Europe’s leaders have raised hopes that, when they meet Thursday and Friday in Brussels, they will agree on a banking union aimed at severing the link between the health of the euro area’s financial institutions and the solvency of its governments.

The plan’s success or failure, as with so much else in the currency union today, will depend on one person: German Chancellor Angela Merkel.

The euro area’s banking system has long suffered from a fundamental imbalance. Most countries have large banks whose failure would have repercussions for the entire currency union, yet the responsibility for overseeing the banks, guaranteeing their deposits and bailing them out falls on national governments. The burden can be unbearable given the size of banking assets in some countries -- about two times gross domestic product in Germany, and three times in France and Spain.

The current crisis has made the pitfalls painfully evident. Spain’s borrowing costs are soaring, with the 10-year bond yield approaching 7 percent, as investors worry that the government can’t afford the 100 billion euros or more needed to shore up its banks. Depositors are fleeing Greece, Italy, Portugal and Spain amid concern that governments can’t or won’t guarantee repayment in euros. Regulators are afraid to run credible stress tests because it’s not clear how the capital needs they identify would be addressed.

Quid Pro Quo

The solution -- laid out this week in a proposal by European Union President Herman Van Rompuy -- involves requiring euro-area members to give up some sovereignty in return for centralized support. A European entity, probably the European Central Bank, would take over the power to supervise all banks in the union, possibly with the help of national regulators. A separate entity would gain the authority to dismantle banks forcibly when they get into serious trouble. The quid pro quo would be a collective promise, backed by all euro-area governments, to insure deposits and recapitalize banks anywhere in the union.

Speed is crucial. With each passing day, the paralysis of the euro area’s financial sector is taking a toll on Europe’s most vulnerable economies, further worsening the plight of both the banks and the governments. At some point, high borrowing costs and shrinking output will render large governments such as Italy and Spain insolvent. If an agreement in principle on banking union could be reached quickly, Europe could move ahead with the kind of stress tests needed to draw a line under banks’ losses, recapitalize and move on.

Problem is, Merkel agrees to only the supervisory part of the banking plan. She rejects any form of risk-sharing, be it collective euro-area backing for banks and their depositors, joint euro bonds, fiscal transfers or direct ECB debt purchases that would reduce the borrowing costs of struggling governments. “I’m concerned that once again the discussion will be far too much about all kinds of ideas for joint liability and far too little about improved oversight,” she said at a conference this week.

There are ways to mitigate Merkel’s concerns. Imposing losses on the creditors of troubled banks, making banks pay for deposit insurance and requiring national governments to contribute to any recapitalizations can all reduce perverse incentives and lessen the likelihood that euro-area members will have to pay for one another’s bailouts. We hope some compromise can be reached.

Ultimately, the question of joint liability is a political one that goes far beyond banking. No currency union consisting of economies and cultures as different as, say, Germany and Spain can work unless its members agree to share the risks of financial and economic shocks. Refusing to do so is tantamount to rejecting the euro.

So what will it be, Frau Merkel?

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