German Chancellor Angela Merkel, in Brussels after her meeting with European Commission chief Jose Manuel Barroso.

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The EBA , could identify capital shortfalls across the banking system of as much as €200bn ($266bn)

Regulator is also closely involved in talks over mechanisms that could be used to forcibly recapitalise banks

EBA is writing a country breakdown of how much new capital banks would need in the event that Greece's bonds were written down

Financial Times  — 

Europe’s top banking regulator has started to re-examine the strength of the region’s banks, modelling a big writedown of all peripheral eurozone sovereign debt.

The exercise, conducted by the European Banking Authority, could potentially identify capital shortfalls across the banking system of as much as €200bn ($266bn).

The EBA, which is mid-way through a two-day crisis board meeting designed to assess the potential hit of mass sovereign restructurings, will use market values, to set “haircuts” on banks’ sovereign holdings.

The regulator is also closely involved in talks with European officials and governments over mechanisms that could be used to forcibly recapitalise banks, enabling them to cope with sovereign defaults.

The move, a tacit admission that the European Banking Authority’s two previous rounds of bank stress tests were not sufficiently robust, came as Angela Merkel, the German chancellor, said she was prepared to recapitalise her country’s banks if necessary. She suggested she wanted to discuss joint EU-wide bank support efforts at an EU summit in two weeks.

“We’re under the pressure of time and I think we need to take a decision quickly,” Ms Merkel said after meetings with the European Commission in Brussels.

According to senior officials involved in the process, the EBA has been instructed to provide a country-by-country breakdown of how much new capital banks would need in the event that Greece’s bonds were written down.

The officials insisted the move was not an indication that EU leaders were preparing for a Greek default. Instead, they said it was a precautionary measure intended to inform rapidly accelerating negotiations on EU-wide bank recapitalisations.

The International Monetary Fund also gave its support for a quick recapitalisation, with Antonio Borges, the IMF’s Europe director, saying a lack of funding was causing banks to cut back on lending, which in turn was a drag on economic growth.

Mr Borges pegged the cost of a Europe-wide recapitalisation at €100bn-€200bn, and urged leaders to require all European banks to take part.

The primary hold-out appeared to be France. Despite Paris’s ongoing efforts to rescue Dexia, the troubled Franco-Belgian bank, the French government signalled it was uncomfortable with the accelerating talk of recapitalisation, insisting its banks did not need help.

“French banks do not need more capital than they have decided to accumulate by 2013,” one French official said.

The top three French banks, BNP Paribas, Société Générale and Credit Agricole, all own huge stocks of debt issued by struggling eurozone peripheral countries like Italy, Greece and Spain and have come under intense pressure from financial markets. All three have committed to reach minimum core capital levels set under the Basel III regulatory regime by 2013, six years ahead of the official deadline.

Jörg Asmussen, the German deputy finance minister, indicated Berlin was looking to “backstop” its banks more quickly. Mr Asmussen told the Financial Times that Berlin was looking at reactivating a bank rescue fund that expired last year. “Under this [reactivated] regime, banks could apply for new capital and continue to keep operating,” Mr Asmussen said.

Paris is resisting a quick recapitalisation effort run out of national capitals. According to French officials, Paris prefers to conduct Europe-wide capital injections with the eurozone’s €440bn rescue fund. But the fund, the European Financial Stability Facility, will not have those powers for at least several weeks.

“The response, if it must be made, will be European, it will be collective, it will not be French,” finance minister François Baroin told RTL radio.

Any state recapitalisation could threaten France’s triple A sovereign debt rating, which underpins its own fiscal retrenchment plan and its ability to help anchor the eurozone’s crisis measures.

George Osborne, British chancellor of the exchequer, has long argued that Britain’s banks are relatively well capitalised compared with those in the eurozone.

While Mr Osborne is satisfied with the situation at the moment, Treasury officials say that “we are constantly vigilant” about the safety of British banks in the event of contagion spreading from Greece across the eurozone.

For instance, there is a view in senior government circles that if the Greek crisis led to a break-up of the euro and widespread turmoil in the sovereign debt market that could require further recapitalisation of the UK banking sector.

Signs the European leaders were moving to recapitalise banks helped European shares rise for the fourth day in a row. The FTSE Eurofirst 300 index jumped 3.1 per cent, while European bank stocks rose by 4.6 per cent. The UK’s FTSE 100 index was also up 3.2 per cent amid the growing hopes that policymakers will act to stem the problems in the region.

Additional reporting by George Parker in Manchester and Joshua Chaffin in Brussels