Is the European banking system strong enough to withstand the double whammy of rising interest rates, along with growing fears that some of the “peripheral” eurozone countries might soon decide to reschedule their debts?

The question has been troubling investors this week ever since European Central Bank boss Jean-Claude Trichet hinted that a rise in eurozone interest rates was still on the table for next month, despite the impact of Japan’s devastating earthquake and tsunami, and the conflict in Libya.

Addressing the European Parliament on Monday, Trichet noted that inflationary pressures in the eurozone were rising, and said it was important for central banks to ensure that increasing price pressures caused by higher commodity prices didn’t trigger a wages outbreak.

When he was asked about the impact higher official interest rates will have on the weaker eurozone countries, Trichet replied that the ECB had to set monetary policy for the entire region.

But markets are most definitely worried about the damage that higher official interest rates will make it even more difficult for the debt-laden “peripheral” eurozone economies to service their borrowings.

What’s more, they’ve been rattled by the latest plans for the European Stability Mechanism (ESM), the permanent eurozone rescue fund that’s due to replace the current bailout fund in the middle of 2013.

Under plans hammered out by European finance ministers on Monday night, any loans made by the ESM will have preferred status, which means that they will be repaid first.

But bond holders are worried that this will see them being pushed to the back of the queue when it comes to recovering their loans should one of the peripheral countries default on their debt. And they responded by selling off Greek, Irish and Portuguese debt, pushing their borrowing costs even higher.

The latest Portuguese political crisis — with Portugal’s prime minister resigning after losing an important vote on an austerity packaged aimed at cutting government deficits — has added to the market’s nervousness. Portugal is likely to follow Greece and Ireland, and put its hand up for a bailout.

The problem is that the bailouts haven’t solved the basic problem for Ireland and Greece, that their debt burdens are simply too high.

The simmering problems with the Irish bailout came to the surface earlier this week when unfounded rumours that Allied Irish Banks had failed to make a coupon payment on some of its bonds swept through European bond markets.

The Irish central bank will be revealing the results of its latest “stress tests” on the country’s banks later this month, and the newly elected Irish government will then have to decide how much capital each bank needs.

But investors are nervous that the process of recapitalising the Irish banks could result in losses for the senior bond holders. During the recent Irish election campaign there were frequent calls to force bond holders to bear some of the losses, thereby sparing Irish taxpayers from having to bear the full cost of paying for the Irish banks’ reckless lending.

There are hopes European Union’s latest round of stress tests will likely provide investors with some reassurance.

Last year’s stress tests, which failed only seven out of 91 banks, were proved to be farcical when the Irish banks collapsed only months after passing the tests.

This time around, the European Banking Authority is making the stress tests more credible. The banks will be required to test for the impact of further drops in the value of sovereign debt, a tougher economic recession, higher interest rates and lower property prices.

Still, some claim the tests are still too soft on the banks, particularly when it comes to forcing the banks to recognise losses on their huge investments in eurozone sovereign debt and requiring the banks to top up their equity capital.

As a result, concerns that European banks remain under-capitalised are likely to linger.

*This first appeared on Business Spectator.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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