Greek Banks Expose Europe's Flaws

Still not all for one.

Photographer: Christophe Ena/Getty Images

Now that Greece has survived a standoff with its European creditors and a snap general election, it faces another ordeal: reviving its paralyzed banking system. Flaws in Europe's new banking union will make this job harder than it ought to have been.

Months of brinkmanship and economic free-fall have left Greece's largest banks in a dire state. Losses are expected to wipe out much or all of their equity capital. Deposits are down about 25 percent since the beginning of the year. Lending to nonfinancial companies fell nearly 7 percent from January through July, the largest six-month decline since 2009.

Turning things around will require a thorough reckoning. Banks will have a hard time attracting deposits and lending unless their finances are repaired beyond reproach. That's why it's crucial for the European Central Bank to be unsparing in writing down troubled assets and estimating capital needs. There must be no more smoke and mirrors. The banks need capital in the form of equity -- money from shareholders willing to bear risk.

Greece's Financial Odyssey

The next question is who will supply the capital. Europe's banking union has rules for full-scale bailouts, but following them could be disastrous. They require banks' creditors (including depositors) to bear much of the loss, unless special exceptions are invoked. That's right in principle, but in Greece's case such losses could hurt businesses severely and further damage the economy. The rules also limit the use of public money from the euro area to directly recapitalize banks. Yet the Greek government lacks the fiscal capacity to solve the problem by itself.

There's a workaround, and it ought to be deployed. The new bail-in rules don't go into force until Jan. 1. This allows the government -- with European creditors' blessing -- to avoid harming depositors as long as it acts quickly. Also, euro-area officials have devised a way to inject capital almost directly. The European Stability Mechanism has set aside as much as 25 billion euros that Greece can use to buy equity in banks, on the condition that the shares are deposited into a privatization fund supervised by European creditors and directed largely toward paying the government's debts.

It's good to see that European officials can be creative under pressure. Still, the maneuvering hardly reflects well on the banking union's design.

There are two lessons. First, banks should have a lot more capital in the first place. That way, the question of who pays for bailouts will be much less likely to arise. Currently, the largest European banks have, on average, even thinner equity cushions than their U.S. counterparts. Second, in cases where public money is nonetheless required, European authorities need the power to recapitalize banks directly without resorting to subterfuge.

Europe's banking union was supposed to sever the link between big banks and national governments, so financial and sovereign-debt troubles won't reinforce one another like they did during the region's last crisis. Greece shows that this plan still has a long way to go.

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