Europe Has a Looming Debt Problem

(Bloomberg Opinion) -- Europe's leaders have so far demonstrated surprising courage in handling the coronavirus pandemic. If they want a banking system capable of supporting a recovery, they'll have to muster some more.

European Union members have taken bold steps to help the economy heal, most notably by pooling hundreds of billions of euros to support the hardest-hit among them. Yet as the pandemic drags on, another challenge looms: managing the losses that banks will inevitably suffer as corporate and household borrowers prove unable to pay their debts. By one estimate, worst-case losses could exceed 800 billion euros across the U.K. and continental Europe — comparable to the 2008 financial crisis, and enough to destabilize large swaths of the banking sector.

The people who oversee Europe's financial system have essentially two options. They can pretend everything is fine, hoping that banks will gradually earn their way back to health. Or they can opt for a more complete reckoning, using the crisis as an opportunity to weed out the weak and build a better system.

The first approach is pretty much what Europe has done since 2008, with dismal results. The banking sector has remained in limbo — dependent on government backstops, too bloated to be profitable and too burdened with bad loans to support a strong recovery. Despite some progress, the region's larger banks still had more than 500 billion euros' worth of nonperforming loans just before the pandemic hit. Investors have so little confidence in European banks that they value each dollar of equity at about half the level of U.S. banks.

Pretty much everyone agrees that a reckoning is needed. Problem is, the convoluted supervision of Europe's banks makes this extremely difficult. Supranational entities — the European Central Bank and the Single Resolution Board — oversee the largest banks and have the power to declare them insolvent, but the responsibility for recapitalizing or shutting them down falls largely to individual governments, which have their own agendas and sometimes lack the resources to provide support. Worse, because the euro area lacks a harmonized system of deposit insurance, financial trouble in one member state can trigger an exodus and undermine the common currency. As a result, European officials are understandably hesitant to do what's necessary.

The solution is as conceptually simple as it is politically difficult. The EU's members need to cede more power to supranational authorities, giving them the independence and resources they need to restructure the banking system. This means, for example, enabling the Single Resolution Board to liquidate or recapitalize banks on its own, and providing it with ample public funds to do so. It also requires mutual deposit insurance, along with other measures to disconnect the finances of banks and individual governments.

The coronavirus crisis has shown that, under duress, Europe's leaders are capable of doing what's needed to make their economic union work. To that end, they must complete their banking union.

Editorials are written by the Bloomberg Opinion editorial board.

©2020 Bloomberg L.P.