Save the sovereigns to save the banks

The eurozone’s economic policymakers have admitted that their banks need more capital, something they have long been told by everybody except the heads of the banks. Better late than never, but there is a risk of treating the symptom of banking system fragility while ignoring its cause: impaired sovereign debt markets.

This summer Christine Lagarde, head of the International Monetary Fund, warned that European banks needed more capital and liquidity. As for the latter, the Euro­pean Central Bank is ready to give banks what they need. But on capital, Ms Lagarde echoed the worries of investors such as money market funds that were reducing their exposure to eurozone banks for fear that they might not weather the sovereign debt crisis. Her former colleagues, however, would have none of it: as late as last month finance ministers were pushing back against IMF analysis.

So the change of heart is welcome. At the same time it confirms the attitude that mars eurozone policymaking: a denial of how serious the problems are until there is no alternative but to acknowledge them. By then the cost of action is greater than it might have been with a more timely response.

The eurozone must now get its priorities right. Given that the biggest systemic risk to the region’s banks is contagion from sovereign debt, the best that can be done for the banking system is to contain that crisis. By now, that means ensuring that Italian government bonds are indeed the safe investment that leaders say they are. This requires completing the July expansion of powers for the European financial stability facility and significantly leveraging up its size. It is a mistake to draw down the EFSF’s ammunition to fund bank bail-outs – the same mistake that Ireland made in sacrificing the solvency of the sovereign for the sake of that of banks.

If the run on eurozone government debt is not stemmed, no bank bail-out will help. If it is, the pressure on banks will lift, and raising capital for those that still need it – those with bad non-sovereign investments – should be easier. No doubt some banks will still be so exposed that private capital shuns them. It is essential to help investors be certain which they are, so that money again flows to healthier banks. The hopeless cases then fall to national capitals, which will again force taxpayers to pay for failure – unless laws have been made to convert debt into equity, as the UK and Germany have done. Other countries should follow their lead without delay.