Monday, 26 September 2011

Eurozone Debt Crisis Part Two: Is there a common cents solution?

As we discussed in Eurozone Debt Part One, the crisis may emanate from the government markets but, if allowed to fester, it will hurt economies through their banks. That is why previous rescue plans have foundered. So far bailouts have broadly been loans made in exchange for good intentions to cut and consolidate.

These have failed to inspire the markets. This is because politicians suffer a credibility gap. By denying the possibility of any defaults they are unable to draw a line in the sand between Greece and the rest. Until that line is drawn investors will wonder whether more good euros will be sent after bad. But investors also worry that banks might not have enough capital to weather the losses when they come (to remember why banks need capital head for Walmington-on-Sea). Concerns that banks' losses could overwhelm their capital are causing the market's stresses and raising the cost of loans banks make to each other.

Uncertain losses and dubious balance sheets point towards a crisis. So what would a resolution need? To our mind there are three likely components:

1. Shock and awe. Skepticism is high and so, to win over investors, gestures must be bold.
2. A central role for the European Central Bank (ECB). Varying fiscal positions, disparate levels of electoral support and convoluted legislative processes are rendering governments impotent in their responses to a very fluid situation.
3. At least one foot in the real world. Greece is going to default - everybody knows it but until that truth is officially acknowledged no credible consideration can be given to whether other countries can be saved.

To fulfill this wishlist an approach could centre around ECB capital injections into banks on a contingent convertible basis (contingent convertibles are loans which become permanent investments if needed by the borrower). Then, while each bank’s capital position remains secure, the ECB would receive interest. If a bank’s capital position does deteriorate then the ECB would gradually assume some equity ownership - similar to the creeping nationalisation of RBS and Lloyds (in this case creeping internationalisation or continentalisation).

The ECB is ideally placed to fulfil this role as has the fleet of foot to respond to market conditions with limited concern for the public’s reaction (not always ideal but, in this case, probably for the best).

Data from European Banking Association stress tests suggest that an investment of €130bn euros would be required to raise capital ratios to the new Basel III ratio of 8.5% that will be required by 2018. Whilst that is a big number (although smaller than the existing securities market program which buys Italian, Spanish and Portuguese debt in the secondary market) the commitment would probably translate to a smaller ultimate investment.

If the ECB acted as ultimate underwriters, governments and investors would likely participate where they can, to avoid having their sovereignty or their investments diluted at these extremely depressed levels. Some banks price to book ratios have fallen from around 2 times to between 0.2 and 0.7 times.

If this action were to take place in conjunction with a realistic appraisal of the health of sovereigns then it would provide the confidence to investors that the crisis is being resolved.

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