Bank recapitalization an inadequate panacea for eurozone’s woes

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This post is a guest contribution by Asha Bangalore, vice president and economist at The Northern Trust  Company.

Angela Merkel, the Chancellor of Germany, is prepared to recapitalize German banks, if necessary. The finance ministers of the European Union have asked the European Banking Authority (EBA) to undertake a new stress test, which will be the third stress test in the last two years. This time around, the aim of the test is to determine how much new capital banks would require if all peripheral eurozone sovereign bonds were written down. The IMF’s Europe director, Antonio Borges, estimates that about €100 billion to €200 billion would be the tab for recapitalization. The source for these funds remains unknown. But, the important issue is that whether the funds are provided by the respective nations or through the European Financial Stability Fund (EFSF), sovereign debt will increase. In other words, solutions to address the weak capital positions of banks would entail additional funds which are not available for all members of the Euro-area. Public debt to GDP ratio of both Germany and France should increase if new funds are raised for recapitalization directly by the respective countries or indirectly through the EFSF.

Source: http://www.imf.org/external/datamapper/index.php?db=WEO

Financial markets have captured the likely ramifications of the debt crisis in the eurozone and the cost of insuring sovereign German and French debt has moved up noticeably since early-July (see Chart 2, courtesy of Mark Reynolds of the Treasury Department at Northern Trust), with the CDS for Italian and Spanish sovereign debt also showing large increases. Political dithering has lead to the long overdrawn process of resolving the debt crisis in Europe. A complete recapitalization of banks and restructuring of sovereign debt of Portugal, Greece, Ireland, Italy, and Spain will be necessary to convince financial markets that debt challenges have been adequately addressed.

Today, the IMF has indicated it would step in to set up a special-purpose vehicle to purchase bonds of Italy and Spain to prevent a financial meltdown. Italy and Spain are deemed solvent but facing challenges of economic growth and budgetary pressures. The European Central Bank has purchased Italian bonds and helped to hold down Italian bond yields. The IMF proposal may never be implemented. Political leaders continue to grapple with the sovereign issues in Europe.

Source: Asha Bangalore, Northern Trust – Daily Economic Commentary, October 5, 2011.

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