European Central Bank.

(Bloomberg) 

Europe’s quest to sever the link between Spain’s fiscal fate and its failing banks hinges on an obstacle-strewn race to hand greater powers to the European Central Bank.

Until euro-area leaders overcome German doubts, ECB concerns, and turf battles everywhere, Spain will remain on the hook for a bailout of its banks of as much as 100 billion euros ($121 billion). Policy makers want to protect taxpayers from losses so potentially big they risk bankrupting governments, as happened in Ireland and Iceland.

“We have got to cut the fatal loop between sovereigns and banks, which will otherwise bring the euro-zone project as it exists now down,” Adair Turner, chairman of the U.K. Financial Services Authority, said in a London speech yesterday. The euro area needs “rapid progress” towards a central fund that can directly recapitalize banks, he said.

According  to  Bloomberg, officials are working against a self-imposed September deadline to thrash out plans that would hand oversight of lenders to the ECB as the first step in a campaign to break a cycle of banks and sovereigns fuelling each others’ debt woes. Spain’s role as middleman in the bank bailout has helped send its borrowing costs to euro-era record, with its 10-year yield above 7.5 percent. Germany’s is about 1.2 percent.

“The day a Spanish bank can put a big fat sign in its window that says ’regulated by the ECB,’ the risk of deposit flight declines,” Erik Nielsen, global chief economist at UniCredit Bank AG in London.

European Union taxpayers have provided 4.5 trillion euros in capital injections, guarantees and other forms of support to their lenders since the 2008 collapse of Lehman Brothers Holding Inc., contributing to the weakening of public finances.

In drafting the measures, the European Commission is navigating demands from the ECB that the plans mustn’t meddle with its independence, and competing calls from lawmakers that with greater power should come greater central bank accountability. At the same time, the ECB is being prodded to take on a bigger role because of its duty to support the euro.

A plan to move toward a banking union won support from EU leaders at a June 28-29 summit when they pledged to allow the European Stability Mechanism, the euro area’s firewall, to lend directly to banks once nations have deepened supervisory ties. The initiative ignited debate in Germany, with some politicians and banks warning they amount to backdoor pooling of debt that will remove pressure on profligate nations.

Germany’s savings banks last month said setting up a deposit guarantee program would create “a situation in which German savers could be liable for saving foreign banks.” Similarly, lawmakers in Berlin have demanded assurances that their contribution to Spain’s banks will be channelled through the Spanish government and will not pass directly to lenders.