Eurozone countries must implement a planned banking union in full as backsliding could throw the economy into a tailspin, an International Monetary Fund staff paper has concluded.
The 17 countries sharing the euro scrambled last year to put together a scheme that would tighten policing of Europe's banks and end their ability to suck states into crisis. Now there are signs of unravelling, Reuters reported.
When it takes the role of watchdog for eurozone banks in March next year, the European Central Bank will be confronted with a financial system that is still limping. In some countries, such as Cyprus and Spain, it is in critical condition.
Setting up a fund and agency that could shut weak banks - known as "resolution" - is central to this ECB-led union because it would remove the onus on countries like Ireland (OTC BB: IRLD - news) to save failing banks alone, running up bills that overwhelm the state.
Yet the political drive to complete banking union is waning, with the reluctance of Germany and other economically-strong countries to put themselves on the line for bad loans made elsewhere coming back to the fore.
The IMF staff note, entitled "A banking union for the euro area", said it should eventually include such backstops as a joint deposit guarantee fund, which has met opposition as creditor countries want to limit sharing risk.
"Banking union is obviously not a panacea, but it can be pivotal in fighting the current crisis by breaking the vicious loop between sovereign and bank costs," the paper said, adding that putting in place a common supervisor alone was not enough.
"Agreement on burden sharing and ESM direct recapitalization must also not be delayed ... Policy paralysis or backsliding in the current environment could derail confidence and the recovery."
German Finance Minister Wolfgang Schaeuble said on Tuesday that the eurozone's ESM bailout fund should limit any recapitalisation of banks to somewhere between zero and €80bn.
The IMF paper said the ECB should ultimately supervise all banks - something Germany also opposes - but warned against thinking the transition would be easy.
"The challenge of developing the requisite competence at the ECB and building credibility in supervision should not be underestimated," it said.
It also said conflicts of interest could arise when the same institution is responsible for setting interest rates and supervising banks.
For non-viable banks which can be shut down without systemic repercussions, national and industry funds should be used. If, however, consequences could be systemic, banks need to be recapitalised by the rescue fund.
Such a strong backstop could even reduce the need for it to be used as it would increase confidence.
"ESM direct recapitalisation would remove future tail risks from the sovereign balance sheet; by ensuring that the banks have an owner of unquestioned financial strength, it would improve bank funding conditions," the paper said.
"Mobilising the ESM direct bank recapitalisation tool in a forceful and timely manner is critical to developing a path out of the current crisis."
The paper said contributions from the industry should be used first to finance resolution but having a public sector backstop would be crucial.
"Common backstops can prevent self-fulfilling panics that might occur if a national scheme is not credible. Actual costs to taxpayers could be relatively small, particularly if the need for subsequent sovereign bailouts is reduced."
The paper said that it represented the views of the authors, not necessarily those of the IMF.