Commentary: Time to Fix Europe's Banks

Europe has too many broken banks and the time has come to fix them. With Dexia's problems laid bare, it must now be apparent to even the most myopic politician that the European Banking Authority's 2011 stress tests were a complete failure.

The phony war is over and it is time for decisive decision making.

With sovereign stress showing no sign of abating and with the AAA ratings of countries like France apparently in need of protection, it is hard to imagine a recapitalization on the scale sought by the IMF taking place on a country by country basis.

To make matters worse, the IMF is still probably underestimating the actual amount needed to truly convince the markets that the financial sector has enough of a capital cushion to deal with the defaults that are coming.

Is the EFSF Europe's the answer?

Once EFSF 2.0 has been ratified by all 17 euro zone members (still by no means a certainty) its new powers would in theory allow it to step in and help the financial sector.

The problem is that Germany sees such a move as a last resort.

Paris on the other hand is desperate for the facility to do the heavy lifting in order to preserve the French AAA.

Another issue is that the EFSF may not have the resources necessary and that any leverage would also likely lead to a French downgrade. As one of the six AAA's backing the EFSF such a ratings move could be a counter productive.

There is also a moral dimension to the situation.

Why should taxpayers be forced to take on even more risk?

The answer is that they should not especially when bank bond holders remain untouched.

Andrew Lilico of Europe Economics argues that it is now time to put these bondholders to the sword, and I have to agree with him.

While bondholders deserve more protection than equity investors they nevertheless took a series of bets on banks that went bad and it is time that they stood up to be counted.

Ensuring that private sector involvement not only applies to sovereign debt but also bank debt could be one of the only ways to short circuit the sovereign/bank negative feedback loop that is gripping Europe.

While the no way of knowing with one hundred percent certainty that a plan for senior bank bondholders to take a haircut would not lead to disaster, it looks like one of the most manageable options.

The banks would be restored to health and sovereigns would not have to take on even more debt. Even the ECB might now be willing to see the logic of such a move.