Banks wait in Europe's emergency room

Despite last night's fall, markets still don't really believe that when it comes to the crunch Angela Merkel will pull the plug on the euro – the consequent German banking losses are too great.

But if she does pull the plug – and, for what it is worth, I think there is a good chance she will – then everyone needs to understand that we face a major world banking crisis.

The European Banks have been close to the biggest funders of world trade. They have also taken in major amounts of Middle Eastern oil money via deposits (particularly from those who dislike Americans) and used that money to fund banks around the world via the so-called wholesale market.

Historically, Australian banks have been among the biggest borrowers of this wholesale money, although thankfully they have cut it back. However, wholesale borrowing still represents in the vicinity of 40 per cent of major Australian bank funding. If the euro crumbles wholesale funding is not going to be available, so our banks will have to replace the money over the next three years from our self-managed and other superannuation funds. Lending will be curtailed.

Most of the European banks have been technically insolvent for a year or two because of the massive losses they suffered first in sub-prime lending and then in lending to bankrupt European governments. Many also got caught in the Spanish and other inflated property markets. But if the euro breaks up the major European banks will suffer further enormous losses. Germany may save its banks but banks in countries that leave the euro can't be saved.

The turmoil will infect the whole global banking system and the American banks will be particularly hard hit because they are deeply involved in the inter-bank derivatives markets, where there are trillions of dollars exposed.

Because this crisis has been anticipated, most of the major world banks, including Australian banks, have their emergency plans in place. We are going to see a lot of pain but the global banking system will come through.

Angela Merkel is currently not prepared to put German wealth at stake in Europe unless there is a delegation of sovereignty over financial affairs – effectively to Germany. Those trying to convince Merkel to soften her line were not helped when the new Greek government effectively moved to step away from its commitments (Greece sets its own price, June 25).

Greece will not be at this week's summit.

That tells everyone that Greece and most other countries will agree to austerity but are unlikely to implement those agreements unless they have given up sovereignty and therefore have no choice. One alternative strategy is to let Greece go and then let other Europeans see what happened to Greece.

Italy, Spain and others will then be prepared to accept austerity and German control to avoid the Greek fate.

But the austerity pain Merkel is trying to impose on these countries is simply too great. In my view the pain must be inflicted via the currency. In other words, the best way to have Greek wages and asset values halve is to halve the value of the Greek currency. That can't happen if the Greeks have the same currency as Germany. But the euro is embedded in the system and the break-up pain is even harsher than austerity in the short term.

Meanwhile the banking system, until recently, did not see this coming.