New IMF chief Christine Lagarde's call to recapitalize European banks by force struck a nerve among the continent's Europe's policymakers and showed she is not afraid to challenge her former peers as many feared she might be.

The message Lagarde delivered from the International Monetary Fund was not new -- it had been shared privately with European policymakers in the past. The difference is that the former French economy minister took the message public.

Speaking before top central bankers, finance officials and a phalanx of journalists at the Federal Reserve's annual retreat in Jackson Hole, Wyoming, on Saturday, Lagarde argued a recapitalization of European banks was urgently needed to erect a firewall against Europe's debt crisis.

A draft of the IMF's Global Financial Stability Report, to be released in late September, has estimated European banks could face a capital shortfall of up to 200 billion euros ($287 billion), according to a European source on Wednesday.

The pushback from Europe's politicians, who argued their bank balance sheets were just fine, took the IMF by surprise, but the reaction showed the officials got the message.

Either she had been misinformed by her staff at the IMF, that's a possibility, or she did not have French banks in mind, said Christian Noyer, head of the Bank of France, in an interview with French television station BFM.

Emerging market economies have long called on the IMF to show evenhandedness in its advice to member countries, including the advanced economies that have always shunned the fund's advice.

Jacob Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, said Lagarde had chosen the right subject to pick a fight with her former European colleagues.

It illustrates that Lagarde is evidently not treating Europeans with velvet gloves, said Kirkegaard, noting that many of those she offended had supported her nomination to the IMF's top post. She has chosen a good subject over which to show her independence, he added.


While Lagarde is likely to flesh out her thinking on bank recapitalization in the run-up to meetings of financial chiefs in Washington on September 23-25, the IMF has been saying since the global financial crisis erupted that weaker European banks were undercapitalized.

International markets have also yet to be convinced that European banks are sound despite successive stress tests, which Lagarde had backed as finance minister. Eight of 90 lenders failed those tests with a total capital shortfall of 2.5 billion euros.

Markets fundamentally don't believe that many of Europe's banks hold enough capital, said Kirkegaard. They thus question the solidity of the entire European banking system.

Questions over the health of balance sheets weighed down by European government debts has made it difficult for some banks to find the capital they need. But officials in Europe argue that reflects a problem of liquidity and not of solvency.

Lagarde's concern is that the world economy has entered, in her words, a dangerous new phase and that politicians do not have the conviction to take the tough steps needed to tackle the problem.

The danger is that European growth could slow further, or that the world economy may suffer another recession, which would worsen Europe's debt crisis and put weak banks further at risk.

One way to cut the close ties between sovereigns and the banking sector is to combine credible medium-term fiscal tightening with efforts to strengthen the financial system, including requiring more capital as a bulwark against credit risks and a potential economic slowdown.

While Lagarde believes banks should first try to raise the money themselves, the difficult market conditions that have left some banks without access to wholesale funding may instead require funds from the European Financial Stability Facility.

The EFSF is similar to the U.S. bank bailout program rolled out at the height of the financial crisis in 2008 to bolster the capital of viable financial institutions.

Alas, there is little reason to believe that EU leaders will follow Lagarde's advice and inject government money into Europe's undercapitalized banks, however, Kirkegaard said, adding: The time may come before long when they realize that they should have listened to her recommendation.

(Editing by Gary Crosse)