If all the resources promised (Û750 billion, including financing from the International Monetary Fund) were to be used fully, the EU could fully refinance all distressed countries (Portugal, Spain, and Ireland) for a couple of years. But this official financial firepower has left markets unimpressed.

Spreads on Spanish government bonds continue to creep up, and are now higher than before the announcement of the EFSF. And there are ominous signs of tension in the interbank market, as  more banks, reflecting weak confidence that the stability of the system has been restored, would rather deposit their money at the ECB than lend to other banks.

The explanation is simple: the problems that underlie the crisis have not been solved, though they should actually be easily manageable in a pan-European context. Greece represents about 2% of the eurozone economy; even if it defaulted on its public debt, and the recovery value were only 50%, the losses would be about Û150 billion, or just 1.5% of eurozone GDP.

The problems in Spain are likely to be somewhat larger, although official estimates of the losses in the Spanish banking system amount to only Û100 billion. But the real problem in Spain might well lie elsewhere: the exposure of French, German, and other banks to Spain's real-estate sector.

Many loans to Spanish developers will have to be written off. But, even in the worst case, the combined losses of Spanish and other banks in the Spanish real-estate sector should not exceed Û300 billion, or about 3% of EU GDP.

So, the real question is why problems of manageable proportion on Europe's periphery are paralysing the eurozone's entire banking system. A key reason why Europe's financial markets remain nervous is that, officially, there is no problem.

Officially, Greece does not have a solvency problem, and restructuring of its public debt is not an option. Similarly, in Spain, the official line is that the domestic banking sector is well capitalised.

Greece's experience has shown that pretending that problems do not exist can result in a self-reinforcing spiral of increasing risk premia and declining confidence.

In this respect, the publication of the results of "stress tests" conducted on the EU's 100 largest banks, promised for the end of July, is a clear step forward.

But there is a second and more disturbing reason why financial markets remain unsettled: large swathes of the European banking system remain vastly undercapitalised. According to ECB statistics, eurozone banks have about Û20 of liabilities (including interbank debt) for every euro of capital and reserves. This implies that for every capital loss of one euro lurking in some bank, there will be about Û20 of doubtful debt. Even a worst-case scenario for Greece and Spain would imply losses of Û450 billion at most. The funds mobilised so far under EFSF (Û750 billion) would be amply sufficient to deal with all of this - provided  these potential losses are clearly identified and the necessary funds earmarked to deal with them. Yet this is not the approach that is being followed.

Instead, European funding will be used only to bail out governments, which in turn need the money to bail out their banks. But, given the 20:1 liability-capital ratio in the banking sector, this approach implies that the funding requirements will become astronomical: compared to a Û450 billion bill if potential losses remain undisclosed and dispersed, Û9 trillion in debt guarantees would be needed to ensure the stability of the eurozone's banking system.

Europe cannot escape the crisis in its financial markets until it fixes its banks. Unfortunately, Europe's policymakers have let themselves been misled by politically convenient views of the crisis .

But the real problem is that the EU's banking system is so weakly capitalised that it cannot take any losses, while also being so interconnected that problems in one country quickly put the entire system at risk. Until the banks' balance-sheet problems are dealt with decisively, financial markets will remain on edge.

* Daniel Gros is Director of the Centre for European Policy Studies.
Copyright: Project Syndicate, 2010