European banks walk tightrope with no net

    Corporate retreats sometimes feature a trust-building exercise in which participants fall backwards into the arms of their colleagues. European banks are now involved in the same exercise, but there is considerable doubt whether they will be actually caught before they crash.

    Earlier today we wrote about the European Central Bank's plans to stress-test European central banks; the results will be released on July 23.

    However, we neglected to mention the various discussions of backup plans for troubled European lenders. Well, not so much "neglected" as "regarded with such intense skepticism that we didn't bother to mention them," but it still may be worth exploring to see just how few options Europe's banks have if they are found not to pass muster.

    Until recently, the European Central Bank gave out 12-month loan facilities that provided a cheaper borrowing option for banks than interbank lending. In a crisis, interbank lending gets expensive - and may even shut down - and it's by now common for central banks to step in with some direct lending. The Federal Reserve did something similar with its successful TALF program in the United States. The ECB's program was temporary, and it required banks to pay back the $540 billion they borrowed.

    However, the ECB is no longer providing that 12-month loan, which takes away one backstop in a crisis. Many banks are now tapping three-month loans from the ECB (albeit in smaller numbers), which saw about $161 billion of demand compared to the $300 billion that many were expecting. That's good, because it shows that many banks are not in such bad shape that they have to borrow from the ECB - but, if you look more closely, the numbers do show that considerable demand considering that the ECB's interest rate of 1% is much higher than banks charge each other for interbank lending. That means that the banks who tapped $161 billion - a significant amount - are in weak shape and need to pay more to get access to loans.

    In addition, those three-month loans are a nice option, but they are not a long-term solution.

    Then there is the European Union band-aid solution. It has promised its member countries that they can tap a $630 billion euro backup plan if they run out of money to support the lenders.

    This is, of course, a somewhat entertaining choice because the Eurozone countries themselves have a bailout fund, the ESFS, that is a backup plan if they cannot support themselves. That fund is paid into by other countries in the eurozone, many of which have their own troubles. Greece, for instance, does not have to contribute to the bailout fund, but would get help from the fund if it needed it. But this backup plan is itself weak because its parameters are unclear; investors can't even say for sure whether it has a triple-A rating.

    Essentially, the EU is offering a backup plan to a backup plan - which itself is not really a "plan" so much as "vague promises." All the while the potential recipients don't need backups at all. They need real money now. If the EU really wants European banks to impress the markets, it needs to do better than that.