Yesterday president Barroso presented a plan to recapitalize the European banking sector. Synthetic lenders ought to reinforce their required minimum capital levels from 5% to 9% after taking their exposure to sovereign debt into consideration. If they do not comply with solvency requirements, they will not be able to pay dividends or bonuses to employees. Those that cannot manage to get the funds privately will have to appeal to the government or, if that is not viable, the European recovery fund.
German chancellor Angela Merkel wanted this to happen and a spokesperson from the French government accepted the strategy minutes before Barruso announced it publicly.
There is one more step toward recovery. EU leaders know that Greece cannot pay, so during the first phase they have to support the banks by reinforcing a capital buffer that will ease the Greek default. The second step is to establish a firewall to avoid a contagion spreading to other countries and that debt emissions do not become sustainable. Third, the Europeans will impose debt restructuring programs on Greece and Portugal. Lastly, the EU is trying to move forward and draw up a coherent answer to the crisis. Markets are responding favorably to the overall strategy.
Still, applying the details of this strategy could still run into some problem spots. For starters, a comprehensive solution to fix the banks is not limited to elevating capital buffers, but needs to include steps for cleaning up toxic assets. Real costs need to be assessed. We know that the bailed-out Dexia counted on debt payments from French town councils, but the company never saw them. In Spain?s case, a recovery would necessitate cleaning up balances on real estate loans that will not be paid off and are impeding future credit business. Great effort would be necessary in savings banks that were just freed from implementing new requirements.
Another serious unknown lies in who is going to pay for the strategy. Necessary funds are estimated between 250 and 100 billion euros, reflecting analyst estimates of 10% debt forgiveness on Spanish and Italian bonds. This would be excessive if Spain trims their deficit, which the expected incoming government has promised to do. It does not look like lenders are interested in these funds, nor that EU members can support such financial burdens without enduring more uncertainty about their future health.
Any improvement to the recovery fund to provide solvency for the banks and bring liquidity to European nations could seriously affect credit ratings in France and Germany. Owed to their resistance, only the European Central Bank printing money could give enough muscle to deal with this operation at a time when a deflationary situation is dangerously close. We will need to help lenders even though they will ask citizens to make great sacrifices.
The situation needs some explaining. While true that the banks ought to do their part by reducing dividends, in the EU they ought to consider that if dividends are suppressed entirely then they run the risk of devaluing stock prices and instigating more problems. What happened in Ireland and Latvia shows that the peripheral countries can adjust while still using the euro and begin to grow in a way that gets Europe out of a jam. But the process will not be easy, and it will cost a great deal.
