Europe’s leaders can’t save their currency union without figuring out a way to salvage the region’s banks. Spain is a perfect place to start.

Perhaps no country better illustrates the mutually reinforcing links among the euro area’s banking, sovereign-debt and economic crises than Spain. Its banks are largely paralyzed amid concerns about heavy losses on real estate loans that, by various estimates, could require as much as 120 billion euros ($150 billion) in fresh capital to offset. Tight bank credit has in turn deepened the country’s economic slump, increasing banks’ potential losses and fueling fears that bailout costs will overwhelm the Spanish government’s already stretched finances. The longer the situation lasts, the worse it gets: Nervous investors pushed Spain’s 10-year borrowing rate as high as 6.7 percent Wednesday, up from less than 5 percent in early March.

Spain’s response has been far from adequate. Government-induced bank mergers haven’t reduced the system’s capital needs. Last week, the country’s third-largest bank, Bankia SA, said it would require 19 billion euros in fresh capital to cover losses -- far more than the resources available in the country’s bailout fund. A bank run of sorts has already begun: Central-bank data suggest that, in the first four months of this year, more than 100 billion euros in private money has fled Spain for other euro-area countries, an amount roughly equal to a 10th of the country’s annual economic output. A European Central Bank measure of deposits in Spain’s banks declined by 31.5 billion euros in April.

Downward Spiral

It’s imperative that Europe step in to break Spain’s fall, lest the country’s problems topple the euro area’s banking system. Europe’s banks have about 672 billion euros in claims on Spain’s banks, government and companies, according to the Bank for International Settlements. Germany’s claims alone add up to about 186 billion euros, or nearly half of German banks’ aggregate capital.

How, then, can Europe draw the line at Spain? Dire as the country’s predicament may seem, it offers an opportunity to create a model for bank recapitalizations throughout the euro area. One crucial element, as indicated Wednesday in a European Commission proposal, would be to allow the euro area’s bailout funds to provide capital directly to individual banks, a route now closed to the rescue funds. The quid pro quo should be a measure of European control over how the money is used, burden-sharing among the banks’ creditors, the ejection of entrenched management and steps toward a unified banking authority with the power to take over failing banks anywhere in the euro area. In short, the type of housecleaning and regulatory framework that many European banks have been avoiding for decades.

Let’s say Spain’s banks need 120 billion euros in new equity -- or capital -- to cover losses and restore confidence. The first place to look for the money would be the banks’ own subordinated creditors, whose claims aren’t secured against any of the institutions’ assets. These investors, who received a higher return to compensate for their low position in the pecking order of creditors, have often been made whole in bank bailouts. Instead, their claims should be converted into equity -- a “bail-in” that could cut 30 billion euros or so off the price tag of recapitalization.

Of the remaining 90 billion, the first 25 billion could come from the Spanish government in the form of equity that would protect other contributors from losses. The rest -- about 65 billion -- could come from the euro-area’s bailout funds. In return, the funds would gain a presence on the boards of the recipient banks. Voting power would allow them to make sure that the managers responsible were replaced and that the compensation of executives and shareholders stayed in check until Europe’s money had been paid back.

Such a recapitalization plan would be a radical move for the euro area. By accepting joint responsibility for injecting capital into a single country’s banks, the nations of the currency zone would be taking another step toward financial federalism and collectively backed euro bonds. The sooner they realize that this is the only viable direction to go, the greater the currency union’s chances of survival.

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