Europe's banks could face a capital shortfall of hundreds of billions of euros if Greece forces them to slash the value of its debt by 50 percent and other troubled euro zone countries like Italy and Ireland follow suit.
Pressure on Europe to shore up its banks -- if necessary with capital from taxpayers' pockets -- is building, as talk of a possible Greek default gains pace.
Banks could probably cope with a Greek default -- analysts at Nomura put the damage to foreign banks at 40 billion euros ($54 billion ) -- but markets are already focusing on bigger countries and debt writedowns right across the region.
Imagine there's no sovereign default -- then ... capital is absolutely fine. However, if there's a sovereign default or they are forced to mark their existing positions to market without a default, then that causes capital problems, said Chris Bowie, head of credit at Ignis Asset Management.
Banks could be forced to write down their Greek debt holdings by half if Athens fails to hammer out a deal about a second bail-out, Greece's finance minister has said, according to two newspapers in Greece on Friday.
The country's government later said it was still focusing on getting its second bail-out done, but worries about Europe's banks were left firmly in place after a French regulator said 15 to 20 banks needed more capital.
He ruled out any French banks needing more capital, however, and other major countries such as Germany and Spain are also dragging their heels, claiming their banks are in no desperate need -- often at odds with the market's view.
The International Monetary Fund reckons Europe's banks could need to recapitalize to the tune of 200 billion euros, and many bank analysts are even gloomier than the Fund.
Credit Suisse calculates banks may need 400 billion euros of capital by 2012 to fill a hole left by a recession, losses on sovereign debt and higher funding costs.
And Barclays Capital estimated European banks could need about 230 billion euros to preserve their capital buffers in the extreme case they lose half the value of Greek, Irish, Portuguese, Spanish and Italian debt.
TUMBLING BANK STOCKS
Worries that a euro zone sovereign crisis has infected the bank sector has sent their funding costs spiraling, rattling credit and equity investors.
The European bank stocks index was up 1 percent by 1303 GMT on Friday. It has tumbled 16 percent this month, and lost 37 percent since the end of June. It is now at its lowest level since March 2009.
Investors are losing patience with the lack of momentum on financial repair and reform. Policymakers need to accelerate actions to address long-standing financial weakness to ensure stability, the IMF said this week.
The spillover cost of the sovereign crisis on Europe's banks was 300 billion euros, the IMF estimated.
Private investors are clear they will not provide the money to fill the capital gap while Europe struggles to find a joined-up strategy to exit its spiraling debt crisis.
Capital markets investors would be willing to step up and subscribe to rights issues et cetera if you could quantify the size of the (capital) hole, said one investment banker who works in capital markets, requesting anonymity.
Investors want to know if they are going to be writing a cheque, that cheque does it, that there is not going to be in three months time another capital increase, the banker said.
A slew of mid-sized banks are most in need of capital, but bigger banks could need funds too. Under Credit Suisse's gloomy scenario, Royal Bank of Scotland, Deutsche Bank, BNP Paribas, Barclays, HSBC, Societe Generale, Santander, Unicredit, Commerzbank and UBS would each need over 20 billion euros by 2012.
But Europe's banks have already received 420 billion euros of capital since 2008 to make them safer, and many bankers and investors reckon fears have been overdone and risk creating a self-fulfilling cycle.
Having a blanket recapitalisation of European banks could be extraordinarily counterproductive because the market will rightly ask 'why are you recapitalizing all the banks?' said Justin Bisseker, European banks analyst at Schroders.
The capital isn't a problem unless you get widespread sovereign defaults, which is a bit of a game changer for the global economy.
(Additional reporting by Douwe Miedema, Sinead Cruise, Kylie MacLellan, Chris Vellacott and Michael Shields; Editing by Sophie Walker)