By Tamara Burnell, Head of Financial Institutions and Sovereigns Research at M&G Investments
Europe has experienced something akin to a series of earthquakes in 2011, in the form of Ireland’s banking crisis, Portugal’s economic collapse, Greece’s failed bail-outs and now the inevitable contagion to government debt markets in Spain and Italy, and even France and Germany. Clearly the Eurozone cannot withstand these pressures indefinitely and some sort of European seismic tectonic shift is inevitable, changing the economic landscape forever.
Until July, governments and regulators were, quite rightly, focused on tackling the thorny issue of separating sovereign finances from the health of the financial system. Since 2007, sovereigns had stepped in to provide implicit and explicit support for their banking systems, driven by fear of the economic consequences of a banking collapse. But markets finally woke up to the fact that many sovereigns literally could not afford to guarantee their outsized banking systems, with Ireland simply the most obvious example, and sovereigns found themselves locked out of funding markets. Thus, the policy priority became to break the reliance of the banks on their governments. Equally, the recent European Banking Authority’s (EBA) bank stress tests highlighted the extent to which banks were also exposed to sovereign debt and were increasingly propping up their governments. Clearly something had to be done to break this mutual dependency.
Bail-out or bail-in?
Having identified the need to ring fence banks from sovereigns, the solution was proposed on 19 July 2011 by the Financial Stability Board (FSB) – an international body that reviews and monitors the global financial system. The proposal suggested that instead of allowing at-risk banks to be bailed out using taxpayers’ money, banks would be bailed in, effectively imposing losses on shareholders and bondholders, to recapitalise critical parts of the failed bank, allowing it to continue functioning – the overall aim being to minimise the systemic shock across the financial system that a default would cause.
No more bank failures, no more taxpayer bail-outs and a stable financial system. Sounds good, no?
Unfortunately, just two days after the FSB’s proposal, Eurozone leaders panicked. In an unprecedented U-turn, on 21 July, they announced in a statement on Greece and the Eurozone that EU banks would, if necessary, be bailed out by member states – thereby reversing the international commitment to creditor bail-in. Given that many member states will be unable to provide further bail-outs to their banks, the likely scenario would be that the Eurozone itself would have to carry the burden. Consequently, it was proposed that the mandate of the European Financial Stability Facility (EFSF) – the Eurozone’s bail-out fund – be amended to allow it to provide bail-outs to banks in non-EFSF programme countries, such as Spain and Italy, and to grant it the ability to buy sovereign (and possibly bank) debt in the secondary market. This is a significant change of mandate for the EFSF and will, in turn, directly impact the recently drafted treaty on the European Stability Mechanism (ESM), the EFSF’s permanent successor from 2013, which will now presumably need to be renegotiated from scratch.
Funding the EFSF
Furthermore, if the EFSF is to take on an increasing financial burden, the question of how the EFSF will fund its ever-expanding mandate must also be addressed. Remember that the EFSF does not actually have any money itself. Currently, the EFSF raises finance by issuing bonds guaranteed by
Eurozone states, the proceeds of which are subsequently loaned to struggling countries. However, the assumption that the EFSF will be able to raise up to €2-3 trillion of bond finance and bank loans without difficulty is a brave one – it seems unlikely that investors will be comfortable lending huge volumes of new money to the EFSF when its mandate is continually changing, its creditworthiness depends on the guarantees of an ever-dwindling core of solvent EU countries, and its bond contracts offer minimal legal protection to investors.
A change in philosophy
The proposed change to the EFSF’s mandate, allowing it to bail out banks, also represents a major philosophical change in banking sector policy and goes directly against the FSB’s announcements regarding both the aforementioned need to ring fence banks from sovereigns and the implementation of a creditor bail-in to avoid future taxpayer bail-outs. Such policy changes increase investor nervousness and financial sector instability, which risks recreating the financial crisis of 2008. Moreover, changing the mandate of the EFSF does nothing to improve debt sustainability in the Eurozone. Instead liabilities are merely shuffled between entities: from banks, to sovereigns, to the EFSF, to sovereigns, to banks, and so on. Moving junk from the living room to the garage and back again, just so that the estate agent can get a good picture for the sales brochure, does not mean you’ve cleaned out your house.
Ultimately it is not sustainable for the Eurozone, in its current form, to support the sheer volume of existing private and public sector debt, and at some point either restructuring of the debt, or reconstitution of the Eurozone, will be necessary. In the meantime, we expect draft EU legislation on bail-ins, as well as proposals to change the mandate of the EFSF and ESM to be tabled in September. Given that the two proposals may well be contradictory, the uncertainty looming over Eurozone economic policy means increasing instability in debt markets and across the financial system as a whole. For now, any resolution to the debt crisis appears a long way off.
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