The unusual speed and enthusiasm with which the European Commission, the Eurogroup and the IMF have greeted the formal Spanish request for financial assistance for its banking sector raises a series of important questions.
It is all too clear that this immediate reaction has as prime objective to reassure public opinion both in Spain (by omitting reference to additional austerity measures) and elsewhere (by providing a firewall against contagion) on the eve of crucial deadlines impacting the future of the EMU, in particular the Greek elections (and accessorily the French ones) as well as the European Summit of the 28th and 29th of June.
The announcement that the EU is ready to provide assistance of up to €100 billion (though the amount of the request has not yet been formulated and is expected to be lower) is meant to demonstrate the availability of sufficient means to calm nervous financial markets.
Let us recall the recent historical background:
Following the Lehman bankruptcy in the fall of 2008, the Eurogroup, under the leadership of President Sarkosy, agreed that no Member of the Eurozone would allow one of its banks to fail; simultaneously, individual deposit guarantees were uniformly increased to €100.000.
The Irish financial assistance package of € 85 billion included € 35 billion dedicated exclusively to the recapitalisation by the State of its banking sector. The reason behind this demand was to ensure that loans granted by European banks to the Irish banks would be repaid in full. Thus the burden and risk of these loans was transferred from the imprudent - if not reckless - European bank lenders to the Irish taxpayer. The unusual participation of the U.K. in the rescue of a Eurozone Member reflected the degree of exposure of British banks to the Irish baking sector. Without wasting time discussing the iniquitous level of interest rates imposed on Ireland, by which lenders pocketed a more or less large profit depending on their own funding costs, the structure of the package was a manifest violation of the 2008 agreements; indeed, had the spirit of these agreements been respected, each country would have had to assume the solvency risks of their own banking institutions rather than transferring the burden to the Irish.
In the aftermath of this less than glorious episode, the sovereign debt crisis gathered momentum. One of its main causes was the incestuous relationship and the reciprocal dependence between the banking sectors and their respective national States. The extension of the crisis to Italy, burdened with an excessive amount of public debt and nearly simultaneously to Spain, where excessive indebtedness and risks were largely attributable to the banking sector and regional governments, focussed attention on the fragility of the Eurozone banking system as a whole because of the enormous amounts of “transnational” loans which financed and refinanced accumulated excessive indebtedness.
This perception only worsened with the aggravation of the Greek crisis which became the subject of a second and third rescue operation motivated strongly by the desire to avoid the exit of Greece from the Eurozone by fear of contagion. Indeed, such an exit raised concretely the question of how to handle “contracts” denominated in € to which a Greek entity was a party. If, at the time of the introduction of the single currency, the principle of the “continuity of contracts” had allowed for a smooth transition from the tributary currencies to the new single currency, applying the same principle to an exit from the Euro did not authorise the simple redenomination of contracts into a “new national currency”.
These fears raised, for the first time, seriously the question of the long term survival of the single currency. It contributed to the emergence of two parallel trends – fully justified by sound risk management considerations – the scope of which needed urgently to be confined:
- On the one hand the risk of massive withdrawals of deposits and their transfer abroad or their accumulation in physical banknotes; this is already the case in Greece and indications suggest that a similar movement is happening in Portugal and Spain. One cannot either exclude that this trend is gaining wider traction which can be inferred from the (relative) recent weakness of the €.
- On the other, the banking sector itself has initiated a “renationalisation” of its activities within the Eurozone itself, aiming at limiting transnational exposures by reducing loans to the amount of funding available in any given country.
These trends are in addition to the deleveraging process undertaken following the 2008 crisis. The growing difficulties for banks to raise new capital from the market to strengthen their balance sheets and support the real economy has shifted this burden onto the shoulders of the States themselves as demonstrated by the Irish, Greek and now Spanish examples.
It is within such an extremely tense environment that the ECB has intervened since the summer of 2011 with additional unconventional tools in order to provide the market with the necessary liquidity. The SMP (Securities Market Program) and the LTRO (Long Term Refinancing Operations) have provided a welcome temporary relief but seem to be rapidly losing their efficiency, prompting President Draghi to encourage politicians to assume decisively their share of responsibility.
It is in light of this necessary reminder of the path leading to the current situation, that one should approach the Spanish request for financial assistance:
Firstly, there are some legal aspects to consider in conjunction with the Treaties establishing the existing intervention mechanisms (EFSF and EMS) which will be called upon to act. It will be difficult to avoid structuring the assistance other than through a loan, if not directly to the Spanish State itself, then at least to a fully nationalised special purpose vehicle (FROB?). While for political reasons no “new” formal conditionality may be imposed, the reconfirmation of Spain’s European commitments, already sanctioned by Brussels, is inevitable.
Secondly, one will need to clarify the position of Spain as guarantor with regard to possible loans by the ESFS. A position as a “Stepping out Guarantor” by Spain would further weaken the strength of the EFSF rating and impact its funding costs. This would limit the financial advantages that Spain anticipates from the assistance of its Eurozone partners.
If adequate answers can be found to the questions raised here above, then there remains to address the most crucial problem:
What is the ultimate purpose of recapitalising the Spanish banking sector?
If, as so often in the past, the aim is to provide a breathing space to the Spanish banking sector, without any further constraints, then one should fear that the treatment will relieve the pain rather than cure the illness. Indeed, as banks in Europe pursue their internal risk re-profiling, one can expect that the temporary (and probable) improvement in the interest rates of Spanish sovereign bonds will only serve to encourage euro-banks to accelerate the “renationalisation” of their loan portfolios. Under such circumstances, Spanish banks are likely to accumulate further Spanish debt which is being discarded by foreign institutions.
In order that EU assistance has a lasting impact and considering that the possibilities of demanding further austerity are more or less exhausted as well as unacceptable to Spanish citizens, it appears necessary to impose on the European banking system a series of specific measures:
In exchange for the recapitalisation of Spanish banks (the main beneficiaries of which will be the foreign banks), creditor banks should be compelled to maintain the current volume of their exposure to Spanish banking and sovereign risk.
Compliance should be enforced by Regulators and, in case of infringement, the sanction could be denial of access to the refinancing operations of the ECB.
Such a measure would constitute first major step towards disentangling the interdependence of banks and their respective nation States. It would be an important signal to financial markets that Eurozone Members are doing everything necessary to preserve the integrity of the EMU and the huge benefits that it provides.
Finally, rather than being satisfied with lecturing Eurozone Members, the U.K. should associate itself to this proposed measure (as it did for Ireland) and impose similar demands on its banks in managing Spanish risk. Nothing should prevent this form of “solidarity” to extend to the United States or any other country worried about the disastrous impact that an implosion of the EMU would have on their own economies.
If, once again, European politicians imagine that the simple announcement of a safety net for the Spanish banking sector will pacify markets and be sufficient to overcome the crisis, then it is to be feared that an inexorable process leading to the implosion of the Euro will take hold. It will then be too late to save all our marbles!
Brussels, June 10th 2012
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259