March 26 (Bloomberg) -- When Northern Rock Plc ran out of money last year, the U.K. government stepped in to rescue the mortgage lender. Likewise, when Bear Stearns Cos. found itself a victim of the credit crunch, the Federal Reserve organized a bailout for the U.S. investment bank.

Yet what happens if a Greek, Spanish or Irish financial institution encounters difficulties? Who will step in to save it?

The truth is that nobody knows. And yet, property markets in countries such as Spain and Ireland look just as stretched as they do in the U.K. and the U.S. It is certainly plausible that a mortgage lender will find itself in big trouble before long.

The euro area's finance ministers should decide now what they will do under those circumstances, and who will pick up the bill. They shouldn't wait until they are in the middle of a crisis -- the worst time to make new policies.

``There should be a lender of last resort in Europe, but we don't really have one,'' says Katinka Barysch, deputy director of the London-based Centre for European Reform. ``The trouble is, there isn't the political will there to create that.''

It is time to make certain who is in charge of the euro area's banking system.

Right now, responsibilities are split.

The European Central Bank runs monetary policy for the 15 countries sharing the single currency. Meanwhile, banking supervision -- and therefore bank rescues -- remains the responsibility of national governments.

ECB Liquidity

In fairness, the system has worked pretty well so far. The ECB has been pumping plenty of liquidity into the system, making sure that euro-area banks don't run out of money. In the one case where there has been real trouble -- when Germany's IKB Deutsche Industriebank AG suffered huge losses on its subprime investments -- it was bailed out by loans from KfW Group, Germany's state- owned development bank.

That doesn't mean there is nothing to worry about. Finance ministers are doing their best to show they have the tools to cope with whatever the credit crunch throws at them.

``We are ready,'' said Dutch Finance Minister Wouter Bos at a conference in Brussels this month, discussing the threat of collapse of a major European bank. ``I hope it won't be necessary to show how prepared we are. There is a discussion going on at the European level on whether we should increase the mechanisms of coordination in the regulatory authorities that we have.''

And yet, while insisting publicly that they have all the tools they need, finance ministers seem intent on acquiring some more. Italian Finance Minister Tommaso Padoa-Schioppa said in the European Parliament that although the ECB has coped well with the crisis so far, ``the supervisory function appears to have been absent at the European level.''

Government Limits

It is easy for the system to function when times are good. It is what happens when there is a crisis that really matters.

There are two problems with how things work right now.

One, national governments can regulate and rescue their banks, using taxpayer funds if needed. But they can't start printing money, and they can't prop up a collapsing banking system by acting as a lender of last resort. Only a central bank can do that.

When a relatively minor institution such as IKB runs into problems, the government can step in. But what happens if it is one of the big Irish, Greek or Spanish banks facing bankruptcy? And what if that triggered panic across the whole financial system? In those circumstances, probably only the ECB would have the firepower to mount a rescue.

Split Responsibilities

Two, in a crisis you can't separate the tasks of supervision and central banking. If there is a major run on a lender, that has such a huge impact on the economy, it is pointless to pretend that the central bank can stand idly by and let it happen.

The U.K. has been experimenting with split responsibilities. The Bank of England is the lender of last resort, while the Financial Services Authority regulates the banking sector. And look what happened. The U.K. ended up with the Northern Rock mess. When the crisis started, no one knew what was happening. And no one could act quickly enough to stop it.

The euro area should make sure it learns the lessons of that. The region's finance ministers should state clearly that the ECB has the ultimate power over the banking system, and that it will take the lead role in any crisis. In return, it should be given the authority to regulate the banking system -- because it can't stand as guarantor to a sector it doesn't supervise.

National politicians are always reluctant to relinquish powers. They need to get over that before a crisis looms. Because if they wait until a major bank goes bust, it will be too late.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.

Last Updated: March 25, 2008 20:13 EDT