Analysis on the importance of the banking sector in helping Europe's economies revive.

Banking system dysfunction has been at the core of the Eurozone crisis. There are two main issues.

First, trust has remained elusive since before the Lehman shock of 2008, as policymakers have refused to identify the weak spots in Europe’s banking system in spite of annual half-hearted stress tests since 2009. Dexia, which passed last July’s test with flying colors (10.4% core equity ratio under adverse scenario assumptions) before collapsing last month, is the latest symbol of this complacency.

Second, banking sector weaknesses and sovereign credit dynamics have been connected in a perverse country-by-country feedback loop. This involves excessive implicit and explicit government guarantees on banks, as in Ireland and Spain, and inexplicably high home biases in banks’ portfolios of EU sovereign debt, as in Greece (94%), Spain (90%), Portugal (79%) or Italy (78%). The result is national fiscal and banking problems feeding each other. This is incompatible with sustainable currency union.

On this basis, it is unclear how much progress, if any, is made with the plan announced by EU leaders in Brussels last week. The recapitalization plan fails the Dexia test: the “well-capitalized” Franco-Belgian bank would apparently not have been asked to raise new equity.

Because it rests on unreliable capital assessments, the plan risks delivering the full economic cost of deleveraging and shareholder distress, without the benefits of instilling confidence that the weak links have been properly addressed.

Meanwhile, because new capital and guarantees are to be provided primarily by national governments, the fiscal/banking connection will be further reinforced. This may worsen both the debt dynamics of periphery countries, and the market distrust of their domestic banks. In addition, it will create a sense of unfairness, as well-run banks from weaker countries will have to shrink, while poorly run ones from stronger countries can merrily expand their international balance sheet.

Europe’s policymakers need to accept the lessons of the past three years. An honest application of the subsidiarity principle should lead them not to insist on action at the national level, but to create a truly federal Eurozone banking policy framework.

They should immediately place all national deposit insurance systems in the Eurozone under the explicit guarantee of the European Financial Stability Facility (EFSF), to prevent retail bank runs in troubled countries. Then, they should ask the European Banking Authority (EBA) to conduct a new assessment of the most important banks’ capital position. The EBA should ruthlessly bypass national supervisors that failed to produce reliable results in previous stress tests. It could rely partly on private-sector help, as Ireland’s central bank did this year with an audit of its banks’ assets by BlackRock.

Leaders should then create a temporary, high-powered European team to negotiate the restructuring of those banks which, on the basis of this fresh assessment, cannot repair their capital position on their own. One option is to create and empower a Eurozone-wide Resolution Trust Corporation that would take over failed banks on behalf of the relevant member states, sell back their viable operations to fit and proper investors, and temporarily manage the rump assets.

Over the long term, the EBA should be granted full supervision and resolution authority over large banks, at least in the Eurozone, and work with national supervisors in a similar manner as the European Commission does with national authorities to enforce competition policy.

From a political standpoint, it may be the case that banking federalism is even more difficult to implement than fiscal federalism, against which national resistances have started to erode. But measures such as the ones suggested above are an indispensable component of any credible crisis-resolution plan.

The Eurozone cannot thrive without an integrated banking system, and this cannot exist without an integrated banking policy framework. Better to start now.

*[This article was first published by Emerging Markets on November 3, 2011]