Europe's dance of death between sovereigns and banks

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Note: This is my response, in the Financial Times A-List, to George Soros\'s suggestion that the the EU guarantee its banks. Re-Define believes that the most sensible thing to do is to first reassure the world that sovereigns such as Italy and Spain are sound

George Soros is right in saying the discussion on recapitalisation of European banks is flawed. However, the best way to address the panic in the banking system is not through guaranteeing the banks, but through restoring full faith in the solvency of large Eurozone economies instead.

Weaknesses in the European banking system have been known for some time, so why the sudden panic?

European Union policymakers have let Greece’s unique fiscal problems colour their prescription for countries such as Spain and Ireland which had banking, not fiscal, crises. Growth has also suffered in other countries, as austerity measures became fashionable. This economic slowdown, weak stress tests and the EU’s inability to handle the relatively small problems of Greece, combined to also erode confidence in Spain and Italy.

As interest rates paid by Italy and Spain soared, bond prices fell and led to deterioration in perceived soundness of banks holding these bonds. With more than €2,000bn in Spanish and Italian government bonds outstanding, even a small deterioration in their quality can put a significant dent in the capital banks hold. Investors and counterparties first shunned banks that held these bonds and then banks exposed to banks that held these bonds. Now we have a systemic crisis.

Today Europe is stuck in a dance of death between sovereigns and banks. In countries such as Ireland, banks have brought the sovereign to its knees, whereas in Greece the weakness of the sovereign has cost its banks dearly. Weak banks, such as some Spanish cajas, continue to weigh their sovereign down, whereas deteriorating sovereigns such as Italy are casting a dark shadow on the soundness of banks.

We must break this sovereign-bank loop and Mr Soros is right to point out that national level recapitalisation will only reinforce it. No amount of bank capital that could be raised, or guarantees that could be offered, would be sufficient to save European banks if doubts about the solvency of Italy and Spain are allowed to persist.

Greece was insolvent, but was it handled as though it had liquidity problems. Spain and Italy, which are solvent but illiquid, are being allowed to drift down towards bankruptcy through an insufficient provision of liquidity support. At this rate, they will take the EU banking system down with them.

The European Central Bank needs to provide an open-ended commitment to support illiquid countries and refinance their debt at affordable rates. It will make bond prices perk up and remove the biggest source of capital shortfall in EU banks. The European financial stability facility could step in, but only temporarily, if the ECB refuses to act.

Capital buffers can be built up through enacting a moratorium on bonus and dividend payouts, with the EFSF potentially supporting weak banks in weak countries. In the future, robust bank resolution legislation would help reduce the dangers weak banks pose to their sovereigns. Some form of eurobonds could be held by banks as protection against overexposure to weak sovereigns.

To restore growth, the callable capital of the European Investment Bank should be doubled to finance a growth-enhancing programme of investments in pan-European infrastructure. Greek debt stock needs to be brought down to not exceed the size of the country’s gross domestic product. Europe’s single-minded focus on austerity needs to go the way of its flawed bank recapitalisation plan.