Buckle up for Europe's bank belting

European banks were belted overnight, as investors fretted about the central dilemma of debt-strapped governments trying to prop up banks that are themselves weighed down with too much debt issued by troubled eurozone governments.

Shares in UniCredit, which is Italy's largest bank in terms of total assets, plunged 17.3 per cent overnight after it announced that its rights issue would be priced at a hefty 43 per cent discount to Tuesday's closing price. The bank has seen its share price almost halved since it announced its plans to raise €7.5 billion ($9.6 billion) in capital last November.

Other Italian bank shares were also sold off, as investors worried about their future capital raisings and their hefty portfolios of Italian government bonds. Italian banks have to raise an extra €14 billion within the next six months to meet the tougher capital standards set by the European Banking Authority, which wants eurozone banks to build up a larger capital buffer to cover losses on their holdings of eurozone sovereign debt.

UniCredit's woes spread to other European banks. In Germany, Deutsche Bank dropped 5.6 per cent, while Commerzbank fell 4.5 per cent.

Spain's banks were also hard hit. On Wednesday, Spain's new finance minister, Luis de Guindos, estimated that Spanish banks would have to set aside an extra €50 billion to repair their balance sheets from the collapse of the country's property bubble. In addition, Spanish banks need an estimated €26 billion to meet the EBA's tougher capital standards by June.

French banks were also battered – Socit Gnrale led the decline with a drop of 5.4 per cent – even though Paris was able to sell almost €8 billion of bonds at an overnight auction, at interest rates that were only slightly higher than in recent sales.

Investors have now realised that the move by the European Central Bank last month to offer unlimited three-year loans to eurozone banks has only helped banks manage their liquidity problems. It has done nothing to solve the basic problem of insolvency.

The €487 billion that eurozone banks borrowed from the ECB last month means they now have sufficient funding to cover their borrowing needs for the first three months of this year. But hopes that the banks would use the ECB loans to buy up government bonds have been disappointed. Eurozone banks have deposited the bulk of their money back at the ECB, a clear sign that they intend to use the ECB loans to make up for their shrinking funding base.

This realisation is seeping back into the eurozone bond markets, with Italian 10-year bonds climbing back over the critical 7 per cent level overnight, while Spanish bonds also edged higher.

Investors are worried that markets will struggle to digest the €1 trillion (about $1.29 trillion) of bonds that the eurozone countries need to issue this year to cover maturing debts, particularly at a time when the region seems doomed to fall into recession as a result of tough austerity programs.

Investors are worried that if countries such as Italy and Spain fall into deep recessions it will erode tax receipts, making it harder for them to repay their debts. As a result they are selling off bonds, which is pushing bond prices lower, and ratcheting up the potential losses that European banks face on their massive portfolios of eurozone bonds.

At the same time, investors are worried that an economic slowdown will lead to increased business and personal bankruptcies and translate into higher bad debts for European banks, which will force them to raise even more capital to cover their writedowns.

But, as the UniCredit experience shows, raising capital is a fraught experience for eurozone banks. Even now, many European banks are wary of raising capital. Instead, they're choosing to cut back on lending and to shrink their balance sheets, rather than attempting to raise fresh funds from skittish investors.