Spain and Italy Hit by Downgrades

The Wall Street Journal

After Fitch's Blow to Two Sovereigns, Moody's Makes Late Move to Put Belgium on Negative Watch

BRUSSELS—Spain and Italy suffered debt downgrades Friday, triggering a retreat in the euro as European governments scrambled to develop a common approach to restoring confidence in the region's banks.

Fitch Ratings surprised financial markets by downgrading Spain two notches to double-A-minus, citing an intensifying crisis in the euro zone and the expectation of growth of less than 2% through 2015; Italy's cut, by one step to single-A-plus, was less of a shock.

Late Friday, in an indication of how the crisis risks spreading to other euro-zone economies, Moody's Investors Service also placed Belgium's Aa1 rating under review for a possible downgrade, indicating concern over the government's high debts. After the government stepped in this week to guarantee the debts of Franco-Belgian bank Dexia SA, Moody's also cited the likelihood that the government would have to step in to provide additional support to banks.

Moody's also downgraded the ratings of nine Portuguese banks, citing in part their holdings of Portuguese government debt. (It also lowered the ratings of a dozen British banks, but for different reasons. The agency said those downgrades were due to changes in U.K. rules that diminished the likelihood of future government bailouts. The U.K. doesn't use the euro.) The downgrades emphasize the self-feeding downward financial cycle in the euro area. The credit-worthiness of governments of weaker economies is being undermined by the crisis, which is in turn hurting the many banks in the region with big holdings of sovereign bonds. But confidence in banks depends on the belief that governments have the financial muscle to support them in a crisis.

In an effort to come up with an initiative to break that cycle, European officials continued discussions about how to dispel doubts about the region's banks.

German Chancellor Angela Merkel and French President Nicolas Sarkozy will confer Sunday in Berlin, in a meeting that could be critical in reaching a Europe-wide strategy for the banks. Differences in the approaches of the governments of the two largest euro-zone economies have emerged, with France appearing to favor a common European solution and Germany emphasizing a national approach.

French Finance Minister François Baroin said Wednesday that any recapitalization of banks in the wake of the euro-zone debt crisis would need to take place at a European, not national, level. The French banks and the government deny that France's banks need any extra capital. Analysts say that if funds are provided on a European level they would have less impact on France's top triple-A credit rating than if they were provided nationally. A French finance official said Friday that "It is premature to say there is divergence as we haven't yet discussed the details" on a political level in Europe. The official said France and Germany agree on the need to boost European banks' capital, and said financial markets were demanding that such a boost happen sooner rather than later.

Both nations view injecting public funds as a "last resort,", the official said.

Speaking Friday, Ms. Merkel said a summit of European leaders on Oct. 17 and 18 should provide an indication of how to go forward. She described a "hierarchy" for bank recapitalization that suggests banks needing more capital should first try to raise it themselves, turning to national governments only if they can't do that. If the governments themselves have trouble raising money, only then should they be allowed to turn to the euro zone's bailout fund, she said.

She said the European Banking Authority, created this year to regulate banks, would determine the need for any possible recapitalization.

European officials said information obtained in this summer's bank stress tests would be used to examine the banks' financial needs amid the deteriorating economic conditions since then. The EBA also would decide whether to raise the capital threshold for banks and whether to investigate the impact on banks of sovereign debt defaults, one EU official said.

The examination is expected to be delivered to the leaders at their summit.

An EBA spokesman, Romain Sadet, said the agency hadn't received any formal instructions from the EU to take another look at the banks. The stress tests have been criticized for failing to examine the impact of what appears to be the biggest threat to the bloc's banking system—a major default by Greece—possibly followed by the defaults of other nations in the troubled euro-zone periphery.

Dexia comfortably passed the summer's stress tests for capital—its ability to absorb losses. The tests also examined bank liquidity—the ability to access ready cash to deal with the kind of strains that brought Dexia down—but the liquidity results weren't disclosed.

In a report Friday, Moody's said European banks needed to reduce their reliance on wholesale funding. Banks in the euro area depend on average for almost half of their funding from often-skittish wholesale markets, whereas U.S. banks on average have close to 70% funding provided by more stable retail depositors.

"Until this problem is corrected, 'fixing' European banks is merely applying band-aids," the report said.

Germany hasn't conceded that its own banks need any more capital. Germany's bank rescue fund, known as SoFFin, could be reactivated if the need arises, but discussions on a possible recapitalization of banks are highly precautionary, German Finance Ministry spokeswoman Silke Bruns said.

France's vehicle for the recapitalization of banks is active and legally operational, officials say.

—Bernd Radowitz contributed to this article.

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