European banks are being forced to pay more for short-term dollar borrowings than banks in the U.S. and Asia—suggesting that lenders world-wide are increasingly nervous about the risks ahead for European banks as financial pain cascades across the continent.

On Monday, the London interbank offered rate, or Libor—the rate at which banks lend money to each other, and thus a vital sign of their mutual trust—rose to its highest level for the three-month dollar rate since last July. While the current Libor, at just above 0.5%, is far below the sky-high levels of 4.81875% reached at the height of the financial crisis in 2008, it is still a significant jump from 0.25% as recently as March.

But Libor’s jump is more pronounced at European banks. On Monday, German state-controlled lender WestLB AG said it cost 0.565% to borrow dollars for three months, up from 0.38% a month earlier. U.S. banks are reporting lower costs: Bank of America Corp., said its three-month dollar Libor stood at 0.48%. J.P. Morgan Chase & Co. reported a 0.47% rate.

The markets “have already downgraded the European banking system,” said George Goncalves, head of U.S. interest-rate strategy in the Americas at Nomura Securities in New York.

Libor’s rise is diminishing the hope for sustained global financial health: The increase in banks’ borrowing costs can translate into higher rates for consumers on mortgages, credit cards and corporate loans.

Strains in the global financial system are likely to push Libor higher, some analysts predict, as European banks find it tougher to borrow and investors around the world limit how much they’re willing to lend to U.S. and European banks.

The benchmark rate could go as high as 1.5% in the next several months, Citigroup Inc. analyst Neela Gollapudi concluded in a report last week. Individual borrowing rates are posted by a panel of 16 banks every day around lunchtime in London to calculate dollar Libor.

In recent days, concerns about the banking system have deepened, following Saturday’s failure of a Spanish savings bank and a confluence of other events. Also troubling investors is the pending overhaul of financial regulation in the U.S. At the same time, some banks in the U.K. and North America are moving more quickly to assess how they could be hurt by a downturn in the euro-zone economy, and pulling back on loans to banks in the troubled region.

Another key indicator, a measure of credit protection on bank debt known as a “bank-fear index,” remains elevated. As of Monday, the cost of five-year default insurance on 10 million euros of European financial-firm debt was 163,789 euros, according to the Markit iTraxx Senior Financials index. That’s slightly below last week’s level, but substantially above the 90,715 euros the protection cost in March.

Markets are getting “twitchy,” said Howard Archer, economist at IHS Global Insight in London. Nervousness is overshadowing confidence-bolstering efforts such as a plan by the Federal Reserve to funnel dollars to the European Central Bank, and subsequently euro-zone banks.

“The banking world is extremely interconnected and still very fragile,” Nikolaus von Bomhard, chief executive of Munich Re AG and president of the Geneva Association, a research group that includes CEOs of major insurers, said in an interview.

“The confidence that has been built since the Lehman crisis is vanishing to some extent, and the challenges for the banking industry are not yet resolved,” he said, referring to the 2008 bankruptcy filing of Wall Street giant Lehman Brothers Holdings Inc. Another problem: Even financial institutions with no direct exposure to Greece or other troubled economies likely are exposed to banks that are, Mr. von Bomhard said.

In another sign that investors are recoiling from risk, Allegiant Travel Co. withdrew a planned $250 million debt offering. Since April 29, seven high-yield deals have been withdrawn or postponed, according to KDP Investment Advisers.

The rise in the cost of short-term borrowings by banks began early last month amid new jitters about Europe’s economy. Those worries have accelerated in the past several days as investors who buy short-term bank debt (thus helping to fund the daily operations of lenders around the world) reassess their views of the risks facing those firms, according to Mr. Gollapudi, the Citigroup analyst.

In the U.S., the financial-overhaul legislation moving through Congress would cover insured bank deposits if a firm fails. But a narrow protection of only those deposits could force investors such as money-market funds and other banks to ask a higher price for short-term loans or IOUs. Meanwhile, credit-rating firms say they are prepared to cut bank-bond ratings amid a belief that the legislation would limit the extent of bank bailouts. These concerns also are helping increase Libor.

In Europe, investors have grown wary that governments have lost their appetite to save a bank. Money-market funds already were leery of lending to banks beyond one month.

Rising Libor in part reflects concerns about European bank exposure totaling $2.8 trillion to debt originating in Portugal, Greece, Ireland, Spain and Italy. The countries say they are determined to reduce their deficits. But that is almost certain to stunt economic growth and make it tough for companies to pay their borrowing costs.

The result: European banks could see losses rise and be forced to pay more to borrow.

Some of these concerns were crystallized with Saturday’s bank failure. The Bank of Spain seized CajaSur, one of some 45 Spanish savings banks. Controlled by the Roman Catholic Church, the 146-year-old lender financed real-estate projects on Spain’s southeastern Mediterranean coast.

By CARRICK MOLLENKAMP

Tags: borrowers, economic recovery, euro zone, european economy, financial, financial crisis, Global Economy, investors, real estate, stock market, us economy

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