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Exclusive: EU officials sound alarm on credit crunch

By John O'Donnell

WROCLAW, Poland (Reuters) - The EU's top finance officials are urging ministers to reinforce banks' capital while warning that a "systemic" crisis in sovereign debt is hurting banks and risks a new credit crunch, according to EU documents.

In a series of bluntly worded reports prepared by officials for a meeting of finance ministers this week, they highlight a "risk of a vicious circle between sovereign debt, bank funding and negative growth" spurring a fresh freeze in lending.

"While tensions in sovereign debt markets have intensified and bank funding risks have increased over the summer, contagion has spread across markets and countries and the crisis has become systemic," officials write in the documents obtained by Reuters.

The reports, which raise concerns in unusually emphatic language and make pointed criticism of some countries for failing to help weak banks, highlight a sense of alarm in European capitals about the financial crisis.

They also show a growing sense of exacerbation at the failure of Spain, Germany and others to deal with flagging banks even after their weaknesses were exposed by recent stress tests.

In the documents, the influential Economic and Financial Committee, which prepares the agenda for discussion among ministers, urges action to bolster the balance sheets of weak banks, especially those with loans in stressed countries.

They level harsh criticism at countries including Spain for not doing enough to reinforce its banks following dismal results in stress tests.

At stake, they write, is the threat of another credit crunch.

One of the reports, dated September 13, cautions that the "spill-over effects" could feed "a dangerous negative loop between the financial and the real sectors (of the economy), whereby funding problems and ... risk aversion ... may lead to ... deleveraging by banks, thereby generating a credit crunch, in some Member States."

Outlining a sovereign debt crisis which they say has "entered a new phase," officials highlight the difficulties experienced by European banks in borrowing.

"Despite the considerable strengthening of capital positions ... European banks have recently experienced market funding difficulties resulting ... from stress on wholesale liquidity markets, high spreads in secondary markets, and, for some EU banks, growing difficulties in accessing funding from U.S. counterparties."

To counter dwindling confidence in the region's banks, officials recommend to ministers that "a further reinforcement of bank resources is advisable."

"This is important for banks that have failed the stress test, but also for those that have passed the test but with capital levels close to the relevant threshold," the report said.

They criticize some countries for not taking such measures, which would include state-backed capital injections in flagging lenders, after the recent stress tests.

"Albeit having five institutions falling below the ... threshold in (stress tests) ... the Bank of Spain announced that no Spanish bank needs to further increase its capital," the report said.

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