Saving the eurozone

25 October 2011

The latest news from Europe is that disagreements between France and Germany over the weekend on boosting the firepower of Europe’s 440 billion-euro bailout fund have seen the scheduling of a second summit for Wednesday. The attendance again of the heads-of-state of all 27 member countries, followed by the 17 heads of euro economies on their own, underlines the importance of the meeting.

Over the weekend, finance ministers agreed that Europe’s largest banks will need to set aside 108 billion euros of new capital over the next six to nine months. This money will be used to boost bank Tier-1 capital to 9%; the ratio of a bank’s core equity capital to total risk-weighted assets.

Germany achieved one of its main summit aims, defeating French efforts to bulk up the rescue fund (known as the European Financial Stability Fund) by enabling it to borrow potentially limitless sums from the independent central bank. The EU is now looking at a broad array of options to assist the indebted governments of peripheral Europe. However, these are unlikely to eventuate given the time frame.

The plans to put fresh capital aside and raise Tier-1 ratios to 9% for European banks are aimed to help prevent a vicious feedback loop developing between European banks and weak sovereigns. The past set of stress tests appear to have been woefully inadequate, requiring banks to a have a Tier-1 ratio of only 5%, plus they didn’t take into account exposure to peripheral sovereign debt.

The eurozone crisis has led to a funding squeeze on European banks – they have found it difficult to refinance in the medium- and long-term because of their exposure to troubled eurozone economies. The European Central Bank had to recently launch a 40 billion-euro covered-bond-purchases program to help ease these funding concerns.

The ECB has had to implicitly intervene as lender of last resort to prevent a potential liquidity crisis emerging; it has set up a US dollar-swap facility for eurozone banks and offered unlimited short-term liquidity until mid-2012.

Next steps

EU leaders will need to agree to a final crisis package for the eurozone by Wednesday. There are three major issues are still dividing the EU. The first is the structure and purpose of the rescue fund. The issues include: Should the rescue fund be used as a lender or guarantor of last resort? Should it be leveraged to boost its firepower? If it’s leveraged, what is the best way of doing it?

The second is how to restructure of Greek debt. Over the weekend, there were discussions for a haircut as much as 60%. Questions remain on whether this will trigger credit-default swaps the banks have used as hedging tools. The third is the level of recapitalisation banks will need. They appear to have to agreed that 108 billion euros in new capital is needed to persuade investors that they can withstand the pressures of the sovereign debt crisis. Will this be enough?

What does it mean?

For investors, the events of the past few days have several consequences. An obvious one is that increasing the haircut on Greek sovereign debt finally accepts the reality that the 21% agreed in July was not enough. A larger haircut should go some way to help achieve a sustainable level of debt-to-GDP for Greece. With appropriate domestic austerity measures, this would help to significantly reduce the magnitude of the “Greek Crisis”.

Equity and bond investors need to remember to remain diversified and flexible, shifting their exposure away from trouble spots, such as financials, which are likely to bear the brunt of a sovereign debt blowout. It’s worth pointing out that equity valuations are very attractive, particularly in Europe. Over the next several months, a combination of robust policy action and depressed equity prices could see European markets rally.

Dominic Rossi, Global CIO equities at Fidelity, says the emerging-market debt crisis of 15 years ago taught us that financial crises of this magnitude take several years to play out so the spotlight will move from Greece to Italy as the market judges the effectiveness of the Berlusconi government's response. “Recapitalising the banks' holdings of Greek debt to the tune of 108 billion euros is the right move, but a Tier-1 capital level of 9% is likely to be at the minimum level of requirements with a low double-digit figure more realistic,” he said. “The current valuation of banks, makes capital raisings via shareholders as unlikely as any move to de-gear by reducing the loan book – a politically unacceptable option. What we should see then is the banks selling non-core assets, whether non-bank or overseas.”

Interbank lending: Three month Euribor-OIS

DataStream. 23 October 2011