ANALYSIS:French leader may soon have no alternative but to recapitalise banks – but where does it end?

ON AND on it goes, relentlessly. Wracked by indecision and disunity, EU leaders are struggling to convince their many doubters that they have it within them to contain the expanding debt crisis. Greece is teetering; Italy is on the rack; fears of a new banking emergency are growing.

It all comes back to Greece, starting point of the crisis and its engine room. The core question right now is whether the ailing country secures access to the next €8 billion under its first international bailout. This is in doubt due to its failure to deliver promised reforms, but the country’s deepening recession has also raised questions over the viability of the rescue.

This poses a series of intractable problems for European leaders, who harbour deep fears that the crisis could spread deeper, into Italy. It also raises tricky issues for French banks, which are heavily exposed to Greece. By extension, this raises questions for president Nicolas Sarkozy.

At one level, Europe is playing hardball with the Greeks, warning in dire terms that the next loan won’t be delivered if new budget cuts aren’t made. At the same time, however, Europe argues that it won’t allow the country to default.

There is an inherent conflict in these two positions. Greece could run out of cash next month without new funding and it is increasingly difficult for the government of prime minister George Papandreou to persuade its backers that it will do as it promises. The evidence suggests the contrary, leading to ever-increasing frustration at the slow progress of the rescue.

Nowhere is this more so than in Germany.

In spite of soothing words from chancellor Angela Merkel, Berlin has produced enough warning signals in recent days to suggest that the default option is under serious consideration.

This serves to fan pressure on the banking system. Unavoidably, the banks with the biggest holdings of Greek bonds feel the most heat. Hence the drubbing meted out to French banks since the beginning of summer. They are estimated by the Bank for International Settlements to hold $56.7 billion (€41.3 billion) in Greek bonds, a sum which would imply huge losses in a default scenario.

The problem for French banks is that their risk assumptions vis-à-vis their Greek holdings centre on a 21 per cent “haircut” on their investment. That was the level foreseen in a deal last July in which EU leaders urged private creditors to participate in the country’s second bailout via a debt swap to lengthen the maturity of some Greek debt.

Mr Sarkozy was one of the chief promoters of that arrangement, but it is still unclear whether it will go ahead as planned. Many market investors have made the working assumption that the deal won’t work anyway, and they assume a 50 per cent haircut in an eventual default.

That’s very bad for French banks as it entails higher losses than they might be able to withstand. It is a further force for pressure on big French lenders like BNP Paribas, Crédit Agricole and Société Générale, which have endured heavy losses.

Their shares recovered some ground yesterday but any renewed upsurge of pressure would fuel expectation that Sarkozy would have to recapitalise the banks with taxpayer funds.

That he would be loath to do. Yet high-level euro zone sources believe there is a big risk now that he may have no alternative. Any such move would provide a cushion against a Greek default for the banks, but it would be akin to flushing money down the drain for Sarkozy. Nevertheless, events seem to be moving in this direction.

It is a given, of course, that any French recapitalisation would trigger demands for similar measures to boost weakened banks elsewhere with the consequent danger of a full-blown crisis if the relevant governments do not or cannot step up with the money.

Risk is everywhere. While markets staged a modest turnaround last night, days of unyielding tumult reflect concern that the crisis is spinning out of control. Cue warnings from US president Barack Obama, and the unlikely spectacle of his treasury secretary going halfway around the world to a meeting of EU finance ministers in Poland. It is a shambles.