Finance

Why European Leaders Are Suddenly Backing More Bank Bailouts

Dexia
Philippe Huguen/AFP/Getty Images

Europe's banks are in trouble. They urgently need to raise money to serve as a safety cushion against losses. If private investors aren't willing to invest, governments should step in.

That's what Christine Lagarde, the new head of the IMF, said in a big speech this summer.

European officials immediately attacked the idea, calling it "confused" and "misguided."

Now, just over a month later, European officials are talking about doing exactly what Lagarde said: injecting public money into Europe's banks.

"Germany is prepared to move to recapitalization," German Chancellor Angela Merkel said today.

"Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty," European commissioner for economic affairs Olli Rehn told the FT.

The quick reversal explains a lot about a problem European leaders have been struggling with for more than a year now: They're perpetually a step behind in dealing with the continent's debt crisis.

Even when European leaders know what needs to be done, they don't always have the power to do it. The European Union doesn't have much central authority. Big decisions have to be separately approved by the parliament of each country in the euro zone.

"The fundamental problem is what is economically necessary in real time isn't politically legitimate," Jacob Kirkegaard of the Peterson Institute told me today. "You need to have parliament approve this. It's taxpayers money."

Case in point: A month ago, when Lagarde said Europe's banks needed to be recapitalized, there was no Europe-wide mechanism to do so.

But in the past few weeks, Kirkegaard points out, parliaments around the continent have approved changes to the euro zone's bailout fund that allow it to put money directly into banks.

Of course, another bailout of the banks is still wildly unpopular in Europe, Kirkegaard says. So just because there's now a mechanism for bailouts, that doesn't necessarily mean the political will is there.

In this case, the will was provided in part by the near collapse of Dexia, a big Belgian-French bank. Just yesterday, the governments of France and Belgium stepped in to prop up the bank.

Dexia holds a lot of debt issued by troubled European countries. And it has been subject to a slow-motion bank run over the past few months, which pushed it to the brink of failure. It will probably be broken up.

Lots of European banks face similar, if slightly less acute, problems. So the Dexia news "meant that European governments could no longer ignore" the troubles in the continent's other troubled banks, Kirkegaard said.

And the way banks work, once you admit they're in trouble, you have to act fast. Banks, perhaps more than any other business, depend on confidence. So the comments this week from Angela Merkel and Olli Rehn mean a broad recapitalization of European banks — which could run to hundreds of billions of euros — may be imminent.

"There's no going back now," Kirkegaard said.

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