It is generally assumed that any capital needs discovered by the Asset Quality Review the ECB is scheduled to finish by the end of 2014 should be filled by public funding (= fiscal backstop). This assumption is wrong, however. Banks that do not have enough capital should be asked to obtain it from the market; or be restructured using the procedures and rules recently agreed. The Directorate-General for Competition at the European Commission should be particularly vigilant to ensure that no further state aid flows to an already oversized European banking system.
The case for a public backstop was strong when the entire euro area banking system was under stress, but this is no longer the case. Banks with a viable business model can find capital; those without should be closed because any public-sector re-capitalisation would likely mean throwing good money after bad.
Daniel Gros is Director at CEPS.