Five Steps to Solving Europes Debt Crisis

By PETER THAL LARSEN Published: August 21, 2011

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crisis of 2008 is repeating itself in reverse. Three years ago, European governments stepped in to save the banking sector. Today, the euro zones indebted sovereigns are threatening to cause a full-scale bank panic and possibly even another credit crisis. Europes lenders must be insulated from their governments and vice versa. Five radical steps could break the bank-sovereign doom loop.
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Five Spanish banks, including Catalunya Caixa, have failed the bank stress tests.

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German Leaders Reiterate Opposition to Euro Bonds as a Way to Ease Crisis (August 22, 2011)
STEP

1: SOLVING THE CAPITAL CONUNDRUM Europes weaker banks need capital if they are to be prevented from pulling the system down. The most pressing problems are Spains cajas, or savings banks, and those Italian lenders that barely scraped through Europes latest stress tests. Among those that failed the tests were Banco Pastor, Caja de Ahorros del Mediterrneo, Banco Grupo Caja3, CatalunyaCaixa and Unnim. Private markets are effectively closed, and Italy and Spain are scarcely able to afford bailouts. The solution is to repurpose Europes sovereign bailout fund to inject capital directly into banks much the same way America retooled its Troubled Asset Relief Program in late 2008. While the European Financial Stability Facility can already make loans to countries for the purpose of recapitalizing banks, this shift would be controversial. It would mean governments ceding control of financial institutions to a pan-European body. Still, the fund could get a big bang for its buck: bolstering the core Tier 1 capital ratios of Europes 90 largest lenders by one percentage point would cost 100 billion euros, or less than the price of Greeces second bailout. STEP 2: SOLVING THE FUNDING FREEZE European banks, especially those in Italy and Spain, risk a liquidity crisis if wholesale markets do not reopen to them by autumn. And even if they are able to issue longer-term debt, it is likely to be expensive. That could choke off credit to the economy. The answer again lies in reinventing the stability fund to offer temporary financing guarantees. The idea, first proposed by

Morgan Stanley analysts, has worked before. The United States and several European countries restored calm after the collapse of Lehman Brothers by guaranteeing bank finances. STEP 3: PREVENTING BANK RUNS Even with capital and wholesale funding worries addressed, banks would still be vulnerable to a loss of confidence by depositors. Bank deposits are guaranteed by a lenders home country, and when savers fret about their governments finances, they tend to move their cash something particularly easy to do in the euro zone. Deposits at Greek banks have shrink by roughly 15 percent since the beginning of 2010, according to European Central Bank data. But if there were a single pan-European deposit plan, savers would be more likely to stay put. STEP 4: SAY NO TO BANKS PROPPING UP THEIR GOVERNMENTSRegulators have unwittingly cemented the sovereign-bank link by encouraging lenders to hold larger reserves of liquid assets, mainly in the form of sovereign bonds. Banks in troubled countries have also come under pressure to prop up their governments by buying even more of their debt. To break this potentially fatal embrace, banks should be subjected to strict limits on their exposure to any single countrys bonds. STEP 5: A PAN-EUROPEAN REGULATOR WITH TEETH If the first four steps were taken, the risk would be that sovereign-bank codependency would re-emerge, but on a panEuropean level. Preventing that from happening requires creditors to face real losses if a bank falls over. Big lenders must also be structured so they can be safely wound down. Achieving that would require a single euro zone financial supervisor something national regulators would no doubt resist. But America provides a good model, with the Federal Reserve and

the Federal Deposit Insurance Corporation overseeing the system with the help of regional bodies. THE CAVEAT These ideas would not instantly fix the sovereign debt, large deficits and stagnant growth that plague the euro zone. But removing banks from the equation would lift one large potential fiscal burden from governments. And banks no longer shackled to sovereign fortunes would find it easier to extend credit. As ever, the problem is politics. This plan would be a big lunge forward in European integration. Politicians and voters who balk at lending to other countries would have to be persuaded to underwrite the euro zones financial system. But if Europes squabbling leaders have a better alternative, let them get on with it.