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Last week the International Monetary Fund sent out a warning about Europe's banks. The IMF said efforts to clean up the bank's balance sheets could actually end up hurting the economy, which is already on the verge of a recession. The warning comes at a time when the health of the banks is generating a lot of concern, and efforts to help them have had mixed results.

NPR's Jim Zarroli reports.

JIM ZARROLI, BYLINE: The walls inside Basia Szlomowicz's Clock Shop in downtown Frankfurt are lined with timepieces of every kind - from digital watches to cuckoo clocks. She's turned off most of them so she can hear her customers, though the occasional chime fills the air.

(SOUNDBITE OF CHIMES)

ZARROLI: Szlomowicz's family has run this store for 55 years. Like a lot of business owners, she's seen revenues fall lately.

BASIA SZLOMOWICZ: You see a lot of people don't have work, so they're afraid to spend money because they don't know what tomorrow going to be.

ZARROLI: Her problems are made worse because credit has been tightened. Szlomowicz's family has used the same bank for years.

SZLOMOWICZ: They know us, we pay back, and then we need some little bit more money and it was like this. But now you have fix. This is the amount, not more.

ZARROLI: In the United States, small businesses raise money by going to credit unions or getting an SBA loan, or even using their credit cards. Bigger businesses go to private equity or venture capital firms, or they sell stock. There are lots of ways to raise money. But in Europe, businesses depend heavily on big banks.

Nicolas Veron of the research institute Breughel says that's one of the reasons the financial crisis hit Europe so hard. Veron says yes, American banks had problems and credit dried up for a while.

NICOLAS VERON: But the financial system didn't stop operating during that process, while in Europe when banks are hit and don't function normally, basically the whole financial system becomes dysfunctional.

ZARROLI: That means reviving Europe's economy will depend heavily on how its banks are doing. And it underscores the banks' dilemma. Europe needs them to keep lending, but they're also under pressure to do clean the toxic debt off their balance sheets in a way that will make lending harder.

Yalman Onaran, author of the book "Zombie Banks," says the financial crisis left the world with a lot of troubled banks that have been kept alive with the help of governments and central banks.

YALMAN ONARAN: But in Europe, there are so many examples in so many countries, and of course, the repercussions of their zombies is also problematic for our banking system, too. I mean, our banks lend to their banks, too.

ZARROLI: Many of the most troubled banks, like the French-Belgian Dexia, lost money in subprime mortgages and Greek bonds. Others have suffered liquidity problems. As Europe's troubles mounted, investors fled and banks couldn't raise the funds they needed to operate. The European Central Bank had to rescue them with short-term loans of more than a trillion euros.

VERON: The banking system has been basically in a state of systemic fragility since, at least, October 2008 and has never got back to normal.

ZARROLI: Last October, the troubles multiplied. European regulators ordered big banks to shore up their balance sheets by adding 115 billion euros to their loan reserves by June. It's not clear how they'll raise the money. The IMF is worried they'll do so by cutting back on lending, Veron says.

VERON: They're afraid of a massive process of bank deleveraging, so banks shrinking their balance sheets and not lending and not taking your risk, and this is bad for the economy.

ZARROLI: The IMF warned that a credit slowdown would hit already troubled countries such Italy and Spain the hardest.

Regulators have tried to reassure investors about the banks' health. They forced the biggest banks to undergo stress tests, which they passed with flying colors. But the tests aren't always seen as very reliable. The last time around, regulators gave a clean bill of health to Dexia, just a few weeks before it imploded.

Jim Zarroli, NPR News.

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