Four years to the month since the global credit crisis began,European lenders remain dependent on central bank aid, plaguingmarkets and economies worldwide.

Emergency steps such as unlimited loans from the EuropeanCentral Bank are keeping many banks in Greece, Portugal, Italy andSpain solvent and greasing the lending of others, while lowinterest rates and debt-buying are containing borrowing costs. Suchaid is needed as concerns about slowing economic growth andsovereign debt prompt banks to curb lending, stockpile dollars andhoard cash in safe havens.

“I'm not sleeping at night,” said Charles Wyplosz, director ofthe Geneva-based International Center for Money and BankingStudies. “We have moved into a new phase of crisis.”

Central bankers rescued financial firms after the collapse ofLehman Brothers Holdings Inc. in 2008 by providing limitlessfunding of as long as a year. While they treated the symptom — alack of ready cash — politicians, regulators and bankers in Europehave proved unable to cure the root cause: some European lendersare at growing risk of insolvency.

The tremors, the biggest since Lehman's collapse, were triggeredby European governments' continuing inability to stop the sovereigndebt crisis from spreading beyond Greece, Portugal and Ireland toItaly and Spain. Renewed signs of economic weakness globally andthe downgrading of U.S. debt by Standard & Poor's rekindledconcern about the quality of all government debt.

Bank Stocks Tumble
The signs of distressare widespread and mounting: Banks deposited 128.7 billion euros($186 billion) overnight with the ECB yesterday, more than threetimes this year's average, rather than lend the money to otherfirms. Banks also borrowed 555 million euros from theFrankfurt-based ECB's overnight marginal lending facility, up from90 million euros the day before.

European bank stocks have sunk 20 percent this month, led byRoyal Bank of Scotland Group Plc (RBS) and Societe Generale (GLE)SA. Edinburgh-based RBS, Britain's biggest government-controlledlender, has tumbled 43 percent, and Paris-based Societe Generale,France's second-largest bank, dropped 39 percent.

The extra yield investors demand to buy bank bonds instead ofbenchmark government debt surged to 302 basis points yesterday, or3.02 percentage points, the highest since July 2009, data compiledby Bank of America Merrill Lynch show. The cost of insuring thatdebt against default surged to a record today. The Markit iTraxxFinancial Index linked to senior debt of 25 European banks andinsurers rose to 252 basis points, compared with 149 when Lehmancollapsed.

Greek Default Concern
It was the specterof government debt turning toxic that has revived the liquiditycrisis policy makers had tried to stop in 2008. As speculation grewthat European banks would have to write down their holdings of moregovernments' debt after a Greek default, lenders pulled funding tothose banks that held the most peripheral debt. It also raisedconcern European governments would struggle to afford a furtherbail out of their banks, because both the state and the lenders hadfailed to reduce their borrowings since the onset of thecrisis.

“The debt has been transferred from the banks to the sovereign,but it hasn't actually been eradicated,” said Gary Greenwood, abanking analyst at Shore Capital in Liverpool. “Until thesovereigns get their balance sheets in order, then these concernsare going to remain.”

Funding markets have seized up as investors speculate thatsovereign debt writedowns are inevitable. Banks in the region hold98.2 billion euros of Greek sovereign debt, 317 billion euros ofItalian government debt and about 280 billion euros of Spanishbonds, according to European Banking Authority data.

Euribor-OIS
The difference between thethree-month euro interbank offered rate, or Euribor, and theovernight indexed swap rate, a measure of banks' reluctance to lendto each other, was at 0.66 percentage point today, within 4 basispoints of the widest spread since May 2009.

“The central bank is the only clearer left to settle fundsbetween banks,” said Christoph Rieger, head of fixed-incomestrategy at Commerzbank AG (CBK) in Frankfurt. “There is a mistrustbetween banks in general, between regions and with dollar providersoverall.”

Overseas banks operating in the U.S. may have cut dollarholdings by as much as $300 billion in the past four weeks asEuropean banks faced a squeeze on funding and sought dollars, JensNordvig, a managing director of currency research at NomuraHoldings Inc. in New York said Aug. 18. Dollar assets declined byabout 38 percent to $550 billion in the period, he said.

'More Nervous'
“Banks are becoming morenervous about being exposed to other banks as they hoard liquidityand become more suspicious of other banks' balance sheets,”Guillaume Tiberghien, analyst at Exane BNP Paribas (BNP), wrote ina note to clients on Aug. 19.

By contrast, banks in the U.S. are “flush” with liquidity, loanloss reserves and capital, Goldman Sachs Group Inc. analyst RichardRamsden wrote in an Aug. 6 report. Large commercial banks combinedholdings of cash and securities at large have climbed to 30 percentof managed assets, up from 22 percent at the start of the U.S.financial crisis in October 2007, Ramsden wrote, citing FederalReserve data.

The Federal Reserve, which provided as much as $1.2 trillion ofloans to banks in December 2008, wound down most of its emergencyprograms by early 2010. One of the few exceptions was thecentral-bank liquidity swap lines that provide dollars to the ECBand other central banks so they can in turn auction off the dollarsto banks in their own jurisdictions.

Trichet, Bernanke
Banks' woes are againthrusting central bankers to the fore as ECB President Jean-ClaudeTrichet joins Fed Chairman Ben S. Bernanke and their counterpartsfrom around the world in traveling this week to Jackson Hole,Wyoming for the Kansas City Fed's annual policy symposium.

After increasing its benchmark rate twice this year to counterinflation, the ECB this month provided relief for banks by buyingItalian and Spanish bonds for the first time, lending unlimitedfunds for six months, and providing one unnamed bank with dollarsto satisfy the first such request since February. In doing so, it'smaintaining a role it began in August 2007 when it injected cashinto markets after they began to freeze.

Coming to the rescue isn't easy for the ECB. Its balance sheetis now 73 percent bigger than in August 2007 and its latestbond-buying opened it to accusations that by rescuing profligatenations it's breaking a rule of the euro's founding treaty andundermining its credibility. Policy makers are also divided overthe best course of action, with Bundesbank President Jens Weidmannamong those opposing the bond program.

Economic Threat
The central bank is actingin part because governments have yet to ratify a plan to extend thescope of a 440-billion euro rescue facility to allow it to buybonds and inject capital into banks. Markets tumbled last week onconcern policy makers aren't acting fast enough.

The funding difficulties of banks was one reason cited by MorganStanley economists Aug. 17 for cutting their forecast for euro-areaeconomic growth this year to 0.5 percent next year, less than halfthe 1.2 percent previously anticipated. They now expect the ECB toreverse this year's rate increases, returning its benchmark to 1percent by the end of next year.

The economic threat is greater in Europe because consumers andcompanies are more reliant on banks for funding than their U.S.counterparts, said Tobias Blattner, a former ECB economist now atDaiwa Capital Markets Europe in London. He says the ECB shouldeventually try to hand over fire-fighting duties either togovernments, who would then inject capital into financial firms, ornational central banks, who could provide short-term loans tolenders.

'Uncharted Territory'
Longer-termsolutions may involve the restructuring the debt of cash-strappednations in a way that doesn't roil bank balance sheets, potentiallyin lockstep with a European version of the U.S.'s Troubled AssetRelief Program.

Lena Komileva, Group-of-10 strategy head at Brown BrothersHarriman & Co. in London, said the central bank may have nooption but to extend the backstop role it is playing for peripherybanks to lenders elsewhere. Refusal to do so would risk a Europeanbank default by the end of the year, she said.

“Markets are back in uncharted territory,” said Komileva. “Thecrisis is a whole new story now.”

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