European leaders are finally beginning to understand the magnitude of the problems posed to their economies by the Continent’s sovereign debt crisis.

As concerns mount over the extent of European banks’ sovereign debt exposure, the European banking system faces a crisis of confidence. Regulators conducted a round of stress tests on the largest institutions earlier this year, but they did little to compel banks to raise capital and shore up their balance sheets. The situation has rapidly devolved since then, and now many banks are experiencing difficulty securing short-term financing.

At the moment, the financial community is bracing itself for the possibility that Greece may soon default on its sovereign debt. According to data from the Bank of International Settlements, German banks hold $40 billion worth of exposure to Greek debt, while French banks hold an estimated $65 billion of Greek debt. Although Greece’s fiscal profligacy is well known to market watchers, other nations, such as Spain and Italy, could also default on their debt.

As a result, the European Banking Authority recently announced that it’s considering a new round of stress tests for European banks. Given the massive rout of European banking shares over the past few months, the market clearly expects the stress tests will reveal the need for banks to undergo a forced recapitalization.

Even if these tests demonstrate that banks should further strengthen their balance sheets, it’s unclear what sort of regime might enforce such a recapitalization. Nevertheless, it’s encouraging that policymakers are discussing potential solutions. Until recently, many financial authorities had been in a state of denial over the possibility of a Greek default, so they’ve been slow to respond as the crisis unfolded.

Fortunately, as this issue went to press, the European Central Bank (ECB) announced new measures to provide its banking system with greater liquidity. The ECB plans to buy EUR40 billion in banks’ covered bonds, while also offering banks collateralized longer-term loans at fixed rates. This action is intended to thaw the freeze in short-term lending, while giving banks more time to recapitalize. And policymakers will also have more time to address their economies’ larger structural issues.