PARIS (Reuters) - On a sunny morning in mid-June, France's chief bank regulator Christian Noyer seemed upbeat as he told reporters gathered at the Bank of France there were no risks facing its banks.
Profits were on the up and affordable funding was more or less the norm. Although some analysts had said banks like Societe Generale and Credit Agricole might eventually need to raise capital to meet tougher rules under the post-crisis Basel III regime, Noyer backed the view of bankers that setting aside a stream of steady future profits would be enough.
Three months on, the picture has changed dramatically.
Shares in SocGen, Credit Agricole and larger rival BNP Paribas are trading at crippled valuations after a summertime sell-off halved their share prices to levels not seen since 2009, wiping nearly 60 billion euros ($82 billion) off their market value.
With the biggest overall exposure to Greece's debt-wracked economy, according to the Bank for International Settlements, French banks are viewed as particularly vulnerable to any deterioration of the euro zone crisis.
It is not just their shares that are suffering. Ratings agency Moody's has downgraded French banks' credit rating and signaled there may be more to come.
Some analysts who have picked apart the business model of the French banks say they are viewed as more risky because of their dependence on short-term wholesale funding, their big balance sheets and their leverage.
These are all things the regulator could have -- and should have -- detected, they say.
"The French regulator has taken its eye off the ball in terms of making the banks robust enough," said Andrew Lim, an analyst at Portuguese bank Espirito Santo. "They haven't forced their banks to raise capital the same way some other countries have."
The markets are not punishing French banks alone. The broader STOXX Europe 600 banks index has fallen 38 percent since the end of June.
A parade of French policymakers, government officials, bankers -- and of course, Noyer himself -- continues to insist French banks are "solid" even as the cost of insuring their debt against default rises.
"These banks do not need more capital," Noyer, who replaced Jean-Claude Trichet as Bank of France head in 2003 and weathered the 2007-2009 financial crisis without a single collapse, told Challenges magazine in an interview released on Wednesday.
But behind the calm language, change is stirring. BNP and SocGen have scrambled to announce they will sell tens of billions of euros in assets to free up capital. The market rout is such that analysts, investors and even bankers are wondering if state intervention will be the next step.
"The state might have to take a stake in SocGen, and it has to be equity if it's to be done properly," said Espirito Santo's Lim, though he added it was difficult to tell how close this was.
It may seem odd to think of French banks as undercapitalized after they emerged relatively unscathed from the financial crisis while huge swathes of the banking systems of Britain, Ireland, Belgium, Germany, Spain and Greece were either rescued or nationalized.
But while regulators in countries such as Switzerland, Britain and even Italy have talked tough to their banks since 2009 to get them to bulk up capital, even beyond the tougher minimum capital requirements of Basel III, in France the opposite has happened.
Citing the superiority of the French banking model -- which according to the Bank of France is based on "universal banking," or underpinning corporate and investment banking with good old-fashioned retail deposits -- the regulator has backed its banks' fight for less onerous capital burdens.
The result is that French banks' Tier 1 capital ratios, a key measure of banks' solvency and their ability to withstand losses, are at between 10.6 and 11.4 percent -- lower than the 11.6 to 17.8 percent range seen at top banks in Britain, Germany and Switzerland, according to Thomson Reuters Starmine data.
Explaining this disparity depends on who you talk to.
Inside the Bank of France, regulators believe they were vindicated by their approach in 2007-2009. By making sure banks kept tight lending criteria and did not parcel out their loans in cookie-cutter fashion, they averted disaster.
SocGen, BNP and Credit Agricole's losses during the crisis were almost zero relative to the size of their total assets, according to the UK's Independent Commission on Banking, while Franco-Belgian Dexia and Switzerland's UBS took hits equivalent to 16 and 14 percent of their assets.
BNP even profited from the turmoil by scooping up assets belonging to Benelux lender Fortis on the cheap, vastly expanding its euro zone footprint.
This explains why French regulators and bankers often speak disdainfully of "Anglo-Saxon" approaches to bank regulation, which they view as lazy and not rigorous because they focus on beefing up capital rather than paying attention to what banks do with it.
BNP Paribas Chief Executive Baudouin Prot in 2010 criticized the importance given to capital ratios in the Basel III rules, set by a global committee of central bankers and regulators.
"The Anglo-Saxons tend to give an excessive importance to ratios, when what is essential is the quality of supervision," he told Le Figaro newspaper.
Nor is it just capital that's giving investors a headache. Liquidity requirements, which dictate a bank's ability to repay its immediate debts and fund its day-to-day operations, are being toughened up by Basel III, and once again French banks and the regulator have pushed back.
The Bank of France has its own tests for liquidity, insiders say. Why should it allow outsiders to demand banks hold enough liquid assets to cover 30 days of net cash outflows, when its own banking system survived the biggest financial crisis since the Great Depression?
French banks are not alone in criticizing a liquidity coverage ratio that is considered by many to be too strict. But it is part and parcel of their long-running resistance to any substantial changes to the way they do business.
