'We Are In A Dangerous New Phase'

U.S. banks and money market funds have loaned hundreds of billions of dollars to European banks, and a European banking crisis would quickly cause big problems in the U.S. financial system and the broader U.S. economy.

So it's worth paying attention to the fight over a speech that Christine Lagarde, the new head of the IMF, made this weekend.

The global economy is in a "dangerous new phase," and Europe's banks need to raise more money to serve as a safety cushion against potential losses, she said. (They need to be "recapitalized," in the language of finance.)

If the banks can't raise money on the open market, European governments should step in, Lagarde added. This might look something like a European version of TARP, with governments taking temporary ownership stakes in troubled banks.

European officials responded by flipping out.

The FT writes:

European officials rounded on Christine Lagarde on Sunday, accusing the managing director of the International Monetary Fund of making a "confused" and "misguided" attack on the health of Europe's banks.

This response is not surprising.

European officials did a round of stress tests on the continent's banks a few months ago, and the banks fared pretty well. One key problem: The stress tests didn't take into account the possibility of European governments defaulting on their debts — and European banks hold hundreds of billions of euros in European government bonds.

Banks don't like the idea of being forced to raise capital, which would reduce the value of existing shares in the bank. Politicians don't like the idea because the prospect of another bank bailout is about as popular in Europe as it is in the U.S., according to Jacob Funk Kirkegaard, an economist I spoke to this afternoon.

Still, it's indisputable that Europe's banks are in trouble.

Like U.S. banks, they fund themselves largely by borrowing money from institutional investors. And it's getting harder for them to borrow that money, as investors get nervous about the banks' big holdings of European government bonds.

Critics of Lagarde's speech say this funding issue — not a lack of capital — is the core of the banks' problem.

But the funding issue is caused by a lack of confidence in the banks. And major capital injections — more than 100 billion euros, spread over banks in several countries — would restore confidence by giving banks a bigger safety cushion to protect against losses, Kirkegaard says.

"If you injected that kind of money into the banking system, that's very different from thinking you can solve a banking problem by having a long series of marginally tougher stress tests every year," Kirkegaard said. "This would be putting your money where your mouth is."