Like drunks at a bar door, the euro zone's governments and banks are leaning unsteadily on each other for support.

The banks know they have to sober up, but governments are urging them to have one more for the road.

Europe's policymakers may have managed to stop the entire building from swaying in the last few weeks, but they have not yet found a way to break the dangerous mutual dependency between over indebted states and overleveraged banks.

If you don't cut the dependency between sovereigns and banks, inevitably states will be inhibited by the risks of their banks and banks will be inhibited by the risks of their states, said Jean Pisani-Ferry, director of the Brussels-based Bruegel economic think-tank.

For almost a decade, European banks binged on euro zone sovereign debt, with the blessing of national regulators, making little distinction between German Bunds, Italian treasuries and Greek government bonds.

They have learned the hard way that there's no such thing as a risk-free asset.

When the true scale of Greece's public debt and deficit was revealed at the end of 2009, the market panicked, setting off a vicious cycle of rising interest rates, credit rating downgrades and bank liquidity problems.

Economists call this a negative feedback loop. Weakened governments are less able to guarantee their domestic banks, which in turn are weakened by the dwindling value of their sovereign bond holdings.

When credit ratings agencies downgrade states such as Italy, Spain or Portugal, that automatically hits banks that hold their governments' debt, often leading to those banks having their own ratings cut and facing an increased cost of credit.

That in turn makes banks less able to lend to business, reducing the country's economic growth potential and hence its ability to repay its debt. So the vicious cycle goes.

In the worst case, it could trigger a run on a bank that might precipitate a chaotic sovereign default.

Silent bank runs have been taking place invisibly across southern Europe over the last year as depositors have withdrawn funds, especially from Greece, but a damaging public stampede has been avoided so far.

Data collated by Bruegel from national sources shows foreign investors reduced their holdings of bonds of Europe's weakest states between 2007 and mid-2011, while domestic banks increased their exposure substantially during the same period.

This exacerbated their mutual vulnerability.

According to the most recent available figures, which pre-date the latest sell-off of bank assets, Spanish banks owned 27 percent of their government's debt. The figure for Portugal was 22.4 percent and for Greece 19.4 percent.

DOOM LOOP

Many banks chose to reduce their sovereign bond holdings after the European Banking Authority ordered them to mark them to market value in stress tests, and to raise their core capital ratio to 9 percent by mid-2012.

The European Central Bank narrowly prevented that doom loop from bringing banks crashing down at the end of last year, when the interbank lending market had frozen up.

The ECB provided nearly 500 billion euros in cheap three-year loans to some 500 banks and is set to conduct a second liquidity injection of a similar scale next week.

Flooding banks with cheap money averted an imminent credit crunch and has helped in the short term to restore market confidence, reopen interbank lending and bring down record yields on euro zone government bonds.

But it may have merely postponed the day of reckoning, and aggravated rather than reduced the interdependence between banks and sovereigns.

French President Nicolas Sarkozy encouraged banks to use the funds to buy still more government debt and pocket an attractive interest-rate differential.

This means that each state can turn to its banks, which will have liquidity at their disposal, Sarkozy said the day after the ECB announced its cheap funding measures in December.

It is too early to measure this so-called Sarkozy carry trade, but anecdotal evidence from recent Spanish and Italian bond auctions suggests some banks are following his advice.

That may help southern Europe's two biggest borrowers get over a refinancing hump, but it leaves banks and governments more rather than less vulnerable to each others' weakness.

In the United States or Japan, notes Erik Jones, professor of European history at Johns Hopkins University, if government bonds become a less safe investment, investors switch to another asset class such as corporate debt, stocks or commodities.

But because of the national segmentation of financial markets in Europe, even after 12 years of the single currency, the flight to safety has seen money flow from countries most exposed to the crisis to those seen as safe havens.

While euro zone policymakers have discussed the problem behind closed doors, they have done little to break the link.

Several steps that could reduce or eliminate the risk have so far been ruled out, notably issuing common euro zone bonds, mutualizing the currency area's existing debt stock or creating a common European bank guarantee and resolution system.

EU paymaster Germany has insisted each member state must remain liable for its own banking supervision and guarantees. Berlin rejected a French proposal for a European bank guarantee fund after Lehman Brothers collapsed in 2008 and remains adamantly opposed to such burden-sharing.

German officials argue that maintaining country risk gives governments an incentive to clean up their public finances. The solution, they say, is to reduce and eventually eliminate public borrowing. But that will be a long, slow process.

In the meantime, the euro zone agreed last year that its rescue fund could lend money to governments to recapitalize banks if necessary. But that would not sever the dependency.

Mutualizing Europe's debts would be a surer way to sever the doom loop.

(Editing by Susan Fenton)

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