The inter bank market dries up, as banks lose trust in one another.

Banks in the eurozone came under pressure, and interbank tensions increased.

But how can we distinguish good banks from bad?

Improved central bank policy is another huge factor.

The chief point of intersection between the European and US approaches is major banks.

That may be part of the story, but competition for talent and for customers seems intense between investment banks and others, yet they have collectively been extravagantly rewarded at the expense of those customers.

In the eyes of most observers, to reach the leaders goal of break ing the vicious circle between banks and sovereigns required centralizing authority for bank resolution and rescue.

As a result, the administration has confused bailing out the bankers and their shareholders with bailing out the banks.

Another breakdown of the interbank market is therefore very unlikely.

Because government provides deposit insurance, it plays a large role in restructuring (unlike other sectors). Normally, when a bank fails, the government engineers a financial restructuring if it has to put in money, it, of course, gains a stake in the future.

Interbank relationships, as well as investment banking operations, are already highly international.

But larger banks can get into trouble when these two principles get mixed up.

One of the earliest applications of this strategy to economic policy is in the design of central banks.

And the interlinkages between major global banks are a major, if diffuse, worry for all involved.

The third, and probably most important, moral hazard results from asymmetric information between banks and their lenders.

Other positive aspects notwithstanding, the presence of foreign banks is associated with currency mismatches.

One way to prevent this distortion would be to create a mechanism to bail out all banks with European money.

Excessive rural credit was one of the important causes of bank failures during the Great Depression.

In the aftermath of the financial crisis, it became fashionable for economists to decry the power of big banks.

One consequence of the ECB s large scale long term refinancing operation (LTRO) has been that Italian banks are once again buying Italian government bonds, and Spanish banks are buying Spanish bonds.

But the contrast between bank profitability and the woes of everyone else turns up the political heat on the central banks, which have to explain why it is only their friends, the banks, who are standing under the helicopter when it drops money.

Certainly, governments should not guarantee interbank liabilities that do not affect customer deposits.

Loose lips sink ships is received wisdom in central banking circles.

Indeed, Santander and BBVA rank among today s most successful international banks.

Their first step should be to separate banks according to their compensation criteria.

One delicious irony in Europe is that Chinese banks are contesting the requirement to subsidiarize in London on precisely those grounds.

The G 7 action plan aims to restore the flow of credit by securing interbank lending, and coordinated central bank actions have provided unprecedented levels of liquidity to the market.

How to Bail out Good Banks and Let Bad Banks Fail

Lending between banks, as well as deposits placed by large corporations, increased spectacularly in the years leading up to the crisis.

Don t confuse saving bankers and shareholders with saving banks.

If gender is a proxy for diversity, then central banks fail a basic test of it.

This is what happened in the eurozone when the interbank market first broke down in mid 2007.

The link between bond purchases and the money stock depends on the role of commercial banks excess reserves.

This was facilitated by the tradition of political independence and cooperation that has developed over the years among central bankers.

The purpose of the ECB s measures was to re establish confidence and bring about a recovery of the inter bank market.

Equality seems to have eluded central banks even in gender conscious Scandinavia.

When banks stopped providing short term liquidity to other banks and industrial companies, central banks filled the gap.

Eurozone banks became among the world s most over leveraged and the worst affected by the crash of 2008.

The US now has its Volcker rule (though disputes between banks and regulators about just how to define it continue).

But the problem is much broader Not a single global megabank has a well functioning board.

The three people who have articulated this problem most clearly include two of the world s leading central bankers.

The eurozone s creeping fragmentation is primarily the result of the mutual dependence of banks and governments.

Investment bankers wait with bated breath for the merger and acquisition league tables, even though the link between a high ranking and profitability is somewhere between loose and non existent.

A high value inter bank funds transfer system settles transactions in real time, eliminates credit risk between system participants, increases circulation of funds, and enhances monetary policy implementation.

Today, however, Spanish banks especially those most heavily engaged in domestic mortgage lending must pay a much higher spread over interbank rates to secure new funding.