EUROPE NEEDS A BIGGER CRISIS FIREWALL / THE FINANCIAL TIMES MARKETS INSIGHT ( A MUST READ )

Markets Insight
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July 25, 2012 12:03 pm

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Europe needs a bigger crisis firewall

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By Gene Frieda

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European leaders are attempting to get ahead of a festering financial crisis by breaking the negative feedback loop between banks and sovereigns.



Having agreed an ambitious timetable for common bank supervision in June, the European Council has formally launched a two-front war in the push towards deeper currency union. Banking union has now leapfrogged fiscal union as a priority.
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Two wars require more ammunition and a solid strategy. By imparting more responsibilities without additional resources, the European Stability Mechanism, the eurozone’s permanent bailout fund, is being enfeebled. Each tap of the facility, which can lend up to €500bn against €80bn in paid-in capital, will tend to underscore how ineffectual the firewall is as a bulwark against multiple risks: sovereign default, bank runs and currency redenomination risk.




The focus on direct bank recaps also misdiagnoses the central problem: Spain, Portugal, Ireland and Greece have sky high external liabilities. Foreign private creditors are abandoning the periphery in droves. The sovereign spread becomes the price variable that adjusts higher for net capital outflows from each country, whether those outflows reflect a foreign exodus from sovereign debt or indeed the inability of the Spanish private sector to roll over maturing foreign loans.




Regardless of who provides the capital infusion, the banks’ assets will remain highly geared to the sovereign and the local economy. This affects profitability and the robustness of collateral that can be used to borrow from the European Central Bank. If good collateral is in short supply, as it is in most of the eurozone periphery, then banks will require sovereign guarantees to gain access even to a very generous lender of last resort. And then we are back to square one.




The enduring link between sovereigns and their banks underscores the Achilles’ heel of the ESM: nearly 40 per cent of the facility is guaranteed by the stressed periphery. A firewall subject to high liquidity risk and to credit rating risk makes a poor weapon for breaking the negative feedback loop.



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The initial focus on direct ESM bank recaps reflects a bad strategic choice: common deposit insurance would be a much more effective and immediate tool in breaking a related link between private funding for banks and subsequent stress on sovereign borrowing costs. But common deposit insurance has been rejected because it mutualises insurance against bank runs. And thus the risk of runs against the periphery remains high.





A strategic proviso for the success of any direct ESM bank recap is agreement on a framework for injecting more capital in the event of greater losses, or alternatively on a point at which the bank should be shuttered. This raises tricky political issues in the months ahead.





First, countries must agree on a framework that allows for additional capital injections above what is initially agreed. Otherwise, markets will assume that the sovereign will still be liable for tail risk associated with banking sector losses. This creates the kind of scenario that the German constitutional court is already considering: whether Germany’s ESM liabilities are effectively unlimited.




Second, the firewall needs to be bigger. Common deposit insurance, a vital innovation to the Federal Reserve system in the Great Depression, and a common resolution fund to deal with non-viable banks are more politically palatable and practical ways to broaden the firewall than increasing the size of the unfunded ESM. Perhaps most crucially, there must be more burden sharing to reduce legacy levels of debt. Loss sharing goes to the heart of the sovereign-bank feedback loop: the price at which the ESM takes equity stakes.




Direct ESM bank recaps mitigate banking sector tail risks to sovereign parents only if the ESM is willing to provide large implicit transfers, in effect absorbing losses by taking bank stakes at inflated prices.

Broader private sector burden sharing, inclusive of senior unsecured bank creditors, should be a complement rather than an alternative. Markets have been quick to discern eurozone governments cannot credibly socialise the losses on private debt incurred by banks. The potential losses are too large. But this option is deemed too much of a risk to financial stability by Europe’s regulators.





Until there is a clear effort to tackle currency redenomination risk – the potential that some countries cannot or will not meet the tougher demands of a “reformed” euro area and thus choose to return to their own currencies – the best that can be hoped from direct ESM bank recaps is they leave the blocks running to stand still. While Brussels seeks a compromise on bank supervision, banks and private investors will continue to renationalise exposures as a means to hedge against the unthinkable: a eurozone break-up.




Gene Frieda is a global strategist for Moore Europe Capital Management



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Copyright The Financial Times Limited 2012.