The Eurozone debt crisis will remain an issue for months

Posted on : Sun, 23 Oct 2011

Reaching a short-term resolution to the European sovereign debt crisis still requires a large gap to be closed between an array of divergent interests. This will take some time to achieve and a final resolution is unlikely at today’s (23rd October) European summit, according to QNB Capital.

At the epicentre of the crisis is Greek sovereign debt, which has reached unsustainable levels. Many banks within the eurozone hold Greek government bonds and are therefore exposed to a Greek default. European leaders have been struggling to put the mechanisms in place that will ensure that banks and EU countries are protected in the event of a write-down of Greek debt.

European leaders are under pressure to come to an agreement that will resolve the crisis at the European summit on 23rd October. On October 16th, a meeting of the finance ministers of the Group of 20 richest nations released a statement that Eurozone countries would need to agree on the following at the summit:
A. The losses the private sector should take on Greek debt
B. A plan for the recapitalisation of banks
C. A plan to ensure that other Eurozone countries are protected from the risk of contagion following any restructuring of Greek debt

Regarding (A): In July 2011, private bondholders agreed to a 21% write-down on Greek government debt. As the situation has deteriorated, it has been reported that European leaders want the write-downs of private investor debt, or “haircuts”, to be increased to as much as 50%. For many European banks, a write-down of this magnitude will trigger the need for recapitalisation.

Unsurprisingly, banks are reluctant to agree to greater losses on their Greek bond holdings. The head of the Institute of International Finance, a lobby group of the world’s largest financial institutions, and the CEO of Deutsche Bank, have publicly insisted that there will be no deviation from the agreed “haircut” of 21%. This shows that stakeholders remain far from agreement on the losses that the private sector should take on Greek debt (A).

Forcing banks to contribute more would be risky. Unless greater private sector involvement is voluntary, it would risk being classified as a credit event or default. According to the ECB, this would increase the risk of contagion of the crisis to other countries; particularly as it would trigger credit default swaps (these are effectively insurance policies for debt and would involve large payouts by financial institutions that could further undermine Europe’s financial system). It would also increase credit default swap spreads, driving up the cost of insuring European government debt and making it less attractive for investors to hold.

With regard to recapitalisation of the banks (B), even a 21% haircut on Greek debt would lead to a number of European banks needing to recapitalise to ensure they can meet the minimum capital ratio currently and during future times of stress, such as recession or further sovereign defaults. The European Banking Authority is expected to carry out stress tests that will estimate the size of the necessary recapitalisations. The tests are expected to be based on a minimum core capital ratio of between 7% and 9%, which could lead to recapitalisation requirements roughly from €100bn to €260bn for between 50 and 70 banks, based on consensus estimates.

According to Reuters calculations, using a stress test with a capital ratio of 8% and assuming a 36% haircut on Greek debt, would lead to recapitalisation requirements of €128bn amongst 54 banks. The banks with the greatest recapitalisation requirements in this scenario are shown in the graph above.

Disagreements between the eurozone’s dominant powers, primarily France and Germany, about how to fund recapitalisations have hindered progress. France argues that the recently expanded €440bn European Financial Stability Fund (EFSF) should be used. However, as the largest contributor to the EFSF, Germany has been in favour of national governments providing recapitalisation funds. As an alternative, banks may be able to sell assets, shrinking their balance sheets, rather than recapitalise.

Although the German government is now generally considered to be in favour of recapitalisation, there is disagreement about how the recapitalisations should be funded. The Germans object to using the EFSF to recapitalise banks and it therefore seems likely that capital that cannot be raised privately by the banks themselves, owing to high costs, will come from national governments. Recapitalisation would only be funded by the EFSF in worst case scenarios in which national governments are unable to meet the funding requirements. It would take some time to coordinate a mechanism that would ensure recapitalisation of banks by national governments. However, with national governments recapitalising their own banks, the EFSF would be freed up to be used to guarantee newly issued sovereign debt. This has reportedly been under consideration by EU officials and should limit contagion to other countries (C).

The divergent interests between different eurozone governments, other countries outside Europe, supra-national organisations such as the IMF and private bondholders, make a resolution to the crisis difficult to achieve, according to QNB Capital. Therefore, no final announcement can be expected at today’s summit and it is more likely that a solution will be achieved incrementally over the coming months.