economy, analysts said.

After months without debt issuance, "the banks will be struggling to catch up, " Adamson said. "Banks will have to be looking at reducing balance-sheet positions." Already, banks in countries such as France have unveiled deleveraging plans that include reductions in certain types of lending.

The situation is putting pressure on European officials to respond. One possibility floated by a number of private-sector experts last week is for euro- zone governments to issue a blanket guarantee of the industry's debts. But while such a plan would make it much easier for banks to borrow, it would risk saddling taxpayers with enormous losses should the industry's health worsen.

The ECB has a number of options that potentially could defuse the long-term funding strains, and some could be considered at the central bank's next meeting on Oct. 6 . One option is to extend the maturities of loans it offers to commercial banks to one year to ensure a steady source of funding. Such a move, which ECB officials have mentioned in recent days, would essentially buy policy makers more time.

The problems aren't confined to the lack of what is known as term-debt issuance. Other funding sources also continue to fade.

Italian banks, for example, traditionally have drummed up funds by issuing certificates of deposits in the French market. In May, the six largest Italian banks had a combined EUR24.5 billion of those CDs outstanding. That number has been declining steadily since then. As of Sept. 16 , it had been cut in half to EUR12.1 billion .

The situation is prompting banks to look for alternative sources of funding. In Spain and Italy , lenders are hoping their retail customers will pick up some of the slack. While banks in those countries--which have fallen out of investor favor--have traditionally peddled debt products to their retail clients, the activity has accelerated recently, according to analysts and bankers.

Banco Santander SA (STD, SAN.MC), Spain's largest bank by market value, last week said it would issue up EUR7.5 billion worth of notes with maturities of up to 25 months. The deal is aimed primarily at retail investors, Santander said. Bankia SA (BKIA.MC), created in July through the merger of seven Spanish savings banks, on Friday did the same, launching a sale of one-year, retail-targeted notes that offer an interest rate of as much as 4% a year.

Competition among banks to issue such retail-oriented debt is heating up. In Italy , where retail bonds play a similar role to certificates of deposit in other countries, the interest rates banks dangle to lure investors have gone up by as much as 25% this summer, analysts said.

But demand could be limited, as those customers are reading the same headlines that are spooking institutional investors. "It's a question of risk appetite," said Alain Tchibozo, an analyst at Mediobanca Securities .

The unavailability of traditional term funding has prompted some banks to turn to what are known as covered bonds, which are secured by assets such as mortgages that reside on the banks' balance sheets. But those bonds tend to be more expensive than traditional funding.

Some European banks have hinted to investors that they would be willing to pay higher prices to issue long-term debt via private transactions, instead of in the public markets, said CreditSights' Adamson. Such deals would have the advantage of taking place out of public view, so banks could afford to pay more without worrying about being stigmatized by the high costs.