The European Central Bank is paying close attention to mounting difficulties at 25 banks deemed crucial to the health of the eurozone financial system, fearing another wave of bank turmoil next year if the recession drags on.

By Ambrose Evans-Pritchard, International Business Editor
Published: 9:57PM BST 10 Jun 2009

Dejan Krusec, the ECB's financial stability expert, said the banks are strong enough to weather the current downturn so long as there is a rapid "V-shaped" recovery but not if it takes longer to refloat the economy.

"If this is 'U-shaped', the banks will have problems. There are 25 banks we monitor that are strategically important," he told a Fitch Ratings conference on Eastern Europe.


"The problem is not 2009. Euro-area banks are well enough capitalised to cover losses. The problem is 2010. We are concerned about the length (of recession)."

The ECB has slashed its forecasts, predicting a 4.6pc contraction this year and a further fall of 0.3pc next year, with no recovery until mid-2010. This precludes any chance of a V-shaped rebound.

The clear implication is that the ECB is battening down the hatches for another storm as rising defaults eat into bank capital.

This aligns the ECB with the International Monetary Fund, which has called for urgent action by EU authorities to clean up Europe's banks and disclose likely damage.

Piroska Nagy, an adviser to the European Bank for Reconstruction and Development, said the danger is that West European banks will retreat from Eastern Europe, "causing a collapse of the banking sector" across the region.

The EBRD and the World Bank have put together a €25bn (£21bn) fund for use as an "incentive" to discourage banks from abandoning subsidiaries. "It is a respectable amount, but not nearly enough," she said.

Some 30pc of fund managers polled at the Fitch conference said they expect defaults in several Eastern European states. A further 11pc expect a full-blown “systemic” meltdown.

West European banks have $1.6trillion (£977bn) of exposure to the region, led by Austrian, Belgian, Swedish and Dutch lenders. While attention has been focused on Latvia’s currency peg, large losses are building up in Hungary, the Balkans, Russia and Turkey.

“Survival is going to be very tough for the majority of privately-owned banks in Ukraine,” said James Watson, Fitch director in Moscow. In a “worst case” scenario, write-offs will amount to $135bn in Russia, $46bn in Ukraine and $38bn in Kazakhstan. Even the “base case” entails losses of $122bn for these three states alone. Russia’s private companies borrow in dollars because it is hard to issue rouble bonds. They must roll over $145bn of foreign debt this year, and pay interest from revenues in devalued roubles. Construction firms face the worst crunch.

There is no quick fix for Eastern Europe. “It is going to be even more difficult for them to export their way out of trouble than it was for East Asia in the 1998 crisis,” said Edward Parker, Fitch’s head of emerging Europe.

This time the whole world is in recession. Besides, Latvia, Estonian, Lithuania and Bulgaria are trapped with currency pegs at over-valued rates, implying harsh deflation. “There is a limit as to how much pain can be borne in democracies,” he said.