Eurozone crisis highlights need for replacement for sovereign guarantee of bank deposits

In a Telegraph article, Citigroup's Willem Buiter, a highly regarded economist and former member of the Bank of England's monetary policy committee, warned that the Eurozone crisis could cause the collapse of the global banking system.

"If things get out of hand in the euro area, no bank in the financial integrated world will stand," he told a parliamentary committee ... the recapitalisation of banks and other systemically important institutions should be a priority in the region.

Actually, disclosure of each bank's current detailed asset and liability-level data should be the priority as simply injecting capital does not answer the question of which banks are solvent and which are insolvent.

With this data, market participants can assess which banks are solvent, which are insolvent and how and over what timeframe the recapitalization of insolvent banks should take place.

Of the insolvent banks, a determination can be made which have viable franchises and which do not.  The banks that have a viable franchise as shown by their ability to either retain enough earnings to restore their solvency or by attracting equity from the capital markets will continue.  The others will be closed.

"If they don't, we are setting ourselves up for a financial crisis following the sovereign crisis," he said, giving evidence at a session of the House of Lords EU Economic and Financial Affairs Sub-Committee on the eurozone crisis. 

In worrying about a financial crisis following the sovereign crisis, Mr. Buiter highlights the need for a replacement in Europe for the sovereign's guarantee of bank deposits.  Specifically, who steps in to guarantee the deposits at banks where the host nation restructures its debt and the banks are insolvent?

Reinforcing this guarantee is important to prevent a potential run on these banks.  In fact, the Eurozone governments don't have to recapitalize the banks if they guarantee the deposits.  So long as the banks have a franchise that is capable of earning money, over time they can retain enough earnings to restore their solvency.

The logical guarantor of the deposits is the European Financial Stability Fund.  It is also the most efficient way to leverage the EFSF in helping to recapitalize the Eurozone banks and sovereigns.