Europe's banks back from brink for now
Fears of a crisis sparked by downturns in Central and Eastern Europe have receded, but observers warn it's too early to dismiss a possible relapse.
NEW YORK (Fortune) -- In the financial crisis, Europe's banking sector has been the shoe that wouldn't drop.
After U.S. banks teetered last fall, some observers warned that huge losses facing European institutions -- particularly on bubble-era loans to developing economies in central and eastern Europe -- could fuel a new round of banking mayhem.
But since then, markets have rallied, as taxpayers pledged trillions of dollars to support banks and global institutions such as the International Monetary Fund lent to cash-strapped smaller governments. And so far, Europe has avoided a full-fledged meltdown.
"We have definitely stepped back from the cliff a bit," said Mary Stokes, an economist who watches developing Europe for RGE Monitor, the analysis Web site run by NYU economist Nouriel Roubini.
One question about the European banking sector's health centers on the region's developing nations, such as the Baltic states of Latvia, Lithuania and Estonia as well as other central and eastern European states such as Hungary.
Their growth over the previous decade was fueled by heavy borrowing from banks in Sweden and other western European nations.
The fear was that a sharp drop in foreign investment flows would crater these economies, hitting the value of their currencies and leaving borrowers unable to repay loans made in now costlier euros, Swiss francs and Swedish krona.
A big enough wave of defaults could break the balance sheets of European banks stretched by years of easy lending, skeptics said. There were fears the big banks -- already dealing with billions in losses tied to bad investments in U.S. mortgage securities -- would compound the problems by cutting off credit to Europe's less wealthy countries.
A year later, the developing nations are indeed in deep distress. In Latvia, for instance, the unemployment rate has more than doubled over the past year, and analysts expect further wage and job cuts in the next year.
And like their counterparts in the U.S., European banks have yet to recognize substantial losses. Banking watchdogs warned this month that European institutions could face more than $500 billion in credit losses through the end of 2010.
But while the economic downturns have indeed been severe, so far the worst case hasn't materialized. "It appears that the European banks that invested in their Central and Eastern European neighbors are staying with them," said World Bank President Robert Zoellick in a speech late last month.
Meanwhile, the global market rally has helped banks raise capital, bracing them against further problems. In just the past week, BNP Paribas of France and UniCredit of Italy have set plans to raise billions in new funds.
"Western European banks appear able to absorb deteriorating credit conditions in emerging Europe," the International Monetary Fund wrote this week in its global stability report.
The latest sign of stability came Thursday, when European Union officials said 22 large banks controlling more than half the region's assets had passed their stress tests -- meaning they should be able to remain well capitalized even were the region to fail to return to modest economic growth next year.
The EU didn't name the banks, but Swiss regulators said giant UBS (UBS) and Credit Suisse (CS) passed a similar test. The Swiss did emphasize though that the banks should continue to raise capital and reduce leverage.
As in the U.S., the key question now is how stable the recovery will turn out to be -- and whether the markets will hold the gains they have made in recent months.
The health of developing Europe and the banks that have lent money there have been bolstered by "the general improvement in risk appetite," Stokes said, which has pushed up asset prices and made capital raising easier.
Still, a rebound based in part on a market rally is vulnerable to a market reversal. Europe's recovery also looks shaky, the IMF said, because banks "may lack sufficient capital to support a recovery in the region."
Beyond that, it's not clear that economic conditions are improving in places like Latvia -- which leaves open the possibility that banks could face massive losses months down the road.
Accordingly, there's an increased risk that a true global banking crisis will still materialize, said Stokes -- though she is hopeful that authorities will respond quickly enough in such an event to minimize the damage.
"How much have policymakers learned from the last brush with crisis?" she asked. "Hopefully this has woken everyone up." 
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