Transforming the European Stability Mechanism into a direct banking intervention fund could prove, in relative terms, the least costly option for Germany - but the rest of the eurozone will have to pay the price if Berlin says 'ja', says Société Générale.
José Manuel Durão Barroso, president of the European Commission, on Wednesday offered some hope to Spain that the European Stability Mechanism (ESM) might ride to the rescue of its battered banking system.
Barroso said the Commission will take an ambitious approach to completing economic union in Europe: The building blocks could include, among others, a banking union with integrated financial supervision and single deposit guarantee scheme.
It seems he hopes the market will take it as a signal that the single currency will not break up that senior EU figures, such as himself, are talking about deeper economic and financial integration. Good luck with that.
At least Barroso is also realist enough to admit that some of those decisions cannot be taken immediately some require, also from a legal point of view, very important steps. Hes not kidding. German opposition is well known to any form of recapitalization of national banking systems that amounts to disguised monetary financing of sovereigns.
And yet something has to be done to break the wretched cycle of bust banks propping up bust governments by buying their bonds in such vast quantities that all other creditors give up on the banks because their assets are so toxic.
In the long run, some form of European deposit insurance scheme might help, but that cant be quickly set up and the potential liability, given the size of the eurozone banking system deposit base, might be worryingly large for Germany and its other more creditworthy sovereigns.
Path of least resistance
Germany doesnt want the eurozones rescue fund, the ESM, directly to recapitalize troubled banks in countries struggling to roll over the funding for fear it might reduce those countries commitment to the fiscal rectitude needed to restore private market access. Could that change?
Michala Marcussen, chief economist at Société Générale, thinks it could start to look like the least bad option to Germany.
In an analysis on Tuesday of Europes options, she notes: Given the potentially relatively modest amounts involved, direct bank recapitalization by the EFSF/ESM could still prove a more palatable option for risk sharing. Even if only a small step, this would be highly significant, marking a break between the national sovereign and the national banking sector, and a small step towards a European banking union.
Assuming that the banks in the non-AAA countries are recapitalized to the tune of 2% of total assets, this would require 300 billion. To achieve this outcome, an increase in the ESM would be required.
She suggests a doubling of the ESMs lending capacity to 1 trillion and calculates that would take the maximum liability of Germany, in a worst case, to 22% of its own GDP. That compares with 170% for effectively backstopping various schemes for common issuance of Eurobonds or even 583% for backstopping an all-encompassing deposit insurance scheme.
So far, the German parliament has agreed to take on a worst-case liability for the new ESM of 11% of German GDP. What would make it double this?
Marcussen accepts that German risk sharing with the rest of the euro area would come with conditions. She notes: The German Council of Economic Experts proposal for a European redemption fund suggests that countries should agree irrevocable budget consolidation, debt-break rules, earmarked tax receipts for ERP repayment ie an important step for mutualization of tax receipts at the European level and thus fiscal union and put up collateral.
And she notes unconfirmed reports that German chancellor Angela Merkel might be drawing up a set of conditions based on the Hartz reforms in Germany that followed reunification, and included privatization and undertakings of provision of funding to SMEs alongside labour market reforms.
She concludes: Ultimately, how much risk sharing Germany is willing to sign up to will also depend on the level of conditionality the other member states are willing to sign up to. This could be the real hurdle.