How to save the European banking system

Daniel Gros 09 October 2008

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A severe banking crisis has developed in Europe. Why? And what could be done to address it?

There are two related reasons for the problem in Europe. The large money-centre banks that provide the backbone for the inter-bank lending market are undercapitalised. With their low capitalisation, they are vulnerable to even small swings in market conditions. Any liquidity problem thus turns almost immediately into a solvency problem. Because of this vulnerability they do not trust each other, thus paralysing the inter-bank market.

A two-pronged approach is thus needed:

  • Recapitalising the large banks, and
  • Restarting inter-bank lending.

The recent measures of the UK government go in the right direction as they contain both elements: bank re-capitalisation and support for the liquidity management of banks. The Italian government has also decided to offer its banks public funding if they are in need of recapitalisation, and it is likely that other European governments will follow.

This leaves as a key problem the dysfunctional state of the euro area money market. This problem cannot be solved by the UK government, even if a large part of that market happens to be in London.

What is needed (and has been proposed by the UK) is a coordinated approach, by all EU member countries under which each government guarantees the lending of its own banks to other EU banks. The impact is stronger, the larger is the number of countries that participate in this approach.

The principle of this approach could be quite simple. Each participating government guarantees its own banks’ reimbursement of inter-bank loans, including cross-border loans to banks in other participating countries. The guarantee would presumably be valid for a limited time and available against a fee. Given current levels of the cost of protection against counterparty default in the banking system, this fee could be substantial enough to provide a comfortable insurance premium without choking off the market.

Of course, finance ministers will object that this exposes them to an unacceptable risk. In reality, this risk will be quite limited because all governments have already announced that they will not let any large bank fail. Hence most governments have implicitly already guaranteed the liabilities of their own large banks.

Moreover, losses from housing-related activities seem relatively minor in Europe (except Spain and Ireland). This implies that the key issue in Europe is not how to make up massive losses but how to resolve a coordination problem. The European governments amongst the G7 should agree rapidly on such a scheme to get at least the euro-area inter-bank market moving again.

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Topics:  Financial markets

Tags:  rescuing jobs and savings

Director of the Centre for European Policy Studies, Brussels

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CEPR Policy Research