06/08/2012 10:45 am ET Updated Aug 08, 2012

To Save the Euro, a Eurozone Bad Bank Is Urgently Needed

The eurozone crisis has been very conveniently framed as a sovereign debt crisis in fiscally loose peripheral economies from the very beginning. The fact that Ireland had implemented the toughest austerity measures but still had to be bailed out because of its banking sector's bad loans to the real estate sector was ignored in the policy circles in the EU and by politicians. This lesson was soon forgotten in the EU, and there has been an unwise concentration of efforts and attention on rescheduling Greek sovereign debt and implementing austerity measures in Greece. Similarly, one of the biggest cognitive mistakes of the media, the eurozone politicians and technocrats has been framing the problems in the eurozone in terms of individual countries or groups of countries -- PIIGS, etc. As I have argued with my co-authors in our recent working paper from CRESC, the eurozone crisis is primarily a banking crisis.

This is Europe's subprime crisis, where a return on equity (ROE) and Basel II complicity caused banks in the eurozone to expand their balance sheets by lending to real estate, sovereigns and in cross-border eurozone interbank markets from 2002 onwards. Under Basel II capital adequacy accord, these three categories of bank assets are viewed as low (real estate and interbank lending) or zero (sovereign debt) credit risk. And in banking, the key performance metric in both stock market listed and mutual banks has been ROE and still is in the post-crisis period. The post-crisis gigantic trading losses at UBS and JPMorgan Chase are mostly the result of searching for an unrealistic ROE of 15 percent.

Share prices of banks are driven by ROE and bonuses are driven by its management accounting equivalent -- return on risk-adjusted capital (RORAC) ratio. The latter has been promoted by Basel as a scientific measure of desirable profitability in banking. Basel capital accord, which is based on modern finance theory that is cognitively incompetent to deal with the reality of asset bubbles, is not sociologically sophisticated either to quantify the risk-weights for bonus-driven behavior in banking. This ROE-Basel complicity then encouraged the eurozone banks to increase their ROEs to Goldman Sachs' level by reducing the denominator through increasing the share of low risk-weighted sovereign debt, interbank lending and real estate loans.

Consequently, the French banks had a staggering 16.2 percent of French GDP exposed to the Italian banks and private and public entities as of Q2 2011. The UK banks' exposure to the French banks and economy was 13.6 percent of the UK GDP. The UK banks' similar exposure to the Spanish economy was 4.5 percent of the UK GDP. French banks had credit exposure of 5.9 percent of French GDP to the Spanish banks and public and private entities. This chain of interconnectedness of bank balance sheets in the eurozone and the UK is the major source of the eurozone crisis. The reason that the ECB had to introduce the gigantic €1 trillion Long Term Refinancing Operations in December 2011 and February 2012 was to save this interconnected eurozone banking from collapsing as banks stopped trusting each other in the interbank market. But the politicians, media, IMF and the EU Commission still focused narrowly on Greece's fiscal deficit and on creating a fiscal pact in the EU.

The dangerously evolving Spanish banking problem should now ring alarm bells in the EU and the UK. It is time to recognize that the eurozone has a banking crisis that is bigger than the sovereign debt problem. An effective solution to this enormous banking crisis involves creating a temporary eurozone bank which buys the most problematic sovereign debt and real estate loans from the eurozone banks. Then eurozone bonds, central bank liquidity injection and equity participation by the eurozone countries through cleverly planned incentives and penalties should fund this bank. And this bank should be free from the unenlightened alchemistic ROE-Basel complicity.

The alternative, which is a knee-jerk reaction of individual countries' suboptimal and unsuccessful recapitalization of interconnected national banks, will be a waste of scarce economic capital in the EU. Spanish government's recapitalization of Bankia is not good for the eurozone, because such state financed single-country recapitalizations are costly in more than many ways. A temporary eurozone bad bank will benefit from the economics of pooling both bad assets and financing such pooled bad assets. Then the policy makers in the eurozone should concentrate their efforts on creating a banking union from the healthier balance sheets of the remaining banks.

Such a banking union together with pension funds can finance the fiscal deficits and the growth policies in the eurozone at a much lower cost with better designed long-term debt instruments. The history of banking crises is full of such successful examples of restructuring of bank balance sheets and dealing with excessive public and private debt at the national level. The EU needs the political will and technocratic imagination to create such a eurozone bad bank and the complementary banking union if the EU wants to save the euro. The alternative is too painful, if not catastrophic, for everyone both in the eurozone and outside.