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Explainer: What's Happening To Europe's Banks?

Fears that Greece may default on its sovereign debt has rattled European markets.
Two years ago, when the Greek government first admitted it was facing bankruptcy, the news sent shock waves through the eurozone.

Now, despite a massive EU bailout of Athens, Greece continues to totter on the brink and the shock waves have spread to the very core of Europe.

This week, the major Franco-Belgian bank Dexia almost crashed because it had calculated its capital as vastly greater than the true value of its assets.

Part of the problem was that it had made loans to Greece that once seemed fully collectible but no longer are.

The fact that Greek loans are no longer fully collectible is due to EU leaders agreeing to give Athens a "haircut" on its debt.

The measure, intended to help Greece recover, means the banks that lent Athens funds will receive 21 percent less money than they planned -- at best -- when they made the loans years ago.

Dexia survived because the French and Belgian central governments stepped in at the last moment to guarantee its financing.

But the thought that the same thing could happen to other European banks which hold Greek government debt, was enough to send global stock markets temporarily plunging.

Scrambling For Solutions

The plunge did not just alarm investors. It also sent EU leaders scrambling to find new ways to convince the world they still can deal with the Greek crisis.

On October 6, German Chancellor Angela Merkel again sounded what has become the EU's familiar cry when she said it was "a necessity that Greece remain in the eurozone and be given a chance to get on its feet again."

German Chancellor Angela Merkel
German Chancellor Angela Merkel
But if the renewed pledge was intended to signal that the eurozone is committed to getting everyone intact through the storm, the fact the crisis keeps widening makes every pledge harder to fulfill.

Peter Boone, a senior visiting fellow at the London School of Economics, says it is no longer just Greece's finances that are a problem.

The whole concept of eurozone governments borrowing money -- and the certainty that it will be repaid in full -- is now in doubt.

"You've gone from an old regime where everyone expected that sovereign debt was sacrosanct and would never be defaulted upon to a new regime where it is quite clear that, within the EU, sovereign debt can be defaulted on, because Greece is entering into a default, even though they don't call it that," he says.

"When you go from that first regime to the second, all the debt that has been issued by these countries is now risky when it used to be safe, and some is more risky than others."

Beyond Greece, the financial world has to worry whether other heavily indebted governments such as Italy and Spain can pay back their future debts without having to partly default, too.

Sovereign Debt, Banking Problems Closely Intertwined

And that strikes at the core of the eurozone, because major banks in Germany, France and Britain hold tens of billions of euros' worth of debt from those countries.

Many analysts say that Europe's sovereign debt and banking problems are so closely intertwined that there is now an urgent need to inject new capital into banks that lend to risky governments.

Jennifer McKeown, a senior European economist at Capital Economics in London, believes the urgency will only grow if -- as some experts predict -- the EU decides to write down yet more of Greece's debt to help Athens recover:

"The banks would need capitalization, they would need extra government funds to be able to withstand it [further write downs of Greek debt], at least in some cases," she says.

"But I think the bigger problem is what happens if bigger economies need haircuts and need to default.

"If it were Italy that were to need bigger haircuts then, no, the banking system simply couldn't withstand it, and if it were Spain there would probably be similar problems."

The EU's economic affairs commissioner Olli Rehn
The EU's economic affairs commissioner Olli Rehn
European Commissioner for Economic and Monetary Affairs Olli Rehn appeared to share the sense of urgency over recapitalizing banks as he spoke to reporters this week amid the Dexia crisis.

He told Britain's "Daily Telegraph" that "European banks must be reinforced to provide additional safety margins and thus reduce uncertainty."

But how the EU would go about recapitalizing banks is highly uncertain.

One problem is where to find the money. The eurozone's war chest for the financial crisis -- the European Financial Stability Facility (EFSF) -- will have 400 billion euros in funds if it is approved by all eurozone states.

But even that would not be enough to both bail out Greece and recapitalize European banks.

Moreover, Germany, the eurozone's richest country, has said that it will not contribute more to the EFSF to bail out Greece. That could make it unlikely Berlin would do so for any other reason, either.

Unilateral Vs. Uncoordinated Action

If so, that leaves two other options for recapitalizing the banks.

One would be an uncoordinated action by the EU states themselves -- something that might solve the problem in one country but not another. The German government -- with its good credit rating -- could easily raise the money to provide additional capital to its banks.

But the Italian and Spanish governments -- with worse credit ratings -- would have to pay more to borrow money and that would put them still deeper into debt.

The remaining option for recapitalization is a coordinated action across the eurozone by the European Central Bank (ECB).

But even this choice is a difficult one. That's because the eurozone states have strong policy differences over how much they want to see the central bank intervene in economic affairs.

"The ideological [argument] is basically one about inflation and the belief in sound money," says Simon Tilford, chief economist at the Center for European Reform in London.

"People who oppose the ECB providing the full range of lender-of-last-resort facilities fear that it could be inflationary.

"They don't want to see the ECB engaged in the kind of strategies we have seen the U.S. [Federal Reserve] employing or the Bank of England or the Bank of Japan, for that matter, i.e. basically just pumping money directly into the economy in order to free up the credit market, or just trying basically [trying] to get the financial system moving again."

None of the EU's bank recapitalization options -- from an expanded war chest to individual country actions or the ECB -- are easy for EU leaders to agree upon.

And that may be one reason why all the bloc's pledges this week that it will confront the crisis had one thing in common. The statements are long on generalities but short or bereft of specifics.

That is not to say such statements have no value. In EU circles, generalities are often employed to buy time and much of the EU's strategy to date has been to hope an economic recovery will make the eurozone crisis disappear before it gets worse.

But if the miracle cure does not come, the EU may eventually have to go back to the drawing board and devise a plan that goes far beyond just bailing out Greece and recognizes the full extent of the bloc's financial problems.

And that could be a far greater test for the EU leaders than anything they've done in the two-year-old Greek crisis so far.