European banks' efforts to clean up their balance sheets could actually end up hurting the continent's already-battered economy, the International Monetary Fund warns. Banks may be afraid to lend, which would hit troubled countries like Italy and Spain hard.

The walls of the Clock Shop in downtown Frankfurt, Germany, are lined with timepieces of every kind, from cuckoo clocks to digital watches. It's a testament to the store's 55-year history as a functioning business.

One of the things that has remained constant for much of that time is the store's relationship with its banks, owner Basia Szlomowicz says.

"They know us," she says. For years, the bank, which she doesn't want to name, has extended credit to her family when they needed it. But in the wake of the financial crisis, small businesses like hers have had a tougher time getting credit.

"Now you have fixed [credit]. This is the amount, not more," Szlomowicz says. "If you need more, you have to ask."

In Europe, businesses of every size tend to rely much more heavily on banks to operate, especially compared to U.S. companies, says Nicolas Veron, a senior fellow at the Brussels-based research institute Bruegel. He says U.S. companies have a much broader array of credit choices available to them.

Since European businesses are so dependent on banks, restoring Europe's feeble economy will depend to a great extent on whether its troubled banking sector can recover.

A Bank Health Assessment

Just as in the U.S., many large European financial institutions came through the financial crisis saddled with bad debt, such as Greek bonds and subprime mortgage bonds. In a few cases, such as the French-Belgian bank Dexia, governments had to come to the rescue by taking them over.

That happened in the U.S., too, says Yalman Onaran, author of the book Zombie Banks. The situation was different in Europe, though, he says.

"In Europe, there are so many examples in so many countries, and the repercussions of their 'zombies' is also problematic for our banking system, too," Onaran says. "I mean, our banks lend to their banks."

Veron says the banking system has been fragile since October 2008 "and has never got back to normal."

The condition of the European banks varies enormously. Still, assessing the condition of banks can be a murky task. Many hold assets that remain difficult to value. Regulations and accounting rules vary by country. Moreover, many European banks aren't traded on the stock market and may not release financial data.

Meanwhile, the sovereign debt crisis has cut a swath through the industry. Many banks had loaded up on government bonds, and when those bonds lost value, they found themselves in a precarious position. Investors were scared off, making it tougher for the banks to raise the short-term funds they need to operate.

The European Central Bank had to ride to the rescue with short-term injections of capital. The moves helped avert a crisis, and credit conditions have largely improved, says Vitor Constancio, ECB vice president.

However, the ECB's moves can't reverse the fortunes of a bank that is truly insolvent – and they weren't meant to, he says.

Balancing Budgets

Now the industry is facing a new problem. Last October, regulators demanded that banks shore up their balance sheets by adding a total of 115 billion euros to their loan reserves by June, part of a renewed push to restore the industry's credibility.

It's not clear where the banks will get the money, though. The International Monetary Fund warned last week that the banks could cut back on lending in an effort to improve their capital levels. With the continent on the verge of a recession, IMF officials say that is exactly the wrong thing to do. The IMF warned a credit slowdown would hit already-troubled countries like Italy and Spain the hardest.

"They're afraid of a massive process of bank deleveraging, banks shrinking their balance sheets and not lending and not taking risks, and this is bad for the economy," Veron says.

For all the banks' troubles, they also have one big thing in their favor, says Gregory Turnbull-Schwartz, an investment manager at Kames Capital. In the end, governments won't let them fail, he says.

"They do have a problem, and it's something that, for a bank analyst, is kind of concerning. However, I do think government support, despite the rhetoric, is still there," Turnbull-Schwartz says. "I don't think we're at the stage where governments in the U.K. and Europe, or even in the United States for that matter, are going to stand by and let one of the large banks go under." [Copyright 2012 National Public Radio]