For weeks the International Monetary Fund (IMF) and countless experts have warned of a looming financial specter that the political class in Europe did not want to see but can no longer ignore: a new crisis among the big banks. The situation in the banking sector is worse than it was after the Lehman crash in 2008, which triggered a global recession.

Only gradually have Chancellor Angela Merkel and other leading politicians admitted that the banks in France, Greece, Italy and Spain - perhaps Germany as well - need a lot more money from the state and fast.

Many of Europe's banks are sitting on rotten bonds whose repayment appears increasingly unlikely. Already the mere presumption that a reduction of Greece's debt threatens stiff losses for individual banks has led to an escalation of the crisis. The first victim was the Franco-Belgian bank Dexia, which will most likely have to be saved with taxpayers' money for a second time and then broken up into its constituent branches.

The banks are no longer lending to each other because they do not trust one another, forcing the European Central Bank (ECB) and other central banks to jump in to provide the banking sector with more money simply to keep the system functioning. This game can continue only for a couple more weeks or perhaps a few more days, according to experts.

No vision

The head of the World Bank, Robert Zoellick, was unfortunately right when he said that Europeans have no concept but instead are simply buying time with their fanciful bailout fund. Zoellick, however, did not mention that the US also has no real concept for its economic woes. Instead, the Federal Reserve simply prints money with uncertain consequences.

Chancellor Merkel and French President Nicolas Sarkozy announced after their meeting in Berlin on Sunday that they will present a solution for the pressing banking crisis only at the end of October - a risky game. Merkel wants to write off some of Greece's debt but needs France's approval for such a move. Sarkozy will only cooperate if French banks exposed to Greek debt receive money from the European Financial Stability Facility (EFSF). Germany, however, has blocked this idea with the argument that German taxpayers should not be on the hook for poor decisions by French bank managers.

Yet there is no longer any time left for these principled considerations - action must be taken. Merkel's argument that the banks should first seek capital on the market is adventurous and no longer credible. If the banks could raise capital on the market, they would not be in a tight spot.

Merkel's moment

As the representative of Europe's largest economy, Merkel has the chance to take a brave step and push the stabilization of the banking sector and the entire economy forward. At the same time, however, Merkel has to tell German voters and taxpayers that such a step will not come cheap and will most likely force Germany to take on more debt.

The rating agencies have already downgraded Italy and Spain because they sense that the bank bailout will further weaken the credit worthiness of those countries. Belgium also faces a possible downgrade, and France could confront a similar fate in the future. Depending on how large the financial burden is from reducing Greece's debt and bailing out the banks, Germany could also lose its AAA rating.

ECB bailout

It is already clear that the largest owner of government bonds in Europe, the ECB, will need fresh capital if a portion of Greece's debt is written off. The ECB would have to make the write-offs, and the 27 members of the European Union would have to cover those losses. Germany would presumably be responsible for 19 percent of the burden - billions of euros in any case. The German government's Credit Institute for Reconstruction, which has granted Greece loans, would also have to absorb losses.

One can complain about the helplessness of European policymakers and the power of the financial markets, but at the moment, there is no time for that. The reality has dictated what needs to be done. A collapse has to be prevented and governments must reform the banking sector, which they unfortunately failed to do after Lehman Brothers folded in 2008.

The investment banking sector in Europe and around the world has simply become too large, and an orderly restructuring will be unavoidable in the ensuing years. But first the current crisis has to be mastered. The EU summit this coming weekend is probably the final chance to get the crisis under control.

Author: Bernd Riegert / slk
Editor: Nicole Goebel