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European inaction on banks is costing time and money

Thursday 10 June 2010 - by Nicolas Veron

 Bruegel’s senior fellow Nicolas Véron says European banking reform is as urgent as addressing the fiscal deficit and says failing to achieve a restructuring of banks could have devastating consequences

The European Union faces an existential crisis that results from three simultaneous challenges.

The most visible one is fiscal. Several member states have poorly managed their finances, and the eurozone policy framework has been toothless in getting them to address their complacency.

The second is about competitiveness. Property bubbles and a benign international environment have until recently masked the loss of economic fitness of countries that now require painful structural reforms, such as freeing labour markets and breaking corporatist holds on services sectors.
But equally important is the third challenge—that of addressing Europe’s banking fragility, which has been at the core of the dramatic policy developments since the beginning of May.

In much of the public discussion, the concern about contagion from Greece has focused on the vulnerability of Spain, Portugal, and other countries that might find themselves unable to refinance themselves at reasonable conditions.


In fact, the fear that Greece’s difficulties could undermine the stability of Europe’s banking system, which holds most of its debt, is the main reason why the eurozone and International Monetary Fund (IMF) have bailed out Greece without going directly for debt restructuring. Banks exposed to the Greek debt risk could become insolvent, sending shockwaves through the system just as Lehman did in 2008.

The apparent seizing up of interbank markets at the end of the first week of May, more than anything else, is what prompted eurozone leaders and the European Central Bank to preempt market panic and announce their huge €500bn ($614bn) backstop, plus half as much from the IMF.

The European banking system has been in a state of severe fragility since at least the post-Lehman shock; the ensuing public liquidity assistance had the perverse additional effect of encouraging the weaker banks to overinvest in high-yield debt such as Greece’s. If banks had started 2010 with stronger balance sheets, broader options could have been considered by policymakers, including a Greek debt restructuring which may need to happen eventually anyway, and whose cost could have been minimized if it had been engineered earlier.


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