The ECB’s Risky Business

BRUSSELS – A central bank always has a crucial role to play in a financial crisis. But the European Central Bank’s role within the eurozone nowadays is even more “central” than that of the Federal Reserve or the Bank of England.

A key difference between the eurozone and the United States is that lending between two banks located in two different member countries is still perceived as carrying quite different risks than “domestic” lending (between two banks in the same country). This is not the case in the US, because it has an integrated financial system, and support for banks (deposit insurance or outright bailouts) is administered at the federal level.

As a result, the fact that California might be closer to bankruptcy than some eurozone countries has no influence at all on the credit rating of banks headquartered there, or on their ability to obtain funds on the interbank market. In Europe, by contrast, the fate of all banks depends upon their home governments.

During the credit boom before 2007, enormous cross-border interbank claims built up, because banks trusted one another. Then, in 2008, the interbank market suddenly froze as that trust evaporated. This was a generalized phenomenon, not focused on particular countries, because it was still assumed at the time that all eurozone governments would be able to bail out their own banks.