Testing Europe's fragile bonds

Investors face a nervous start to the week as they ponder the extent to which the emergency bailout of a troubled Greek bank on the weekend reflects the much more deep-rooted and disturbing problems in the European financial system.

Faced with the dire prospect of a run on the country's fragile banking system, Greece's four major banks had little choice but to agree to participate in a €50 million recapitalisation of the small lender, Proton Bank.

Proton's problems had been brewing for several weeks, as nervous depositors rushed to withdraw their funds amid reports that the bank's largest shareholder, the 39-year old pharmaceuticals and media magnate, Lavrentis Lavrentiadis, was being investigated for alleged embezzlement and money-laundering. The bank reportedly has a large exposure to struggling businesses within his empire.

Earlier this month, Greece's central bank replaced Proton's board and senior management after discovering a €51 million hole in the bank's balance sheet.

But the weekend bailout is a stark reminder of the fragility of the Greek banking system. It also comes at a time when Greece's four major banks – National Bank of Greece, Alpha Bank, EFG Eurobank and Piraeus Bank – face their own liquidity challenges because the Greek government is set to withdraw about €10 billion of government deposits from local banks in order to pay back maturing debt. As a result, several Greek banks, which no longer have enough high-quality collateral to borrow from the European Central Bank, will have little choice but to turn to Greece's central bank for some emergency liquidity assistance.

The latest turmoil in the Greek banking system comes at a time when investors are increasingly worried that some European banks could face major losses as a result of their heavy exposures to the debt of the weaker eurozone economies. This anxiety, combined with the wider gloom about a slowing European economy, has caused European bank shares to plunge by more than 20 per cent since the beginning of the month. What's more, few expect this gloomy mood to dissipate quickly. According to Frdric Ouda, the head of French bank Socit Gnrale, "nervousness around banking stocks could last at least until the beginning of November.”

But European political leaders are refusing to bow to market pressure to stem the widening eurozone debt crisis by issuing 'eurobonds' – that is, bonds that are collectively backed by all members of the eurozone.

Proponents argue that eurobonds would make it cheaper for countries such as Italy and Spain, which have faced a steep increase in borrowing costs in recent times, to fund themselves at more favourable rates. However, Germany, which is currently able to borrow at extremely low rates, would be faced with higher borrowing costs.

German chancellor Angela Merkel again urged European leaders to stand firm in the face of the "dramatic crisis” engulfing the eurozone, and reiterated the German view that the only way out of the eurozone debt crisis was for weaker countries to slash their deficits, and to boost their competitiveness. "This is a hard and arduous path, which we will not be able to avoid by means of some magic bullet, like issuing eurobonds,” she said in an interview on German television on Sunday.

Merkel also staunchly refused to tailor policy to placate investors, saying "the markets want to force us into doing certain things, and that we won't do.”

Meanwhile, French Prime Minister Franois Fillon warned that issuing eurobonds could push up France's borrowing costs, and put France's triple-A credit rating at risk.

"Some argue in favour of European bonds, 'eurobonds', which they see as a panacea. But they forget to say that this would increase the cost of France's debt and could even jeopardise its credit rating," he wrote in an article for the French newspaper, Le Figaro, which was published on Saturday.

Fillon argued that eurobonds would not be possible without far greater fiscal discipline, and stronger economic governance in the eurozone. But he added there was, at present, no political consensus for such initiatives.