European bank shares were pummelled overnight, while the cost of insuring bank and government debt hit record highs, as investors worried about the worsening eurozone debt crisis and the extreme fragility of the European banking sector.

The sense of doom was reinforced by comments made by Deutsche Bank boss Josef Ackermann, who told a conference in Frankfurt that conditions in stock and bond markets were reminiscent of the 2008 financial crisis.

“The ‘new normal’ is characterised by volatility and uncertainty,” he said. “All this reminds one of the fall of 2008, even though the European banking sector is significantly better capitalised and less dependent on short-term liquidity.”

Ackerman also acknowledged the fragility of the European banking sector, saying it was “obvious, not to say a truism, that many European banks would not cope with writing down the government bonds held in the banking book to market value.” However, he rejected the recent IMF suggestion that troubled banks should be forcibly recapitalised, saying this would undermine the credibility of the bailouts of debt-laden countries (The ‘L’ word is back).

Investors were also alarmed after another leading banker, ABN AMRO boss Gerrit Zalm, conceded that European banks were finding it increasingly difficult to raise funding in capital markets, and that interbank lending had become more difficult as banks were holding onto their liquidity.

In an interview on Dutch television on Sunday, he said that interbank borrowing for more than six months had become problematic because banks were reluctant to lend to competitors with “big positions in weaker countries’ debt”.

Instead of lending to each other, the banks are putting spare cash on deposit with the European Central Bank. Financial institutions have increased their overnight deposits with the ECB to the highest level in more than a year.

The ECB faces unprecedented pressure to rescue the European banking sector by providing unlimited amounts of liquidity. Major European banks have borrowed about €8 trillion ($US11.3 trillion) from wholesale and interbank markets, with almost half maturing in less than a year.

Last week, several banks were able to issue covered bonds — debt secured against pools of loans. But the unsecured bond market — where banks traditionally raise most of their funding — has been pretty much closed since early July. With banks now being forced to come back to market to complete their 2011 borrowing programs, there is a fear that even highly rated banks will be forced to pay much higher spreads, while the less well-regarded banks may find that they continue to be locked out of the market.

The doom overhanging the European bank sector has been intensified by the fact that some major European and UK banks have been named in a landmark US legal action over the sale of mortgage-backed securities.

The US Federal Housing Finance Agency is alleging that units of 17 banks, including Royal Bank of Scotland, Barclays, Deutsche Bank, Credit Suisse and Société Générale misrepresented the risks of almost $200 billion in home mortgage-loan securities sold to US housing agencies Fannie Mae and Freddie Mac (Freddie’s bailout revenge).

But Ackermann overnight appeared to shrug off the threat of legal action, saying Deutsche Bank intended to fight suits in the US, adding that proving fraud “won’t be simple”.

*This first appeared on Business Spectator.

Peter Fray

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