I am afraid that the leaders are contemplating some inappropriate steps. They are talking about recapitalising the banking system, rather than guaranteeing it.
A fair enough point, but where will the money come from to do that?
In exchange for a guarantee, the major banks would have to agree to abide by the instructions of the ECB. This is a radical step but necessary under the circumstances. Acting at the behest of the member states, the central bank has sufficient powers of persuasion. It could close its discount window to, and the governments could seize, the banks that refuse to co-operate.
The ECB would then instruct the banks to maintain their credit lines and loan portfolios while strictly monitoring the risks they take for their own account. This would remove one of the main driving forces of the current market turmoil.
The other driving force – the lack of financing for sovereign debt – could be dealt with by the ECB lowering its discount rate and encouraging countries in difficulties to issue treasury bills and prompting the banks to subscribe.
Um…if it all is a liquidity crisis, this might work, public choice problems aside. Otherwise it is calling for possibly insolvent banks to prop up not only the real economy but the governments too, which in turn will guarantee the banks, which by the way now have to keep on making bad loans.