Why banks are eurozone's fault line

Greece, where the banks are only alive thanks to support from the ECB and the nation's central bank

If, as I mentioned on Friday, the latest EU council has failed to solve the eurozone debt crisis in a sustainable way, what could shock eurozone governments into effective evasive action - or, in a worst case, be the explosion that causes the disintegration of the eurozone?

The most likely disaster would be a big bank - or banks - running out of money.

What do I mean by that, given that the European Central Bank is lending unlimited sums to eurozone banks, to replace the money that these banks are no longer able to borrow on markets in the normal way?

As you know, conventional dollar funding of eurozone banks has almost completely dried up - which is why the European Central Bank (and other major central banks) reached an agreement with the US Federal Reserve to borrow dollars, which the ECB then lends to eurozone banks that need the money (last week, the ECB lent more than $50bn to eurozone banks in 84-day loans).

And the ECB is also lending more and more euros to commercial eurozone banks.

But the ECB can only lend against the security of assets that are pledged to it by the banks. It does not give unsecured loans, because to do so would expose its owners - who are the taxpayers in eurozone countries - to serious risk of losses.

Now banks all over the eurozone, in Greece, Cyprus, Portugal, Ireland, Spain and Italy (as the most extreme examples), are only alive at the moment thanks to the sheer scale of the money they've been able to borrow from the ECB and from their respective national central banks.

Some would say they've already failed: but in these fraught times, that definition of bank failure now looks pretty academic.

Here's the thing. The ECB has a pretty generous and broad definition of the assets or collateral it is prepared to take as security for loans to banks.

But what is keeping regulators around the eurozone on red alert is the danger that the banks under their scrutiny will run out of eligible collateral, and will no longer be able to borrow from the central bank.

To state the bloomin' obvious, when a bank can't borrow from anywhere, even from the central bank, to repay its own debts as they fall due, well that's what causes panic and bank runs - because no one would leave their money in a bank that can't repay its debts.

And, of course, because of the interconnected nature of the banking systems - with banks lending to each other - the collapse of a big bank in that way would wreak significant harm on contiguous banks.

How likely is that hideous scenario?

Well bankers and regulators tell me it is the potential disaster for whose impact they are putting in place contingency plans.

What could eurozone governments do to minimise the harm from such a banking debacle?

Well any bank that ran out of money in this way would probably have to be nationalised, to reassure the depositors that their savings were not about to vanish.

But if it was a big bank, and if it was nationalised by a government such as Spain or Italy already perceived by many to have unsustainably large debts, then there could be serious contagion from the credit-worthiness of the bank to the credit-worthiness of the state: there would be an escalation of concern that the relevant government would be unable to repay everything it owes.

Here's the lethal chain of causality: banks have found it harder to borrow because of their big loans to the likes of the Italian, Spanish and Portuguese governments, and because of fears these governments will struggle to repay their debts; but if one or more of the banks were nationalised, the perceived liabilities of these governments would increase; and that in turn would erode confidence in the ability of other banks to repay what they owe; and so on, till no institution in the eurozone is seen to be sound.

Or to put it another way, we have a sovereign debt crisis, which caused a banking crisis, which is in turn leading to a worsening of the sovereign debt crisis, in a vicious cycle that threatens to destroy the currency union.

What's the solution? What's the circuit breaker that would prevent the tumbling dominoes of bank and sovereign defaults?

It's the same as it ever was: mutualisation of all the eurozone's debts, which in practice means that the mighty German sovereign balance sheet would stand behind the enormous liabilities of the rest of the eurozone.

How likely is that to happen, in the absence of a much greater surrender to a central authority (which many would see as a proxy for Germany) of national controls over spending, taxing and borrowing than is currently on the eurozone's agenda?

Here is the simple equation which makes it quite hard to be optimistic about what lies ahead for the eurozone: the stability of the eurozone probably requires Germany to underwrite more-or-less all eurozone sovereign debts, to end the contagion from weak sovereigns to weak banks; but that won't happen unless and until there is an all-powerful finance minister (in effect) for the whole of the eurozone, to reassure Germany and the German people they wouldn't be throwing good money after bad.

Or to put it another way, unless a country like France is prepared to make a much greater sacrifice (for the good of the currency union) of its own government's budget-making powers than it currently seems prepared to do, it is quite hard to paint a rosy picture for the eurozone.