From the FT's Lex blog
How to avoid the doom loop? The euro zone could easily fall into a self-reinforcing cycle of bank and government debt default. Christine Lagarde of the International Monetary Fund has a solution: more bank capital. There is a better way.
The cycle could start if sovereign debt worries cut off the supply of bank funding (the money needed to support operations). Morgan Stanley calculates that European banks need €80-billion before the end of the year. That is not even 1 per cent of the outstanding sovereign debt in the EU, but a shortfall could start a downward spiral of bank failures -- if neither governments nor the European Central Bank were willing to replace fearful private investors.
Ms. Lagarde has not explained last week's call for an "urgent recapitalization"of European banks, but she probably believes investors would fund banks which have enough equity to survive substantial writedowns on Greek, Portuguese and Italian debt. True in principle, but it is almost inconceivable that banks could raise enough equity in a hurry to calm investors. And if governments provided the equity, sovereign worries would worsen.
But central banks can always and immediately print enough money to keep banks in business. Such a policy requires political support and monetary determination, both of which are lacking right now. But the ECB could create what Morgan Stanley calls a Temporary Bank Liquidity Guarantee Programme, a promise to make up for any private sector funding shortfall. A TBLGP might have to create almost no new money, if investors are comforted by its existence and threatened governments can move to better fiscal balance, or pre-agreed default.
Money-creation is risky; it can create inflation and distort financial markets. But when the alternative is disintegration of the banking system, monetary stinginess is riskier.