A potential €200bn (£175bn) recapitalisation of the European banking sector loomed yesterday after the French and Belgian governments unveiled a rescue package for Dexia to stop the bank's woes from contaminating the wider financial system.
The planned boost to banks' capital reserves will see national governments in line to inject new cash if the lenders cannot raise the money in the market.
The urgency of increasing eurozone banks' buffers against losses was heightened by the near-failure of Dexia, the French-Belgian bank with big exposures to debt issues by Greece and other financially stretched countries.
The deal to bail out Dexia was designed to stop the bank's crisis spilling out into the rest of the banking sector. The fates of troubled eurozone countries and the region's banks are intertwined and threaten a vicious spiral of losses.
European leaders yesterday delayed by a week a meeting scheduled for next Monday to leave time to receive a definitive report on Greece's fiscal crisis.
Belgium will pay the Dexia Group €4bn for the Belgian retail banking business and provide 60 per cent of state guarantees for a "bad bank" to house Dexia's troubled assets. France will provide 36 per cent of the guarantees, which cover up to €90bn of funding, with Luxembourg supplying the rest.
Dexia's balance sheet of €518bn is bigger than the entire Greek banking sector and is a similar size to the total assets of institutions rescued in Ireland. The bank passed European "stress tests" in July that were meant to shore up confidence in the banking sector.
France and Germany have agreed that Europe's banks should be made to raise extra capital to cushion the impact of a Greek default. The International Monetary Fund has calculated that the region's banks need up to €200bn of extra cash to withstand losses.
Alistair Ryan, an analyst at UBS, said: "If capital is to have any chance of stabilising the banks, it will need to be large: we would start with the IMF's €200bn." He said eurozone governments could end up owning 40 per cent of the sector if they supply the capital.
Markets were calmed by hopes that France and Germany would finally come up with a plan big enough to support the eurozone's banks when Greek defaults – an event seen as inevitable.
The Eurostoxx 50 index closed up 2.3 per cent and the euro rose 1.9 per cent to $1.3648.
The cost of Dexia's bailout has raised questions about France's and Belgium's national credit ratings. France's Finance Minister, Francois Baroin, stressed that Dexia was a "unique" case and that other French banks would not need bailouts. However, many believe France's Société Générale and BNP Paribas would be part of the recapitalisation plan.