The Financial Education of the Eurozone

LONDON – In 2017, Europe’s leaders will confront an array of severe tests, including tumultuous elections featuring populist insurgencies, complex negotiations over Britain’s departure from the European Union, and a new American president who thinks that the transatlantic alliance is “obsolete.”

But, despite these challenges, EU leaders will also have an opportunity to strengthen their battered union and reinforce its institutions. In particular, they should focus on restoring the banking sector’s credibility, by providing it with more capital and better oversight. Even if they make progress on nothing else, achieving this goal could turn 2017 into a very good year after all.

Europe’s banks have long been central to the continent’s economy. In France and Germany, bank assets amount to 350-400% of GDP, whereas in the United States, they are equal to just over 100% of GDP. After the 2008 financial crisis, the eurozone’s weakest banks quickly buckled under the weight of their bad loans, and then threatened to drag their respective governments down with them. With many countries’ creditworthiness in doubt, even strong banks were caught in a “doom loop,” as they suffered losses from the collapsing sovereign debt on their books.

Ironically, eurozone banks’ interdependence is what eventually saved the day. Because Irish, Portuguese, and Greek banks owed money largely to German, French, and Dutch banks, the external shocks to the weakest banks and economies were immediately shared with the strongest. This forced all stakeholders to cooperate on a joint response, despite the political costs. Had all European banks and economies not been imperiled, it is hard to imagine that European leaders ever would have agreed to a $1 trillion backstop for financial markets.