LONDON – The gravity of the eurozone crisis has finally sunk in. The stakes could not be higher. Governments and international financial institutions have scrambled to put together a solution within exceedingly tight political and economic constraints. Many questions have yet to be answered about the design; implementation will be at least as challenging.

Eurozone leaders must now aim to preserve not only the single currency, but also the gains from financial integration in Europe. No region of the world has benefited more from cross-border banking, yet these achievements are now at risk – and with them the European bank groups themselves.

The threat to cross-border banks comes not only from their deteriorating balance sheets in the face of lower sovereign-debt quality and weaker growth prospects, but also from the policy response itself. The fact that Europe’s banks need massive amounts of new capital is by now generally accepted. Yet, despite valiant attempts by the new European Banking Authority to mandate and coordinate the measures that are needed, a European solution must take account of the network of foreign subsidiaries across Europe.

Mobilizing support for European banks will be hard; extending it to subsidiaries will be even harder. But, unlike the ill-advised exposure to sovereign debt across Europe, cross-border banking through foreign subsidiaries has been beneficial for investors, and for home and host countries alike – nowhere more so than in emerging Central and Eastern Europe, still the most important export market for the eurozone.

For core eurozone banks, this has been a region of extraordinary returns, and it is now integral to their operations. In emerging Europe, foreign subsidiaries have helped to build financial systems that are less prone to instability, and have helped economies to converge more rapidly with average European income levels.

When the global crisis erupted in 2008, there was no regulatory framework to protect the cross-border networks, and large vulnerabilities, in the form of excessive leverage and foreign exchange, were exposed. Much has been achieved since then: balance sheets have been strengthened and funding models adjusted. Along with institutional reforms at the European level – particularly the creation of the European Systemic Risk Board and the European Banking Authority – regulation and supervision have been reinforced in subsidiaries’ host countries.

Some of this might make finance more costly, but it will also make banking operations less risky. On balance, this is a good thing.

Even so, the threat to financial stability is possibly even graver today than it was in 2008, as the capacity of Western European governments to backstop banking systems is clearly reaching its limits. Allowing foreign banks’ subsidiaries to become orphaned amid a worsening crisis in home countries would undermine confidence in emerging Europe’s financial systems, which could trigger asset-price declines and precipitous contractions in credit. Ultimately, this would boomerang back on Western European banks, given their deep financial and real linkages with the region.

In 2008, such a catastrophic scenario was narrowly avoided, owing to policy intervention, including the coordination effort under the so-called Vienna Initiative (in which the European Bank for Reconstruction and Development, among others, was involved). A new pact to secure the achievements of financial integration is now urgently needed. Authorities from these banks’ home and host countries must sit down together.

As with the Vienna Initiative, a "Vienna 2.0” would require commitments by all concerned parties. In responding to the higher capital requirements imposed by authorities, and choosing whether to raise more capital or sell off assets, the banks must take into account the important role that their subsidiaries play in many countries. For many banks, this happens naturally – their subsidiaries, as important value creators, are critical to their business models. For some, however, the subsidiaries are smaller relative to the parents’ size – and thus less central to their strategies.

Home countries must also contribute. Within the eurozone, any recapitalization, guarantees, and other funds offered to parent banks should be made available to subsidiaries in equal measure. Any restructuring requested in return for capital support should take into account the cross-border nature of the groups and not discriminate against subsidiaries abroad.

Subsidiaries’ host countries, for their part, must reassure parent banks that financial regulation will remain predictable. Some of the recent abrupt – and at times overly ambitious – measures to tax the industry or redistribute the burden of foreign-currency loans have undermined capital cushions and set back recovery in credit and growth.

All of this requires coordination. The European Banking Authority has a chance to establish itself. It must ensure that national interests do not undermine the integrity of the cross-border bank groups. Ultimately, we need a Europe-wide deposit insurance and bank-resolution authority that can take over and restructure failed banks.

Just as the eurozone has fostered financial development and economic growth among its members, the current crisis now risks inflicting severe collateral damage far beyond its borders. Any sustainable solution to the crisis must ensure the integrity of the bank groups and respect the interests of these banks’ home and host countries. Ultimately, it is cross-border banking that is in the balance.

Erik Berglof is Chief Economist, European Bank of Reconstruction and Development.
Copyright:

Project Syndicate, 2011.