EU calls for "banking union" to fight debt crisis

As Europe's debt crisis intensifies, top officials say the continent urgently needs a central authority with the financial muscle to fix its broken banks.

The proposal could give immediate relief to Spain's increasingly fragile economy, with its borrowing rates rising to unsustainable levels, rattling investors.

The European Commission called Wednesday for a "banking union" that can oversee and, if needed, bail out banks without having to go through national governments. It would have the power to force banks to heal their finances and also have access to a pool of money to rescue banks, lifting pressure off individual countries — like Spain — that are already strapped for cash.

Germany resists allowing a central body to spend money — much of which Berlin provides — to rescue banks around Europe. But markets nudged Spain, the fourth-largest economy in the eurozone, ever closer to needing financial aid that Europe can scarcely afford to give it. Its 10-year bond yield rose to 6. 64 percent on Wednesday, close to the 7 percent threshold that caused Greece, Ireland and Portugal to need financial assistance previously. Stock markets tanked globally, with the Dow falling 1.3 percent and Madrid's index down 2.6 percent.

Spain is in a particularly bad situation because its banks are not only holding massive amounts of shaky government bonds, but also sit on huge real estate investment losses. One of them, Bankia, asked for €19 billion ($23.6 billion) last week. How the government, which has been making savage austerity cuts to lower its debts, will afford that — and other potential bailouts — is worrying investors.

Adding to the pressure, depositors in some countries, most notably Greece, have been pulling their money out of banks. There are concerns that Greece might have to leave the eurozone if political parties that reject its bailout terms come to power next month. While the drain in deposits from banks in Athens has so far been slow, some fear it could become a quickly devastating bank run.

The solution, economists and a number of European Union policy makers say, is to cut the knot between governments and banks. Europe should create a central banking authority with the power and the money to take broken banks off governments' hands — and override national regulators who may be reluctant to force expensive and politically painful restructuring of failed financial institutions.

The current European Banking Authority lacks such sweeping powers.

"Already before the crisis, it was acknowledged that the EU model of cross-border banking was not stable," the European Commission said in a report Wednesday.

The commission suggested that the permanent European bailout fund could be permitted to put money directly into banks, bypassing the governments.

But Germany, which contributes most to the bailout fund, has long resisted such a move and said Wednesday that it would continue to oppose it.

Whether Berlin and the other European leaders will be able to find some compromise to create a new central authority will be key to snuffing out the continent's 2 ½ year-old crisis.

"What you need is to create a system at the scale of the eurozone that would consolidate the systems that exist in member states," said Nicolas Veron, a fellow at the Bruegel think tank in Brussels. "If you have more centralized decision-making for the whole bank restructuring agenda throughout Europe, then you can be tougher because you get a hold of the entire branch."

Europe's banking vulnerabilities include:

— No central regulator with the power to step in and force weak banks to ask investors for more capital to strengthen finances, or to break them apart and restructure them.

— No central deposit insurance backstop, making it more likely that a bank failure would exhaust one country's fund to compensate depositors.

— National regulators who may be protective of their home financial services industry and reluctant to declare a home institution a failure and break it up.

The U.S. bank bailouts made clear the significance of a central authority that could restructure banks. Insurer AIG failed financially and had to be bailed out. Although it was incorporated in Delaware and headquartered in New York, neither state had to go bankrupt paying for the rescue. The burden was shouldered by the U.S. Treasury.

In Europe, Ireland went bankrupt because it was unable to cope with the size of the bailouts it had to pay for banks. The government was ready to force bondholders to accept some losses as part of restructuring the banking system. But European officials, fearing a spread in financial chaos, pushed Ireland to have taxpayers shoulder the burden, adding hugely to the country's debts.

Governments are under pressure to rescue failed banks because the financial system is the source of credit for businesses and thus key to growth. A bank failure may spread financial damage if other banks loaned the failed bank money.

Michel Barnier, the European commissioner for the internal market and services, on June 6 is expected to reveal more proposals for Europe to restructure banks. He has spoken of the need for "bail-in," where creditors — like a bank's bondholders — can be forced to take losses, as opposed to "bail-out," where taxpayers take the hit.

The EU is likely to phase in any new system. Earlier studies suggested first increasing cooperation and making rules more uniform and only later creating an EU-wide authority.

The timing of such a process is slow. New measures would go through the EU legislative process by early next year at the soonest, and then could take laborious rewriting of complex national level laws to conform. Some aspects could take years more to take effect.

European officials are also working on a beefed up deposit guarantee system. One proposal would allow national deposit insurance funds to loan money to each other, creating a much deeper pool of money. That proposal has passed an initial vote in the EU parliament but is currently held up in a dispute between the European Parliament and national governments about the mechanics of funding it.

Veron says quicker help is needed. He proposes putting together a task force similar to the one that oversaw the restructuring of U.S. auto companies General Motors and Chrysler under bankruptcy court protection.

The current system "is unsustainable and we need to change course," he said.