As finance ministers and central bank governors from the G20 meet in Paris today, efforts are continuing behind the scenes to desperately sort out the European debt crisis. There is a growing acceptance among policymakers that Greece must be allowed to write off far more of its debt than the implied 21% haircut that was agreed in July, with many economists now questioning whether a 50% haircut – literally wiping off half of Greece’s debts – would be enough.

But the main problem for policymakers, given this growing consensus, is how to make sure that the rest of Europe copes with a Greek default. In particular, they are worried about how to make sure that European banks do not go bust once the mark-downs on their holdings of Greek paper (not to mention the knock-on impact on Irish or Portuguese debt) are forced through. The European Banking Authority is proposing that euro area banks raise their capital ratios to around 9% or 10% of their risk-weighted assets.

There are two key ways that the banks can do this – and which way they pick will have big consequences for the European economy (and for the UK as well, given that Europe is our biggest trading partner).

The obvious way that banks can increase their capital ratios is by raising more capital. Estimates vary as to how much would be needed, but broadly as much as €200bn or €250bn may be required across the eurozone to get capital ratios up to 9%. There are two potential sources of capital: the private sector, and the public one. The likelihood of European banks being able to raise that sort of capital from private investors – which would typically be via rights issues or some similar means – is small. So, if banks want to build up capital, they would have to rely on governments to pump in more cash. That money could potentially come from the European Financial Stability Facility (FSF) or national governments, depending on how much is needed in each instance. The Germans, for example, are reluctant to let the French recapitalise SocGen and BNP Paribas with FSF funds, as they think the French are rich enough to pay for it themselves.

The knock-on impact of these recapitalisations would be a further increase in the ratios of gross government debt to GDP across the euro area. France, in particular, might see its debt climb from the estimated 82% of GDP last year to well over 90%. At that kind of level, and with a poor track record of genuine fiscal consolidation, France’s AAA rating could be under threat. Italy could also suffer further ratings action if it needed to prop up its banks. The end result all round would be higher debt, and hence even more austerity within the euro area to get public finances back under control, which in turn would hit businesses, growth and jobs. It’s not an appealing outcome.

The alternative is that, instead of taking more money from taxpayers, banks raise their capital ratios by shrinking the size of their balance sheets. Under Basel rules, the amount of capital required is measured as capital (or equity) compared with total assets. So, even if the absolute amount of capital stays the same in euros, banks can boost their capital ratios by selling off assets or calling in loans.

That would result in a massive credit crunch. City estimates vary, but some suggest that banks might need to cut their lending (assets) by as much as €2trn – a disaster for any business or household that is reliant on bank funding. It could make the credit crunch that we’ve seen so far – with many small businesses still unable to find or afford bank credit – look like relatively small beer.

Neither of these outcomes is very palatable – essentially, banks get to pick between forcing the pain on taxpayers, and hitting the economy via greater austerity, or cutting back on their activities to the extent that business could grind to a halt anyway. But the reality is that there are ultimately only two other possible alternatives: widespread default and contagion at the sovereign level, which really is unthinkable; or full-blown deficit financing by central banks, which is technically banned by the Lisbon Treaty. But faced with a prolonged austerity-induced slump (or credit crisis), a proper bit of inflation could soon start to look tempting.

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