Economists-EU needs work on bank crisis response

JACKSON HOLE, Wyo., Aug 23 (Reuters) - The European Union urgently needs a better plan to share the costs of dealing with large bank failures to prevent the risk of a severe “contagion effect,” according to two top economists.

In a paper prepared for the Kansas City Federal Reserve Bank’s economic symposium in Jackson Hole, Wyoming, economists Franklin Allen and Elena Carletti said that without clearer guidelines, European and global capital markets could be at risk.

Allen is a finance and economics professor at the University of Pennsylvania’s Wharton School; Carletti is a finance professor at the University of Frankfurt.

The KC Fed’s annual economics forum has been focused on fallout from the 2007 financial crisis. Delivering the keynote address on Friday, Fed Chairman Ben Bernanke said the year-long financial storm “has not yet subsided.”

In the United States critics have focused on the question of an institution being “too big to fail,” or an implicit guarantee that authorities will step in to support struggling financial firms -- as the Fed did in engineering the rescue of investment bank Bear Stearns in March.

But Allen and Carletti mulled a “too big to save problem” posed by large banks headquartered in small countries.

“Even the threat of contagion posed by the failure of the largest banks in the United States ... can be avoided by central bank and government intervention,” they said.

At the same time, some European banks are so large relative to their home countries that they pose a “too big to save problem,” said Allen and Carletti.

For example, the Belgian-Dutch financial group Fortis FOR.BR "has assets that are greater in size than the gross domestic product of Belgium."

If such a bank were to fail “the key issue would be how the burden would be shared between countries of the European Union,” the economists said.

Because current guidelines are unspecific, any concerted response could be slow to evolve and “during this time the prospect of contagion could effectively freeze many European and some global capital markets, with enormous effects on the real economy,” said Franklin and Carletti.

Similarly, they said the International Monetary Fund or the Bank for International Settlements should devise a response that could be activated if a large bank fails in a country that is not part of a larger grouping, such as Switzerland.

The potential damage from the failure of a major Swiss bank “is very large. It is again an urgent task to devise a system to prevent this kind of problem.”

Writing by Ros Krasny in Chicago, Editing by Chizu Nomiyama