Euro crisis: the banks are back in the line of fire

The stock markets are now getting what the bond markets have known for a while. Growth in Europe will be weaker than previously forecast even if the eurozone can stave off another crisis. Europe’s central banker in chief Jean-Claude Trichet warned as much today.

Britain’s blue-chip index is down 10pc from its February peak, but it’s taken a second Greek rescue and a threat of deeper crises in Portugal and Ireland, and contagion in Spain and Italy to relay the message. Bank shares are back in the firing line, with Lloyds, RBS and Barclays shedding up to 10pc.

Weaker economies will mean more bad debt for the lenders and, if Spain or Italy are plunged into Greek-like sovereign debt despair, all bets are off. Another credit crunch would ensue, which would be highly damaging to those banks most exposed to funding markets (it’s no accident that Lloyds is the biggest loser today).

The sense is that the stock market has woken up to the fact that the choice is either bad (slower growth) or terrible (new crisis). Fears that the US recovery is coming off the boil aren’t helping.

If we’re lucky, this is how it will pan out. The Germans, in charge behind the scenes, will use the crisis to instruct Italy to accelerate its social reforms to boost competitiveness and implement fiscal reforms to make swift inroads into its debt. Similar pressure on Spain would see it bolster its austerity programme, potentially with more pension changes.

With that agreed, the eurozone bail-out fund, the EFSF, will be raised from €440bn to around €1 trillion – largely through German guarantees. In the meantime, the European Central Bank will have been calming markets with Spanish and Italian bond purchases.

In the US, the Federal Reserve will make it clear that a third round of quantitative easing is very much on the agenda. And, finally, we’ll enter another of those periods of market calm.

Europe’s track record is that it does the right thing at the 11th hour. Unless pushed, it doesn’t react. The US has been better, quite happily printing money. So, the optimist in me reckons this latest bout of market soul-searching should come good. Just how much damage will be wreaked in the intervening period is anyone’s guess, though.