The short but important conclusions from the all night summit of Euro area leaders can be found here.
First the good news, four very important decisions were taken 1) A decision to eventually hand the European Central Bank direct supervision of Eurozone banks 2) A decision to allow, in principle, the European Crisis funds the EFSF/ESM to directly inject equity into troubled banks 3) A decision to waive seniority or preferred creditor status that Member States had claimed for the ESM, for Spain’s rescue 4) An agreement to activate crisis support for Spain and Italy through the EFSF/ESM buying bonds in order to bring borrowing spreads down.
Then the bad news 1) The decision to give supervision to the ECB will take years to properly implement and raises serious question marks about accountability, concentration of power, manpower and the future of the single market in financial services amongst other things
2) The decision to inject equity, it has been stated, can only be carried through once ECB supervision is in place – hence not in the foreseeable future so its short term impact is rather limited. And it would mean a change in the mandate of the ESM which would take a long time to enact if political agreement can be found at all. Also, as a prerequisite for this, subordinated and even senior bondholders in banks being considered for aid would probably be asked to take haircuts, something for which the legal mechanisms don’t yet exist and the political willingness may never come about.
3) The decision to waive seniority for Spain is being given a lot of importance by commentators but we think it’s not quite that important as I have highlighted in my note “The Spanish Bailout and the myth of Seniority”. It would in any case have been impossible to have kept a preferred creditor status while injecting equity – as by definition equity is junior to bondholders. Also, what really matters is whether seniority will be waived for Italy as the support there is expected to come in the form of bond purchases not equity injection into banks.
4) The decision to agree to activate the purchases of Italian and Spanish government bonds by the EFSF/ESM is not fleshed out i.e. whether this would happen when interest rates hit a certain ceiling? What this ceiling might be? Whether these would be senior or pari-passu with private bondholders? Without these it’s impossible to say how important this is. What is very clear however is that the limited firepower of the EFSF/ESM and the fact that 25% of their backing comes from the crisis ridden countries limits how much this program can achieve.
Why is this good news? And why it may be bad news? Let us consider each of the conclusions in turn.
The ECB as supervisor for Eurozone banks
In the run up to the crisis, banking supervision standards across EU member states were generally shoddy but with a great difference in exactly how shoddy. The variance in the quality of supervision has been high with the quality of supervision inversely related to the cosiness between the banking sector and regulators and with competence. This has continued after the crisis hit and has manifested itself in several forms, including the very different standards that supervisors have applied in the European Banking Authority stress tests and recapitalization exercises.
Hiving off supervisory authority to the ECB would mean that the quality of supervision across the Eurozone would become more even and hopefully also uniformly better.
Central banks, in their role as lenders of last resort, are supposed to lend as much as needed to solvent but illiquid central banks. But often, as in this crisis, the hardest thing to do is to distinguish between insolvency and illiquidity. One of the reasons the ECB has offered for not having done (even) more to support the banking system is that it’s trust in national supervisors is rather limited. Its fear that national supervisors would overplay the strength of their wards and understate their weaknesses has come true for example when the truly shoddy state of Spanish and Irish banks was revealed soon after they had been given a clean bill of health by their national regulators. It has said that it would be more willing to support banks and sooner if it had greater confidence that it knew the true state of affairs. The decision to put supervision in the ECB’s hands will thus make it more comfortable playing its lender of last resort role.
Central bankers are, particularly if they cannot be fired as those at the ECB can’t be, more likely to be independent and less beholden to particular political or financial interests to which national supervisors have been shown to be vulnerable. So ECB supervision may not just be more uniform but tougher and more independent.
The less good news takes several forms. The first and foremost is that any realistic effective transfer of supervisory powers to the ECB will take several years. The ECB has no capacity on this yet, and given the experiences internationally it would really take a long time for it to develop effective capacity no matter how accelerated a program of recruitment it carries out. A compromise in the form of the ECB being given power over national supervisors may be politically effective but all of the current problems with national supervision will remain. This can be no more than an interim solution.
The second concern we have is about institutional overstretch. Supervision is manpower intensive and the ECB’s six-person executive council is already complaining of being overstretched when one out of their six seats is vacant. How will they ever do a quality job with the same top management when the job expands so much? And ultimate responsibility cannot be given to hired staff as it has to rest with the executive board itself.
The third concern we have is that with this move the European Central Bank is becoming the European (Super) Central Bank. As a central bank which is the sole backer of a currency with no equivalently powerful fiscal authority that sits atop or besides it, the ECB is already disproportionately powerful compared to other central banks. Also, given that nothing less than a treaty change could take power away from the ECB and its well-nigh impossible to get treaty change in the EU, the ECB enjoys much more independence than the Bank of England or the Fed do. The 8 year terms for its executive council members are also longer than those at most other central banks and they cannot be fired in most states of the world. This is an unprecedented concentration of power and with the ECB’s letter to PM Berlusconi asking for reforms in exchange for ECB support, many people feel that the ECB has been overstepping its powers and prescribing to fiscal authorities what they should so even as it reasserts its independence from what they may ask it to do.
The fourth related concern is that of the very limited accountability the ECB has to any democratically elected body. The president of the ECB makes regular presentations to and takes questions from the ECON committee of the European Parliament but is not formally accountable to them. Nor it is obliged to answer the questions they ask the ECB. In practice, the situation is even worse with most Members of the European Parliament being deferential in how they speak to the ECB – almost as bad as Bundestag Members are when they speak to the Bundesbank. The complete lack of democratic accountability and the very little transparency in how the ECB works should be matters of grave concern that need to be set right before the ECB is given more powers.
