The world's financial system showed new signs of strain on Wednesday as banks and investors clamored for U.S. dollars and two European banks took emergency measures to address the deepening crisis.
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European Pressphoto Agency
Members of the Italian Northern League Party demonstrate in Parliament with placards saying 'stop taxes.'
Stresses rippled through debt and stock markets despite measures taken by European leaders last week to help restore investor confidence. Reflecting the tension, rates that banks charge each other for short-term borrowing in dollars continued to climb, hitting their highest level since July 2009. Long-term Italian government bond yields jumped back above 7%, a level that would crimp Italy's ability to borrow in the future. Amid the rush for dollars, the euro dropped below $1.30 for the first time since January.
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Crédit Agricole SA, France's third-largest bank, said it will exit 21 of the 53 countries in which it operates to help shore up its finances. Commerzbank AG, struggling to avoid accepting a bailout by the German government, is in negotiations to transfer suspect assets to a government-owned "bad bank."
The Dow Jones Industrial Average dropped 1.1% to 11823.48. Markets in Japan, Australia and South Korea each fell more than 1% in Thursday morning trading.
Investors fret that the recent steps taken by Europe's leadership have done little to dissipate the growing strains across the markets. The concern is that with no solution in sight to the sovereign debt crisis, banks, which hold hundreds of billions of dollars of European government bonds, are at risk of suffering massive losses, threatening to cripple the Continent's banking system.
In this environment both investors and banks are demanding higher interest rates in return for the risk. Some are just refusing to lend. The retreat threatens to create a vicious cycle for the euro zone and could worsen the impact on the region's already weak economy. Europe is far more dependent on lending from its banks than the U.S. economy, where financial markets play a greater role financing companies and individuals.
"The problems are very large and the solutions are very difficult," said Gerard Cassidy, a bank analyst at RBC Capital Markets.
European banks are exposed to big potential losses in countries like Italy and Spain. The banks have huge portfolios of government bonds, and an increasingly likely European recession would hurt the value of all their assets.
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In the U.S., the government stepped in to prop up ailing banks during the 2008 financial crisis. Only after the banks were stable did they ask private investors for more capital to shore up their balance sheets. In Europe, the approach has been the reverse, in part because many European governments have piled up debt without having yet bailed out their banks.
Fitch Ratings on Wednesday evening lowered its ratings on five big banks from Denmark, Finland, France and the Netherlands. Fitch said the downgrades reflected deteriorating market conditions.
Earlier in the day, focus was on the potential downgrades of sovereign nations, as France's finance minister played down the potential impact of any downgrade of France's Triple-A rating.
As the European financial crisis developed, concerns about the euro-zone banking system have mounted. Earlier in 2011, U.S. money-market mutual funds, long important providers of short-term cash to European financial firms, began to cut down their exposures to the region sharply. Banks have been able make up for some of that lost liquidity by borrowing at the European Central Bank. But analysts estimate European banks have more than €700 billion of debt maturing next year that must be refinanced.
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Reuters
Jens Weidmann, president of Germany's Bundesbank, opposes the ECB printing money to ease the crisis.
European leaders continued to resist some of the sweeping measures investors were seeking—such as the ECB buying sovereign debt en masse, or the creation of a common euro-zone bond. Jens Weidmann, president of Germany's Bundesbank and member of the ECB governing council, said he remained vehemently opposed to the ECB printing money. German Chancellor Angela Merkel reiterated that creating such a bond would be no solution to the turmoil.
Europe's troubles are weighing on financial institutions around the world. In Sydney, Westpac Banking Corp. warned Wednesday that Europe's debt woes will impact the price and possibly the availability of credit to Australia's banks.
"Right at the moment, as you know, term markets around the world are effectively closed," Westpac Chief Executive Gail Kelly told reporters after the bank's annual meeting.
Short-term financing costs for banks dropped briefly following a coordinated move late last month by the world's central banks to ease strains in the debt markets. But traders on Wednesday noted that all but the top banks have lost access to these markets again. Many are now turning to the European Central Bank, which has stepped up its lending in recent days.
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European banks are seeking dollars to fund U.S. operations and dollar-denominated loans. On Wednesday, demand surged for the ECB's seven-day fixed-rate dollar funding. The ECB said that it allotted $5.122 billion, up sharply from $1.602 billion last week.
The cost of borrowing dollars for three months in the London interbank market rose steadily higher. Costs of borrowing greenbacks in those markets are now at the highest levels since July 2009.
"People are doing anything they can to get dollars on their books," said Scott Graham of government bond trading BMO Capital Markets in Chicago.
In announcing its plans to retreat from various markets, Paris-based Crédit Agricole also said it will boost reserves, cut costs and trim its reliance on market borrowing.
The moves by Crédit Agricole and Commerzbank are part of a bigger effort by Europe's banks to become leaner institutions. They are ditching business lines, selling assets and closing up shop in foreign markets. In short, the banks are bowing to market and regulatory pressures to get smaller while building thicker capital buffers to protect against unexpected losses.
There's "an underlying sickness" in the European banking industry, said Ronit Ghose, a European banking analyst at Citigroup. Lenders are trying to recuperate by dumping peripheral businesses and cutting back even in core areas.
Deposits at foreign-owned banks and U.S. branches of foreign banks have fallen 20% since May, according to Federal Reserve data, to a recent $877 billion. That's a sign that customers are moving their money elsewhere.
—Liz Rappaport, Tom Lauricella and Ross Kelly contributed to this article.
Write to Matt Phillips at matt.phillips@wsj.com and David Enrich at david.enrich@wsj.com
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