By Sheila Bair, contributor
FORTUNE -- Europe is starting to look more and more like the U.S. as it headed for the cliff in the fall of 2008. The continent's banking system is fragile and overleveraged. Making a scary situation even scarier is the lack of a central, credible authority to protect European bank depositors against losses should their banks fail. While Europe has not experienced any bank runs -- yet -- banks in Greece, Spain, and, to a lesser extent, Italy have experienced bank "jogs," in which depositors have withdrawn significant amounts of cash. Customers in those troubled nations are protected by national deposit insurance systems, but they are understandably skittish, since those systems are only as good as the banks and governments backing them. Greek depositors in particular fear that if their country ends up exiting the eurozone, they may wake up one morning to find their euro deposits converted into drachmas at only a fraction of their previous value.
Bank runs, once they start, are difficult to contain, and they take down both weak and strong institutions indiscriminately. In the early 1930s the U.S. had to close thousands of solvent banks because they were unable to withstand the massive withdrawals of a frightened public. We learned the hard way that central bank lending was not enough to fend off a full-scale banking panic; thus, in 1934, the FDIC was born.
Recognizing that waning depositor confidence poses a threat to the stability of the European banking system, key members of the European Commission and the head of the European Central Bank (ECB), Mario Draghi, have called for the creation of a pan-European deposit insurer, structured along the lines of the FDIC. The new deposit insurer would be funded by the banks themselves, with the ability to borrow from either the ECB or the European Stabilization Mechanism Fund as a temporary backstop. It would have the authority to seize insolvent banks and force their sale or restructuring. This type of system places losses where they belong -- on shareholders and creditors -- with any additional losses paid for through assessments on the banking industry, an attractive feature for bailout-weary European taxpayers.
The need for a new deposit insurer is obvious, but it has run into resistance from German banks, which myopically argue that it would help Southern European banks, not them. But like it or not, German banks have significant exposure to Southern Europe. And while Deutsche Bank (DB) managed itself well during the crisis, it and other private German banks benefited mightily from government bailouts that prevented the failure of mismanaged institutions. Indeed, their deposit insurance fund has not had to pay one euro to protect bank depositors, thanks to the generosity of the German taxpayer. (In contrast, American banks will absorb about $100 billion in deposit insurance losses stemming from the financial crisis.)
Time and again, obvious reforms have been stymied by the parochial interests of individual member nations. As Europe's government leaders have fiddled, their banking system and economy have slowly burned. Years of byzantine discussions and half-baked, incremental measures have resulted in greater confusion about Europe's future. As Draghi recently said, it is time to "dispel this fog."
Europe's leaders must promote the economic well-being of the entire eurozone, even if it requires short-term sacrifices on the part of member countries. A central deposit insurer and resolution authority could represent a first, definitive step. It would be paid for by banks, and it would benefit the general population. It is worth noting that in the U.S., TARP was passed only after Congress included provisions raising deposit insurance limits to help Main Street Americans.
While no panacea, such a "deposit insurance union" could irrevocably demonstrate that a united Europe is more than a political sound bite, and that Europe's leaders are committed to making it happen.
This story is from the July 23, 2012 issue of Fortune.
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