The fifth and the last concern is that the narrow inflation specific mandate of the ECB is insufficient for it to be an effective supervisor and would need to be expanded to include growth and financial stability, without which the ECB’s supervision of banks may be lop-sided.
Injecting equity into banks
We have long complained about the vicious sovereign-bank dance of death underway in the Eurozone and the need to break the far too strong links between banks and sovereigns. In order to do this, we have long called for ESM to be given the ability to inject funds directly into Eurozone banks. This has finally been agreed to in principle which represents significant progress. Also, this would apply not just to Spain but also to countries such as Greece and Ireland and could significantly reduce the burden of debt on the sovereigns by taking the support they have been providing their respective banks off the books and on to the balance sheet of the ESM instead.
However there are several caveats here. First, this will happen only after the ECB has been handed supervision powers – which as we have discussed in the previous section may take years. So this is not going to translate into real support in the short term, but could possibly be used as a mechanism to take over bank stakes from weak sovereigns thus reducing their debt burden and weakening the links with banks.
Second, it is unlikely that this would be allowed to happen without a clean-up of the banks in question first. This would mean a bigger upfront recognition of losses and possible haircuts for subordinated bondholders and even senior bondholders. This would almost surely involve a writing-off or writing down of some of the equity holdings, including some held by the sovereign so the reduction in the debt burden of sovereigns may not be as large as hoped for. Also, as things stand now, there is no European resolution mechanism, which would need to be set up. Even national resolution mechanisms, which may work in the interim, don’t exist in most of the troubled economies.
Third, this would make the EFSF/ESM much more risky and subject them to real risks of losses which would make the whole process highly contentious politically. Any country could choose to pull the plug so the long-term viability and effectiveness of this mechanism remains in doubt.
Waiving seniority
The most important point to remember here is that there is less than meets the eye. Seniority, as I have explained extensively in my note “The Spanish Bailout, the Eurocrisis & the myth of Seniority” was never a big problem with the Spanish bailout. It was that it took the form of a loan rather than equity injection. If the European Council had merely agreed to waive seniority without changing what form this bailout would take, the effect on market confidence would have been very limited.
It’s the decision to allow the ESM to inject equity which is the critical one. This of course, as any sensible person would tell you, cannot happen when it is senior. Equity injections are by definition junior to bonds so the ESM, once it is allowed to inject equity will effectively become subordinated to the claims of existing bondholders.
What really would matter, in terms of the discussion on seniority, is whether or not this would apply to Italy. As I have explained in my note yesterday, “Yet another European Council! Recuing the Eurozone”, renouncing seniority for Italy really matters particularly if the support for it will be in the form of bond purchases by the EFSF/ESM. Secondary market purchases of the kind the ECB made through its SMP program are not effective when they are 1) limited and 2) have embedded seniority. Because an ESM/EFSF program would always be seen to be more limited than an ECB program, the renunciation of seniority for Italy is very important.
Another point I have made in my note on seniority is that it’s one thing to waive it, and it’s quite another thing for markets to believe it. It’s difficult to see how a credible commitment can be made about this, particularly as the amount of support provided to Italy starts to rise.
Supporting Italy and Spain through bond purchases
This part of the declaration of the European Council has almost no flesh on the bone whatsoever. With such few details it hard to make a judgement but we will try.
The good news is that something will be done to lower the borrowing costs for Italy and Spain, which were threatening to snowball. The bad news is that it will at best buy some time and will almost certainly not be enough.
Politically, it is important for the leaders of Spain and Italy not to be seen to be prescribed conditionality by the European Authorities. The governments of each of the countries that went for an EU program with conditionality were voted out of power. So an in-principle agreement that the only conditions that would apply for activating this program would be policies that the Member States are already legally obliged to adhere to under the newly beefed up EU economic governance rules. We have shown how, for example in the case of Spain, these are almost as far-reaching as explicit new conditionality prescribed in the case of a country such as Portugal.
The agreement which will simply transpose existing commitments into a memorandum of understanding and add a timeline for results to be delivered is a good compromise between the interests of the creditor and debtor countries and one which Re-Define has been promoting for several months. There is another added caveat, which is that only countries ‘with good behaviour’ will be able to access these facilities. This is good in terms of discipline and will help hold Monti’s successor government to account, but at the same time undermines belief in the effectiveness of the support by introducing an element of uncertainty.
We don’t know yet, whether the scheme would be automatically activated to provide a ceiling on borrowing costs, which would be good policy. We also don’t know what this ceiling, if agreed, may be – A 4%-5% ceiling would be good, a 7% ceiling would be bad. We have discussed this topic of capping borrowing costs in a note we did on the ECB that can be accessed here.
Another limitation of this scheme that we discussed extensively in our note yesterday is that its size is limited and that this would reduce its credibility and effectiveness. As we wrote yesterday
“The limited size of the ESM/EFSF is yet aspect of this strategy that may limit its effectiveness , as borrowing costs can best be credibly brought down if it is demonstrated that the sovereigns in trouble have access to reasonable cost funding for as long as they need it.
Another complication is that fact that when one includes Italy and Spain, the effective capacity of the crisis funds could shrink by almost 25% as then the bailed-out countries would constitute nearly a quarter of the fiscal capacity that supposedly stands behind these funds.”