The euro zone is going to require a bailout program akin to the United States troubled asset relief program (TARP) of about €700 billion if it is to solve the banking crisis, according to the Organisation for Economic Cooperation and Development (OECD).
"We need to stop calling this a sovereign debt crisis; this is not really a sovereign debt crisis," OECD financial and enterprise affairs deputy director Adrian Blundell-Wignall said yesterday.
"This is first and foremost a euro zone area crisis; the idea of a currency in a group of countries that don't belong in the currency.
"The second thing is that, in the order of what is important, it is a banking system crisis, which is very, very big indeed."
In an address to the Economist Bellwether conference in Sydney, Blundell-Wignall said the banking crisis was caused by the low levels of capital historically held by European banks.
This has led to a situation, where they don't have enough collateral to meet margin calls.
"The European banking system never had any capital. It always had extremely low capital, yet it worked with the lowest common denominator of regulation, which is the Basel system," Blundell-Wignall said.
"The last bank to fail in Europe was Dexia. Why did Dexia fail? Because on the 27th of October they had a US$22 billion margin call it couldn't meet, that is why."
"This crisis always was and still is about collateral. European banks have no capital."
To solve the problems in Europe, Blundell-Wignall argued that the issues in the banking system needed to be addressed first.
"It requires a TARP-style process that starts now, starting with Germany and working its way south," he said.
"This is going to take a very long time to do if they get on with it. This crisis will be around for a long time."
He said the US had addressed its banking problems head on through TARP and, therefore, enabled institutions to deleverage in a sensible manner.
But governments in Europe have largely ignored their banking problems, he said.
"In Europe it is like: hear no evil, see no evil, speak no evil; there is no problem in European banking. But of course ... this crisis is all about collateral, and collateral, if you don't have any capital, is what takes banks down," he said.
The solution for Europe is to initiate a program to purchase assets and equity from financial institutions to strengthen the financial sector in the same way TARP has done in the US.
"You could give the ESM [European Stability Mechanism - a planned institution to manage a permanent rescue funding program in the euro zone] a banking licence and then use the capital the ESM has to capitalise for example through a special purpose vehicle in a European investment bank," he said.
"Give it €200 billion in capital, and the ECB could give it bridging finance to get it up to the amount that I think is the appropriate amount that they need to invest, then that special purpose vehicle would buy, let me just say it: €700 billion worth of equity warrants in the European banking system which it would be forced to issue.
"Then when the problem is solved the equity warrants come into money. Everybody gets paid back and it costs you nothing. This is what the lesson of the TARP was and this is what interests markets."
But currently the bailouts that have been given are too small to make any significant difference, he said.
"This death of a thousand cuts goes on forever. It is going to take time unless they take the banking problem off the table," he said.
Although the European crisis does not affect Australia directly, its influence on market sentiment should not be underestimated, National Australia Bank group executive business banking Joseph Healy said.
"We should not underestimate the contagion effect it can have," he said.
