By Lesley Wroughton
WASHINGTON (Reuters) - New IMF chief Christine Lagarde's call for a mandatory recapitalization of European banks struck a raw nerve in Europe and showed she is not afraid to challenge her former peers.
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.
European policymakers were inflamed by her remarks as well as a supporting draft IMF assessment that European banks could face a capital shortfall of up to 200 billion euros ($287 billion).
The IMF projection is vastly higher than the 2.5 billion euros ($3.6 billion) cited by the European Union following bank stress tests in July.
It is not the first time the IMF's analysis has irked European politicians.
In 2009, the fund and Europe wrangled over bank losses in the aftermath of the financial crisis. The IMF eventually revised its methodology and its estimate of potential losses.
The latest debate is over the IMF's use of mark-to-market analysis in assessing Europe's capital shortfall, which tries to account for the potential for significant losses on sovereign debt held by the banks.
The pushback from Europe's politicians, who argue their bank balance sheets are just fine, took the IMF by surprise, but the reaction shows 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 consistently shunned the fund's advice.
"Lagarde is evidently not treating Europeans with velvet gloves," said Jacob Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, 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.
REPEATING THE MESSAGE
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.
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 IMF believes 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."