The reaction of both the markets and politicians suggests that the latest euro summit has been a success. But the outcome is unlikely to end the euro crisis, and parts of it might actually make it worse.
Politicians have been praising the outcome of the latest euro summit as a real break-through. Stock markets across the euro area were up. However, the enthusiasm might be excessive. Upon closer inspection, the outcome will most likely not end the euro-crisis and parts of it might actually make it worse.
The first point is the leveraging of the EFSF: While the summit documents now talk about up to €1.4 trillion in potential effective volume, it is not clear in how far the solutions envisioned really will bring down the interest rates of crisis countries to a sustainable level. As I have argued on a ‘€ view’ blog post, the insurance solution agreed as one option in the summit conclusion is unlikely to solve the current problem of flight from Italian, Spanish, Portuguese or even French bonds.
The second option decided upon, a special purpose vehicle (SPV) which would issue collateralized debt obligations (CDOs), is also unlikely to solve the problem. The idea here is to issue new securities backed by crisis-country-bonds. The securities would come in several tranches: A first-loss (equity) tranche which would be financed with EFSF money and which would absorb all losses incurred by the bond portfolio first; a mezzanine tranche which would absorb losses once the equity tranche is wiped out; and a senior tranche which supposedly would be very safe as it is unlikely that losses become so large that the other two tranches are wiped out completely and which thus could be sold as a AAA asset. The problem here is that it is unclear whether anyone would be willing to buy the mezzanine tranche and hence whether really a large leverage of the EFSF funds will be possible. Given the current flight to safety, I doubt that there will be sufficient demand from private investors to make this option work on a significantly large scale. If this is not the case, the leverage will be very small, resulting in much less than the promised €1.4 trillion and too little to really make a difference.
What might be worse is that the bank recapitalisation also decided at the summit might push the euro-economy deep into a new recession during this winter. The summit has agreed to force banks to increase their core capital to 9% of their risk-based assets by the summer of 2012. If banks do not come up with private capital until then, they will have to accept public capital. The problem here is that banks might be given an incentive to cut back their loan portfolio and other assets in order to meet the requirement and thus to prevent having to accept public funds. This would cut off the real economy from credit supply and might hence turn the current down-turn into a full-blown recession.
EU leaders, of course, know this problem and therefore the declaration is stating that regulators must make sure that this does not lead to “excessive deleveraging” and that banks maintain “credit flows to the real economy”. However, the wording here is unclear. The key sentence reads: ‘There is broad agreement on requiring a significantly higher capital ratio of 9% of the highest quality capital and after accounting for market valuation of sovereign debt exposures, both as of 30 September 2011 […].’
The use of the word “both” here is especially strange: One could interpret this sentence in a way that the banks have to come up with 9% capital on whatever portfolio they were holding on September 30, 2011. This would be innovative, but a solution that would prevent cutting back lending to the real economy: As capital requirements were based on a portfolio of the past, cutting back lending would not give the banks any possibility to escape forced recapitalisation.
However, at the moment, the financial sector actors seem to interpret the summit results differently. They seem to understand that the valuation of assets and liabilities is taken from September 30, 2011, but whatever adjustment they make to their balance sheet until June 30, 2012 reduces their capital requirements. The Commerzbank, for example, seems to be believe that the requirements can be reached by simple deleveraging, as they write in an ad hoc statement on Thursday morning: 'We can reach the required ratio by means of a reduction in risk-weighted assets in non-core areas, the sale of non-strategic assets […]. One thing goes without saying: We do not intend to make use of public funds.'
If the Commerzbank is right in its interpretation, then banks really will cut back lending over the coming month. A recession in the euro area in the coming months then will be very difficult to prevent, making the debt crisis worse again. More rescue summits would then certainly follow.
The European Council on Foreign Relations does not take collective positions. This commentary, like all publications of the European Council on Foreign Relations, represents only the views of its authors.
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