European Banks’ Borrowing Costs are Rising to Dangerous Levels

The cost of insuring the junior and senior bonds of 25 European banks and insurers has doubled since April, which means banks with more than $100 billion of cash to raise by year’s end will have to pay up. Banks are becoming more reluctant to lend to each other now than they have been since April 2009, according to the iTraxx Financial indexes of credit-default swaps. The cost for European banks to fund in dollars is near a 2 1/2-year high.

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Morgan Stanley (NYSE:MS) has estimated that banks need an extra 80 billion euros by year’s end, and that doesn’t include the extra capital now being required by regulators as a defense against another financial meltdown. With high borrowing costs and new capital requirements to fulfill, all banks but the strongest must turn to the European Central Bank for its unlimited six-month loans.

Many banks are choosing to deposit cash with the ECB rather than lend it to others that need it, says John Raymond, an analyst at CreditSights Inc. in London. “In itself, that’s a sign of stress in the interbank market” and means companies will have to pay more to borrow. The extra yield investors currently demand in order to hold bank bonds rather than benchmark government debt rose to 302 basis points, according to a Bank of America (NYSE:BAC) index, the widest spread since July 2009, and up from 220 last month.

Many have suggested that joint euro bonds, shared by all nations using the common currency, would stabilize weaker economies, but German Chancellor Angela Merkel has already ruled out the option, which might stabilize weaker economies, but at the expense of stronger economies like Germany (NYSE:EWG), which is not only the largest in the euro zone, but was the quickest to pull itself out of the recession.

Lars Frissel, a member of the Basel Committee for Banking Supervision and chief economist at Sweden’s central bank, said last week that it wouldn’t “take much for the interbank market to collapse.” Peter Chatwell, a strategist at Credit Agricole, says “There’s been a huge failure of policy makers to deal with the crisis and that’s led to a general loss of confidence.”

The numbers support Frissel’s and Chatwell’s claims. The Markit iTraxx Financial credit-default swap index, which measures the senior and subordinated bonds of banks and insurers, rose to an all-time high today, while the equivalent index tied to riskier junior bonds rose 11 basis points to 452, an 112% increase from its low of 213 on April 7.

“Funding is as big a constraint on lending as capital is,” according to Huw van Steenis, an analyst at Morgan Stanley (NYSE:MS) in London, which “could lead to a grinding credit crunch in the southern euro zone as banks look to reduce dependency on both the ECB and wholesale funding.” But that also means they are unlikely to witness the sort of liquidity crisis the world experienced in 2008. Matt Spick, an analyst at Deutsche Bank (NYSE:DB) says that he rather expects a “slower moving, but still-toxic, funding crisis.”