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Euro zone split over how to interpret bank debt deal

by on September 26, 2012 2:03 pm BST
 

Wed Sep 26, 2012 10:03am EDT

* Euro zone in dispute over how to recapitalise banks

* Triple-A countries don’t want to handle “legacy” debts

* Statement proves unsettling for Spain and Ireland

By Luke Baker

BRUSSELS, Sept 26 (Reuters) – Efforts by euro zone countries
to agree on how to recapitalise struggling banks appeared to be
in disarray on Wednesday with conflicting interpretations of
what was agreed by EU leaders at a summit barely three months
ago.

The dispute between four AAA-rated euro zone countries on
one hand – German, Finland, the Netherlands and Austria – and
indebted states such as Ireland and Spain on the other,
threatens to undo or severely set back efforts to allow banks to
be directly recapitalised by the euro zone’s rescue fund.

That will in turn undermine financial markets’ confidence in
Europe’s ability to get on top of the debt crisis. Yields on
Spanish 10-year government bonds moved back above 6 percent on
Wednesday as developments in Spain dampened expectations that
Madrid will soon ask for a bailout and secure central bank
support for its debt.

Germany, Finland and the Netherlands gave rise to the
confusion with a joint statement on Tuesday setting out the
conditions under which they would be prepared to allow the
rescue fund, called the ESM, to recapitalise banks.

But rather than sticking to the wording from the summit in
June, when countries agreed that the ESM would be able to
directly recapitalise banks once an “effective single
supervisory mechanism is established”, the three countries added
an extra stipulation in their statement saying:

“The ESM can take direct responsibility of problems that
occur under the new supervision, but legacy assets should be
under the responsibility of national authorities.”

Austria joined the three on Wednesday, saying there was no
question of the ESM being allowed to assume old, bad debts.

The critical phrase is “legacy assets”, which appears to
imply that the debts of struggling Spanish and Irish banks – and
potentially those of Greece and Cyprus too – will remain the
responsibility of the respective governments, rather than being
assumed by the ESM during the recapitalisation process.

That is a problem because the very aim of direct
recapitalisation was to break the debilitating link between
indebted governments and troubled banks – making sure that a
government that is pursuing sound economic policies is not
dragged down by its mismanaged banking sector.

If a way is not found to break the link between sovereigns
and their banks, the euro zone will forever be in an uphill
struggle to get on top of the crisis since government finances
will always be saddled with vast amounts of bad banking debt.

The very first line of the statement agreed by EU leaders at
the June summit was: “We affirm that it is imperative to break
the vicious circle between banks and sovereigns.”

But that same phrase was not used in the statement issued by
Germany, Finland and the Netherlands, indicating perhaps some
change of mind about how and when the link will be tackled.

SOWING DOUBT

Officials from the four AAA-rated countries, speaking on
condition of anonymity, sought to play down the relevance of
Tuesday’s statement, saying there was nothing new in it and that
direct bank recapitalisation via the ESM remained the goal.

“We are still committed to breaking the negative feedback
loop between sovereigns and banks,” one official said.

Asked how, the official would not elaborate but said there
would be “specific measures” for cases such as Spain and
Ireland, where the government’s decision to assume the debts of
its bad banks drove the deficit to painfully high levels.

Another official insisted that the German-Finnish-Dutch
statement did not reopen or undo what was agreed in June, going
on to explain:

“Everybody understands that losses incurred some time ago
will definitely not be borne by the European taxpayer in the
form of a contingent liability.”

The problem is, that does not appear to be how Ireland or
other countries understood the June agreement.

Ireland’s prime minister, Enda Kenny, expressed his surprise
at the three-country statement, saying it was not up to a
handful of finance ministers to rewrite an agreement drawn up by
heads of state and government.

“The difficulty for Europe has always been that you follow
through on the decisions that were made. The decision of June 29
was not an opinion, was not a theory,” he said. “Those decisions
stand, those decisions will be implemented.”

While officials in Germany, the Netherlands, Finland and
Austria may insist nothing has changed, financial markets
clearly took the June statement to mean that any direct
recapitalisation of Spanish or Irish banks would shift the
contingent liabilities off the governments’ books.

Tuesday’s statement did nothing to ease risk aversion fed by
a broad range of factors linked to Spain’s plight that prompted
sharp rises in yields on Irish, Spanish and Italian 10-year
government bonds as well as weakening the euro.

“If there is any risk that the Spanish bank bailout will be
carried by the sovereign rather than any of it transferred so
that it is directly funded by the ESM or the EFSF, it’s an
additional burden on the sovereign,” said Elisabeth Afseth,
fixed income analyst at Investec.

The likelihood is that some of the confusion and
disagreement provoked by the statement will be ironed out at a
meeting of finance ministers in Luxembourg on Oct. 8 or at a
summit of EU leaders in Brussels on Oct. 18.

“This discussion is ongoing,” said Olivier Bailly, a
spokesman for the European Commission, when asked what the
statement meant for the ESM and bank recapitalisation.

“It’s part of an ongoing debate where member states will
clarify in the coming weeks the different details of the final
design of this ESM instrument.”

But the broader issue is that EU member states often
struggle to communicate with one voice or agree on how to
interpret their own agreements, creating confusion in financial
markets and beyond, which will always tend to exacerbate the
very crisis they are trying to resolve.