Resolving Europe’s Banking Crisis in Italy

LONDON – The European banking sector is crippled and highly fragmented. Though its problems are more acute for some countries and financial institutions, the sector runs on a level of profitability that is, on average, lower than its cost of equity and maintains a stock of non-performing loans and hard-to-value assets large enough to undermine its capitalization for years to come.

Italy is a case in point. Not only is its dysfunctional banking sector undermining economic recovery and inhibiting investment; the sector’s troubles are the sharp end of a problem that affects the entire eurozone.

By the spring of 2012, it had become clear that the European banking system was a critical weak point in the euro’s architecture. Common banking supervision, a centralized resolution framework, and a mutualized deposit-guarantee scheme were understood to be necessary pillars of the eurozone. It was thought that these measures would help in the short term to accelerate bank repair, and that they would end financial fragmentation, establish a level playing field, reduce the risk of future banking crises, and ultimately contain and share the costs of banking failures.

But the road to hell is paved with good intentions. The European banking union, in its current state, is not only incomplete; its design flaws have made it a source of inaction and instability potentially worse than the ills it was intended to cure.