Europe’s leaders have at last acknowledged that their banking system is in trouble. What should they do? It is easier to say what they should not do. They should not airily float rescue plans and then abandon them at the first whiff of controversy. They should not convene ad hoc get-togethers, omitting many of the important players, profess a united front and then abandon it within hours. They should not lurch hastily into guaranteeing the liabilities of their banks, policies which not only threaten to “beggar-thy-neighbour” but, conceivably, beggar the taxpayer too. Admittedly, there has been some nimble footwork to save individual banks, but overall it is perhaps best to draw a veil across the European response over the past seven days.

Unfortunately, it is less easy to turn the page on the crisis itself. Few are now willing to lend to European banks, not least other European banks. The situation cannot be allowed to continue. At risk is the prosperity of millions of blameless European citizens who rely on banks for mortgages or business loans.

Policymakers need to end the panic, improve transparency and thus the health of sound banks, while allowing a bloated banking sector to shrink. Unfortunately, it is no easy task to achieve all of these three aims simultaneously.

The US Treasury’s plan to purchase toxic assets at auction should – if executed well – improve transparency by helping to establish the value of banks’ balance sheets. Since the most toxic assets appear to have originated in the US, there may be no need for separate European action on that score. Yet the auctions may also be the low tide that reveals many banks to have been swimming naked. It is unlikely to release a flood of confident lending to the banking sector from the wholesale money markets. It will not provide enough subsidy to rescue bad banks, and nor should it.

Ending the panic will require something else: the recapitalisation of the banking sector. Lacking a queue of eager investors, that will be achieved either through the forced conversion of debt to equity, or by governments taking a stake themselves. This is a crisis that looks fixable, given more capital and more transparency. Hopefully a blanket guarantee of all bank debts, with the horrible incentives that brings, will not be necessary.

The difficulty is that the developed world looks over-banked. Too many bankers have been chasing too few projects. Consolidation and job losses in the banking sector look inevitable, maybe even desirable.

Yet it is no mean feat to work out which banks should be recapitalised at some cost to their existing shareholders, which should be abandoned, which should be forced to slim down and which are fine.

To subsidise permanently incompetent banks is unfair and will lead to trouble in the future: the blanket guarantees currently breaking out like a rash all over Europe fall into that category. Yet to abandon the banking sector would be a disaster too. The middle road is narrow.

Thus far, Europe’s leaders have displayed a purely declaratory brand of unity, jointly proclaiming that they will each take care of the problems in their own back yards. Despite the temptations of a Europe-wide bail-out fund, that looks to be a sensible recognition of reality. Such a cross-border fund would struggle with the inherently political decision of who shall drown and who shall be saved.

Yet Europe still needs a plan, and a more co-ordinated approach. The farcical rush to unconditionally indemnify all depositors is an example of the costs of flying solo. Pioneered by the Irish, closely followed by the Greeks, the Danes and – possibly, or possibly not, the Germans – the stampede has helped to spread nervousness. It has offered no additional protection to the typical depositor, who is already insured, and encourages bad banks to play double or quits. There is no obvious exit strategy. Could this have been what the UK chancellor, Alistair Darling, archly referred to on Monday as “international best practice”? While it is clearly vital that small depositors should be protected, panic among retail depositors is not the cause of Europe’s banking woes.

The European Commission should now be laying the groundwork for a state role in recapitalisation, which looks ever more likely to be necessary. One obstacle is the stability and growth pact, which forbids excessive deficits. EU rules on state aid form another hurdle. The current exceptional circumstances justify a relaxed approach to both restrictions, but not their indefinite suspension. Clarity is needed.

A large and co-ordinated recapitalisation could work, but it will need a conductor and a score. This is no time for improvised solos.