Financial markets are behaving as if they expect a European banking crisis that would require the bailout or nationalization of some European banks. That would feel like a replay of the financial crisis that followed the bankruptcy of Lehman Brothers in the fall of 2008. Only this time, the epicenter would be Europe instead of the United States, and the ripples would expand from the eurozone outward into global financial markets.

How realistic is that fear? Very, I'm afraid. European banks are facing a very real liquidity and capital crisis that could lead to the need for a government rescue of some globally significant banks.

But the crisis isn't an exact replay of the 2008 crisis. The effects of the crisis would not be limited to Europe, but the likelihood that a European crisis would take down a major U.S. bank -- in a mirror image of the 2008 crisis where problems originating in the United States did lead to the bailouts of banks in the United Kingdom, Germany and Belgium -- is relatively small. On the other hand, the crisis is potentially worse this time around because the European Central Bank is much less able to intervene as a lender of last resort than the U.S. Federal Reserve was in 2008.

Understanding this crisis

The current European banking crisis is rooted in the Greek, Italian, Spanish, Portuguese and Irish debt crises. But the repeated collapse-bailout-collapse-again pattern of the prices of bonds of those countries wouldn't have produced the current mess without a series of missteps by banks, bank regulators and central banks.

Image: Jim Jubak

Jim Jubak

European banks hold a huge amount of government debt from the countries involved in the crisis. German banks, for example, held $22 billion in Greek government debt at the end of 2010, according to the Bank for International Settlements. If you add holdings of Greek government debt to holdings of private-sector Greek debt, the exposure gets much higher. For example, in May, Fitch Ratings said that French bank Credit Agricole (CRARY, news) had $35 billion in exposure to Greek government and private debt. BNP Paribas (BNPQY, news) and Société Générale (SCGLY, news) had exposure of about $11 billion each.

The exposure of European banks to Greece, however, is small souvlaki compared with exposure to the much larger Italian economy. BNP Paribas, for example, has an estimated $31 billion in exposure to Italian government and private-sector debt. Even where the total for Italy is not as high as for Greece, the additional exposure is big enough to add to worries. Credit Agricole has an estimated $17 billion in Italian exposure.

But the current banking crisis owes as much to the reaction of banks and bank regulators to the problem as to the size of this exposure. Nobody now expects that Greece will be able to avoid a default in the end. Even Sunday's announcement of new measures to close a $3 billion budget gap just served to convince financial markets that the more Greece cuts, the more the economy will slow, and the fewer taxes the government will collect. Like last year's rescue package, this year's deal, if ultimately approved, only buys time.

Banks were wasting time

But instead of using that time to get Europe's financial house in order, banks and bank regulators have spent the time dreaming that everything would somehow turn out all right. So, for example, banks have avoided marking to market their portfolios of Greek, Italian and other troubled debt securities.

The arguments have been varied and ingenious. Banks have argued that since the Greek II rescue package asked bondholders to take a 21% haircut on the value of their bonds, banks should value their debt at that same 21% discount -- even though the debt instruments were trading much lower. Banks have also argued that since it has become difficult to trade some of this debt, there is no market price that they can use to value it. Instead, they're marking this debt to the values calculated by financial models. Remember how well that turned out in the financial crisis of 2008?

And regulators, especially those in France, have let them get away with it. Regulators have pointed to the latest bank stress test and said, "See, our banks passed." But having a 6.5% Tier 1 capital ratio when 5% was the benchmark to earn a pass in the test was not enough. A 6.5% shouldn't earn applause when many countries are urging their banks toward a 10% standard.

You can probably predict the reaction in the financial markets. Because non-European banks can't trust the books at European banks to accurately state risk, they've stopped lending to European banks.

U.S. money market funds, a key source of short-term capital for European banks, have cut back their short-term lending. An August survey by Fitch Ratings found that 43% of the total prime money market funds reduced their exposure to European banks by 9% or more. Where money market funds have kept lending, they've cut the length of their loans. Fitch found that 20% of the money market fund lending to French banks was for maturities of a week or less. That's three times greater than just a month earlier. Money market fund exposure to Spanish and Italian banks has fallen even faster. It was effectively zero, Fitch found, by the end of July.

Markets don't trust the banks

This is a big deal, especially for French banks, which are particularly reliant on short-term funds from wholesale sources, such as money market funds. For example, French banks rely on short-term funding even for long-term lending. Credit Agricole, for instance, relies on short-term funding for 23% of lending for long-term mortgages. A reliance on short-term funding makes a bank extremely vulnerable to exactly the kind of squeeze that threatened the banking system after the collapse of Lehman Brothers.

And in the current market there's not a whole lot of long-term capital looking for a home at a European bank. Across the eurozone, banks have managed to sell $4.5 billion in debt this year, but almost all of that came in the first half of the year. For the past three months, banks have redeemed more in maturing debt than they've managed to sell in new debt.

According to Dealogic, net issues of bank debt in the region -- excluding covered bonds, which are secured against pools of existing loans -- are a negative $41 billion. Covered bonds can't fill the gap indefinitely, because new issues face limits imposed by the need to find existing loans to use as collateral and by national banking regulations. And it's not as if these banks can go to the equity markets to raise capital, except at a crushing cost. Shares of Société Générale are down 55% since June 15, and shares of Credit Agricole are down 45%.

The math gets pretty daunting if you look at the amount of debt that eurozone banks need to roll over in the next few years. And that doesn't even consider any new money they need to raise to expand their business (in case their economies have, you know, ideas about growing), or to meet new capital requirements. According to Deutsche Bank, eurozone banks need to finance nearly $2 trillion over the next five years.

Where will that money come from? Nowhere, without some kind of guarantee from either national governments or the European Central Bank. The ECB has done an astounding job of eating into its own credibility over the past year and of convincing everyone that its policies are as steady as the wind in Pomerania. Nobody is absolutely certain that the central bank stands ready to supply all the liquidity that eurozone banks might need. The past year has also highlighted the ECB's limitations as a lender of last resort. The ECB is dependent on member central banks for its funding, and it's by no means clear that those banks stand behind the eurozone banking system as a whole.

In fact, one big fear is that some national governments may be preparing to save their own banks while letting those in the rest of the eurozone twist in the wind. So, for example, when the rumors swept through the financial markets last week that Germany was preparing contingency plans to support its banks in the event of a Greek default, the market as a whole found the news chilling.