VoxEU Column Financial Markets

Crisis management tools for the euro-area

Europe’s largest banks are highly leveraged and thus vulnerable, as Fortis showed. But some of these banks are both too large to fail and too big to be rescued by a single government. The EU should: (1) urgently pass legislation to cover banks with significant cross-border presence and empower the ECB to provide direct support, and (2) create an EU-level rescue fund managed by an existing institution like the European Investment Bank.

Europe’s universal banks were supposed to be immune to the fallout from the subprime crisis.

We now discover that any financial institution – universal bank or not – is vulnerable if its leverage is high enough – as is the case for Europe’s largest banks. As we pointed out 10 days ago, Europe’s banks are too big to fail but also too big to be rescued by any single government. The unfolding of Fortis illustrates vividly the weaknesses and hurdles of raising adequate defenses against a fully-fledged banking crisis in the euro-area. This is an area where urgent EU action is needed.

In the case of Fortis, no European solution was possible. The ECB can only provide liquidity against collateral to keep the money market functioning. It has no powers to resolve a solvency crisis. In the absence of a European Treasury, such operations can only be done by national authorities. But national authorities tend to think nationally and are naturally reluctant to pay for the rescue of banks abroad. In the case of Fortis it was relatively easy to cut the bank into three pieces, but this would be more difficult with other large EU banking groups.

Foreign affiliates and banking crises

A key difficulty is that large European banks typically have subsidiaries – separate legal entities – with separate balance sheets in every country where they operate. However, asset and liability management is centralized. Cash and liquidity reserves are also managed centrally and these assets may be ordered back to the mother-company at times of stress. In such cases, subsidiaries receive paper which can become worthless if the bank becomes insolvent.

Given this, burden sharing among national treasuries is controversial in cases of bank failure. Disputes can delay timely decisions. Issues surrounding the equal treatment of creditors and depositors in the different countries can add layers of complexity.

In the case of Fortis, the three governments – Belgian, Dutch and Luxembourgish – choose to inject capital into the subsidiaries on their territory, thus effectively creating 3 separte, state-owned banks. This is no doubt a harbinger of the Balkan-isation of the EU banking system that might spread like a forest fire unless decisive action is taken immediately.

EU policy makers need to take two steps quickly:

  • First, a new EU ‘Statute of Union’ for chartered banks should be established for banks in the EU/euro-area with “significant” operations in more than one member state. This could be done by Regulation adopted by the Council of Ministers.   

These banks would be subject to fully consolidated capital requirements and supervision. In exchange, they would have direct access to ECB liquidity support – support they could count on even in case of a severe, bank-specific crisis. By the same legislative act, a new supervisory authority should be created in Frankfurt – preferably at the ECB – but in any case it should be legally obliged to cooperate fully with the ECB in all its activities.

  • Second, an EU-level contingency fund for rescue operations should be created at the European investment bank (EIB).

The EIB already is a public agency and issues publicly guaranteed bond to finance its operations. Its Board of Governors is made up of the ministers of finance of all EU members and they hold the purse strings. Given that this infrastructure is already in place, the rescue fund could be operative within weeks. Policy makers only need to give the EIB the power to take equity stakes in financial institutions under clearly defined circumstances. When these circumstances materialize, however, the EIB should have full power to act without further government interference, issuing (guaranteed) bonds as required to finance the operation.

One could even go a step further. The EIB and/or ECB could be allowed to act preventively to stop contagion, or at least make it less likely. They could do this by forcing highly leveraged EU banks with significant cross border operations to recapitalize themselves or accept public funds. For instance, a capital injection of €280 billion would be sufficient to reduce the leverage ratio of the 10 largest euro area banks from its current value of 33 to below 20. This would underpin confidence and thus reduce the risk of massive liquidity withdrawals by depositors. Such an investment could be unwound once distressed conditions in financial markets started to ease.

Of course, support by the EIB must come with strings attached to preserve the value of the public investment and to make sure those who mismanaged pay the consequences. Thus, the price paid for the (preferred equity) public sector stake should fully protect the value of the investment, and management should be changed. Enhanced controls and supervisory procedures should be envisaged during the period of EIB support.


We are living in extraordinary times. The uncertainty created by the US Congress's rejection of the Paulson Plan will render the market environment even more forbidding for European banks. Policy makers in Europe cannot continue to muddle through. They need to rise to the occasion. The implementation of these simple proposals would put them ahead of events in the unfolding crisis.

Being behind the curve is extremely costly – a fact that US taxpayers have discovered in a spectacular and exceedingly expensive manner over the past two weeks.

Editors' note: This is an updated version of a column that appeared today in the Financial Times newspaper, 30 September 2008.


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