The fear is that with all of Europe's banks struggling to reach their new capital limits, they will dump the least valuable assets first. Those happen to be government bonds issued by Italy, where interest rates have topped 7%, forcing the new government of Prime Minister Mario Monti to adopt a severe austerity program in a hurry. Now the concern is that the falling value of Italian bonds will destabilize banks in other nations, such as France. That could lead to French bonds losing some of their value, in a never-ending "death spiral," as one analyst termed it.
Steil says Europe should have learned from former Treasury Secretary Henry Paulson, who on October 13, 2008 called in the CEOs of the nine largest U.S. banks and told them they had no choice but to agree to an infusion of government capital. He had them sign pledge cards agreeing to take the money.
Paulson's approach worked, Steil says, because it didn't allow the banks any alternative but to take the money. Europe's banks, on the other hand, have until June 2012 to adjust their capital ratios.
"They should have done it right away on Oct. 26 and not waited nine months," says Karel Lannoo, head of the financial markets unit at the Center for European Policy Studies in Brussels. "In the meantime, the damage will be done."
Another policy mistake Lannoo cites is the statement by Mario Draghi, the new president of the European Central Bank, that the ECB would not be a lender of last resort to foundering countries like Italy.
"This was the biggest stupidity you could have," Lannoo says. It sent a message to the markets that the ECB would buy some Italian bonds on the open market, but only a limited amount. Bankers concluded that they should sell immediately before the ECB changed its mind, triggering a stampede to the exits.
The ECB is currently split politically over whether to continue buying sovereign debt of struggling European nations in order to keep interest rates at reasonable levels.