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The Curious Case of the Eurozone

Europe is suffering from Benjamin Button syndrome. Like the man who aged in reverse, its financial markets are unwinding 20 years of integration.

The disintegration is happening on many fronts. Capital and deposits are leaving the periphery of the euro zone and moving to core countries. Spain is a prime example of this "walk on the bank": Deposits there dropped 4.7% in July. As capital drains, borrowing costs rise for banks, households and businesses in Spain and other troubled euro countries.

Under Mario Draghi, the European Central Bank has reduced the risk of an accelerated deleveraging. By providing bank liquidity through its long-term refinancing operations, and by realigning funding costs in sovereign bond markets, the ECB has addressed some of the symptoms.

But liquidity injections are an anesthetic for financial markets, not a cure. The divergence between periphery and core borrowing costs is not only a phenomenon of bond markets, it is gradually impacting the real economy. Bankruptcies for small firms and individuals in Spain are at all-time highs. Households and small businesses, which rely most on loans for funding, are the worst hit.

To repair the transmission of monetary policy to the real economy, European policy makers must take steps to shore up both sides of banks' balance sheets. This means acting on bank capital instead of just liquidity and funding. Lack of capital, together with economic uncertainty, is the main reason why banks are not lending. We estimate European banks will need to generate more than €200 billion in capital over the next three years to cover bad loans and new regulatory requirements.

First, policy makers should consider tapping the European Stability Mechanism to launch an asset-purchase program similar to the U.S. Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF). This would let them buy out existing bank loans from strong banks that are backed by the ECB. The move would free up bank capital and allow new lending. It would also expose taxpayers to less risk than equity injections, and avoid moral hazard.

Second, a cross-border deposit guarantee fund should be established to help prevent further capital flight. The liabilities issue is key in the euro zone. Capital and deposit flight from periphery markets cannot be reversed with bond purchases alone. In a currency union without cross-border deposit guarantees, depositors and investors who worry about return on capital will always be tempted to move their money to the safest countries. This starves companies in the periphery countries of vital funding, and makes banks even more dependent on the ECB. Just a few weeks ago, Spanish banks started accessing the Banco de España's "emergency liquidity assistance," the last option after banks have run out of assets to use against regular ECB funding.

A cross-border deposit guarantee fund would prevent capital flight from accelerating. Each country could charge banks a percentage of deposits each year and use the proceeds to cover potential losses across the euro zone. This would require a common bank regulator, as European Commission President José Manuel Barroso has recently suggested.

Such a proposal would need stronger political consensus and would meet resistance in Germany, which is one of the main beneficiaries of deposit flight and a country where many second-tier banks are undercapitalized. But a deposit-guarantee fund would be easier to implement than a full-fledged fiscal union. It would also be necessary to prevent euro-zone banks from being at the mercy of rating agencies and swings in investor sentiment.

Our indicators show that bond-funding costs in periphery euro countries have partly come back in line after the ECB announced its bond-buying plan this month. But loan funding is still diverging, and loans are 90% of credit in Italy and Spain. In other words, ECB purchases of Italian government bonds do not mean that local banks will give Italians a cheaper mortgage.

In addition, the ECB liquidity injections allowed periphery banks to increase their holdings of government paper, further exposing them to sovereign volatility. Banks in the euro-zone core, meanwhile, have retrenched from foreign lending to focus on their domestic markets. The result is that periphery credit markets have become increasingly localized and isolated, quarantined by foreign investors.

Over time, inaction could lead to a slow undoing of Europe's years of economic integration, with periphery countries becoming increasingly cut off from the core. Firms in the periphery countries will suffer from ever-higher funding costs and become forced to sell off foreign assets to raise cash. Eventually the flight of capital becomes the flight of people, as young workers leave their countries for better opportunities elsewhere.

The euro zone needs more than anaesthetic injections of liquidity. By persistently relying on temporary solutions, European leaders only risk making the problem worse. Europe must move quickly to improve bank capital and stop deposit flight. Otherwise, its clock will continue to tick backward.

This article was originally published by The Wall Street Journal on September 26, 2012.

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