"The French banks have been identified from an early stage as having a less robust liquidity coverage ratio under Basel III than others," said a London-based banker specializing in the financial services industry.
"As the pressures on wholesale funding continue, and given the overhang of potential losses on Greece and the impact that would have on capital, it's not surprising they are coming under pressure."
A study by Barclays published last week showed French banks relied on funding with a maturity of less than three months for 50 to 60 percent of their liabilities. At the top British lenders, that share is below 50 percent.
That means French banks are going back to the market to roll over their debts more frequently than many of their peers, a risky business if a crisis of confidence hits these markets and robs the banks of a primary source of funding.
The practice was seen as a British disease in the 2007-2009 crisis and caused the collapse of banks like Northern Rock. The situation is different today but investors are clearly twitchy.
One London-based analyst said that while nationalized British bank RBS had halved its overnight liabilities from 300 billion pounds ($474 billion) to 150 billion since the crisis and tripled its liquidity buffer, SocGen had done nowhere near as much to cut its dependence on short-term wholesale funding.
"It's the UK business model -- that was the Halifax business model," said one London-based bank analyst, referring to the British bank that was forced into a rescue deal with Lloyds Banking Group in 2008. "The French banks aren't as bad to that extent but there is today this dependence on wholesale funding."
Asked for comment, the Bank of France said: "This is totally false. French banks are large universal banks that have a strong deposit base and therefore do not depend on interbank funding."
A CULTURAL THING
Some outsiders say it's a matter of culture. French bankers, regulators and politicians are all cut from the same cloth, they say. They attended the same elite civil-service academies and criss-cross between the public and private sectors.
"France is a country where the banking lobby is more powerful than in other European countries," said David Thesmar, professor of finance at business school HEC. "It's powerful because the same people who are running the banks are also regulating them. They're too close."
Biographical details don't tell the whole story but do throw up an interesting web of connections. Christian Noyer was in the same graduating class as BNP Paribas's Prot at the prestigious Ecole Nationale d'Administration academy. SocGen Chief Executive Frederic Oudea worked as an aide to Nicolas Sarkozy before he became president -- as did Francois Perol, who was brought in to lead a turnaround at crisis-scarred investment bank Natixis.
Some scoff at reading too much into these links, however.
"French banks are certainly the victims of their own arrogance as they refuse to acknowledge certain risks," a senior source at Rothschild's said.
"But accusing them of circumventing rigorous banking rules and stress tests because of a supposed connivance between their management, the regulators and government is outrageous."
Insiders at the Bank of France have pointed to more tangible reasons for the regulator's protective approach.
Bank loans finance more than two-thirds of the French economy, a much higher level than in Britain and the United States, where companies mostly borrow via the bond market.
The priority is to keep the system profitable, stable and mostly French -- the regulator does not want a foreign bank taking over a significant slice of deposits. While British bank HSBC did acquire French retail bank CCF in 2000, its market share is estimated at below 10 per cent.
Others say the regulator became complacent because financial markets were complacent. Funding markets treated French banks well because they were a cipher for the French economy, an "AAA" nation filled with solvent, risk-averse households that favor life insurance and regulated savings over cheap credit.
But after the downgrade of the U.S. sovereign rating by Standard & Poor's in August and the intensification of the euro debt crisis, French banks have been given a rude awakening.
"Until two months ago French banks were supposed to be the best banks in Europe ... Now, they're simply catching up with the rest of European banks," Mediobanca analyst Antonio Guglielmi said.
"They have above average sovereign exposure, above average capital exposure, and average liquidity exposure, and the rating of France is under scrutiny, what would you expect?"
The most recent measures taken by BNP and SocGen indicate they are getting the message. They have promised to sell an estimated 120 billion euros of risk-weighted assets and cut back on certain lending activities to free up capital and reduce their exposure to dollar funding.
The Bank of France continues to vigorously defend its role.
"It is at the very least bizarre to criticize so violently a system that proved its resilience at a time when others saw collapses and nationalizations," a Bank spokeswoman told Reuters on Thursday.
"These attacks are in vain and will not change the fact that French banks do not have any problem with solvency or liquidity. Each country puts in place the supervision that benefits it the most, and ours is based first and foremost on intrusive oversight and on rigorous management of risk."
And the reality is that hindsight is often easier than oversight.
"It is right to ask whether the French banking regulator should have stepped in to prevent the French banking industry's current perilous position," said Lucy Frew, a lawyer at Gide, Loyrette and Nouel.
"However -- as always when regulators are accused of failing to prevent a crisis -- it is difficult to maintain that they should have not only foreseen, but also come up with a workable solution ... to prevent the situation."
($1 = 0.731 Euros) ($1 = 0.633 British Pounds)
(Additional reporting by Steve Slater in London and Sophie Sassard and Lorraine Turner in Paris; Editing by Alexander Smith and Sonya Hepinstall)