At first glance, the statements coming out of the Euro summit are good news. I have been saying for the past year that, to calm global markets, the transmission mechanism from the sovereign debt crisis to the markets must be severed. The link is the banks. If the banks are adequately recapitalized (from whatever source), markets will calm down. Last night’s statement shows that policymakers agree with that view.
The devil is in the details of course. Here is the key quote from the statement:
When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution specific, sector-specific or economy-wide and would be formalized in a Memorandum of Understanding.
A pan-European bank supervisory mechanism was a key demand of the Germans and they got it. Note that no direct bank recapitalization can occur UNTIL this mechanism is established. Who is going to decide what this mechanism looks like? In effect, the Germans will. This sets up a prolonged period of squabbling over the details that markets will inevitably despair over.
Left unsaid is the role of the ECB in all this. The European Stability Mechanism (ESM)—the roughly $400bn European stability fund—is the ultimate mechanism for sovereign, and now banking, support. Theoretically, the ESM may not lend directly to banks as it does not itself have a banking license. That needs to be granted. More importantly, this would allow the ECB to support the ESM and would give the ESM as much firepower as the ECB would be willing to grant. So far, the ECB has acceded only grudgingly to various support mechanisms. A blank check for the ESM would be the final debauchment of the ECB and bearish for the Euro after a brief rally, I suspect.
It’s also worth noting that the Euro leaders agreed that recapitalization of Spanish banks will not be senior to sovereign creditors. Left unsaid is whether that will be true for other countries. I expect this precedent to be broadened.
I believe this shows Merkel is weakening politically. Cracks in her stony façade started to show last week when she agreed to extend more federal support to the German states. Does this mean that Euro-area bonds will be the next “Nein” that turns to “Ja?” Markets outside of Germany would be thrilled by this but German yields would rise.
The bottom line is I am encouraged by these events, even as I am unwilling to say the problems of sovereign debt are being solved. But, I do hope these problems are becoming less of an impediment to firmer global asset markets.