A proposal to tackle the crisis in Europe

Luigi Guiso, Marco Pagano

09 October 2008

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While the US is trying to attack the bank solvency crisis with the Paulson Plan, no comparably comprehensive response is emerging in Europe. No single political institution in Europe can enact a comprehensive rescue package comparable to that of the US. European governments are proceeding in a piecemeal, disorderly way to attack the problem at a national level, while its scale far exceeds that of their national boundaries. The Ecofin meeting this week effectively abandoned any attempt to set up a coordinated action plan and gave the green light to country-by-country intervention in the capitalisation of intermediaries.

This decision was wrong, for two main reasons.

  • First, case-by-case, ad hoc intervention weakens the chances of success, especially if it concerns large banks with considerable cross-border operations, which are precisely those that pose the greatest challenge to systemic financial stability.
  • Second, the differences in the form of interventions that will unavoidably emerge put at risk the process of financial integration in Europe, for instance tearing up large intermediaries along national boundaries (as in the case of the Fortis group) and distorting competition.

Ministries of finance should reverse this decision immediately and agree on a common set of rules to recapitalise European banks and establish or appoint a European institution to manage this recapitalisation. Of course, such an institution would have to be based on mutually agreed rules for burden sharing in case of bail-outs of large banks with cross-border operations. National governments wanting to strengthen the capital of domestic banks should do so through this agency, which should:

  1. Make new equity capital available to financial institutions mainly through preference shares, so as to allow EU taxpayers to share in the eventual recovery of the banks that are rescued;
  1. Commit to sell these shares as soon as the financial crisis is over and in any event not after a predetermined number of years (say, three years);
  1. Appoint new management, whenever required for the effective rescue of a bank.

This proposal is a second-best solution to Europe's lack of an institution capable of a coordinated response on the US scale. Of course, designing the rules to determine when to bail out a cross-border bank and how to share the implied costs across EU member states is no easy task. Their design will have important implications for the incentives of bank managers and bank regulators, as well as for European taxpayers. Yet, however technically and politically thorny, these issues can no longer be dodged.

So far we have been blessed by lucky circumstances - none of Europe's largest crossborder banks have become insolvent or seriously distressed. But if this were to happen, the limitations of Europe's policy response would become tragically apparent.

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Topics:  Financial markets

Tags:  rescuing jobs and savings

Axa Professor of Household Finance, Einaudi Institute for Economics and Finance; CEPR Research Fellow

Professor of Economics, University of Naples Federico II and CEPR Research Fellow

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