Europe Needs a Genuine Financial Union

by Simon Nixon

Wall Street Journal
May 20, 2012

Confidence in the European banking system is crumbling. Last week, Spanish and Greek authorities both had to deny reports of a run on their banks. But the fact these reports are circulating underlines the fragility of the situation. Bank runs are the nightmare endgame for the euro crisis since there is little policy makers could do to tackle the situation. The European Central Bank can only provide liquidity to solvent banks against good collateral; national central banks can provide "emergency liquidity assistance" against looser collateral at a higher cost with the agreement of the ECB, but this couldn't protect a bank against a full-blown run on its deposits. Restoring confidence in the banking system is therefore the most urgent priority facing euro-zone leaders.

What can be done? Greece aside, Spain is now the front line. The market is in broad agreement the Spanish banking system requires an equity injection of between €50 billion to €100 billion ($64 billion to $128 billion). So far, Madrid has been in denial about the scale of the problem: With the exception of Bankia SA, which has been nationalized, no major bank expects to raise equity to meet the government's latest demands for further write-downs of real-estate loans. But things may be changing: a deep-dive review of bank balance sheets by two government-appointed independent consultancies may identify further capital needs. The market will also scrutinize decisions taken over Bankia for clues about capital holes at other banks.

But it isn't just how much capital but who provides it. Responsibility for bailing out banks currently resides with member states. Governments that can't borrow from markets can tap euro-zone bailout funds. Some argue Spain should be able to avoid this; after, all €50 billion is just 4% of gross domestic product and Spanish debt to GDP is still only 70%, low compared to Italy at 120%. But Madrid is understandably reluctant to put this to the test. Spanish 10-year government bond yields are already 6.197% and the only buyers of its bonds are the very banks it would be bailing out.

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