ECB Changes Its Mind on Senior Bondholders of Spain's Banks
Before we go into the topic alluded to in the title of this post, here is a brief comment on what appears to be a potentially revolutionary change in EU bailout policy.
The EU's 'memorandum of understanding' on the Spanish bank bailout called for subordinated creditors of shaky banks to be wiped out before any public funds were transferred to them, but indicated that senior bondholders would once again emerge unscathed.
As readers may remember, it was on the insistence of the then Trichet-led ECB that Ireland was forced to fully bail out the senior bondholders of its insolvent banks. The argument then went that contagion had to be averted at all cost. As we noted last week, Ireland's minister of finance Michael Noonan recently remarked that Ireland had 'taken a hit for the team' on that occasion and was therefore entitled to relief.
However, the ECB has now changed its mind regarding the treatment of senior bondholders of Spain's banks.
As the WSJ reports:
„The European Central Bank, in a sharp turnaround, advocated imposing losses on holders of senior bonds issued by the most severely damaged Spanish savings banks —though finance ministers have for now rejected the approach, according to people familiar with discussions.
The ECB's new position was made clear by its president, Mario Draghi, at a meeting of euro-zone finance ministers discussing a rescue for Spain's struggling local lenders in Brussels the evening of July 9.
It marks a contrast from the position the central bank adopted during the 2010 bailout of Irish banks—which, like Spain's, were victims of a property meltdown—when it prevailed in its insistence that senior bondholders in bailed-out banks shouldn't suffer losses.
The ministers rejected the advice from the July 9 meeting out of concern financial markets would react badly. A draft of the rescue agreement, which will provide as much as €100 billion ($122.5 billion) for the Spanish banking system, requires Madrid to force losses only on shareholders and junior bondholders in banks receiving bailout money, and doesn't mention creditors higher up in the pecking order. A spokesman for the European Commission, the European Union's executive arm, said: "It is clear that senior bondholders won't be involved in burden sharing."
The ministers' decision confirmed a pattern in the euro zone for dealing with bank troubles in which senior bondholders have been spared even in the most brutal failures. But the ECB's shift may be a sign that the tides are turning on the issue, as the euro zone embarks on a fundamental overhaul of the way bank failures are dealt with within the currency union.“
If this shift in the ECB's stance actually holds sway, then it would represent a long overdue and very welcome development. We could never understand the reluctance to let those who have voluntarily assumed risk off he hook while tax payers are saddled with the bill. It never made any sense.
Of course one could speculate here why exactly the ECB has had this change of heart. Obviously Mario Draghi is not Jean-Claude Trichet, so it may be a mere difference in style between the two ECB chiefs.
However, a more likely explanation is that the ECB actually has an inkling how big the losses in Spain could eventually become and wants to head off ever bigger bailout demands at the pass. This time the euro area's finance ministers are apparently opposed to the idea, stressing once again 'contagion risk'. However, the WSJ report indicates that the real reason has to do with the treatment of Ireland in 2010:
„Imposing losses on bondholders reduces the amount of money taxpayers need to inject into struggling banks. One euro-zone official said the desire to avoid putting more public money at risk than necessary was one reason behind the ECB's change of heart since 2010. The ECB's new stance can also be explained by the different scenarios — including the existence of a bank-restructuring framework for Spain that didn't exist for Ireland, and that the Irish government, unlike Spain's, guaranteed much of its banks' debts.
But a chief reason ministers decided not to make more privileged bondholders take losses was the Irish precedent, two people said. Dublin has had to pump more than €60 billion, equivalent to around 40% of its annual gross domestic product, into several struggling lenders, forcing it to request a €67.5 billion bailout from other European countries and the International Monetary Fund in 2010.
Forcing senior creditors to take losses in Spain would have raised more questions in Ireland about why taxpayers were forced by the EU to take on the huge burden of repaying high-ranked bondholders.“
And sure enough, like a jack-in-the-box, up pops Michael Noonan, eager to 'discuss the ECB's policy shift on senior bank bondholders':
„The European Central Bank’s “extraordinary” shift of policy on burning senior bondholders will form part of the discussions between Minister for Finance Michael Noonan and bank president Mario Draghi in Frankfurt today.
Mr Draghi had told a meeting of EU finance ministers last week that the ECB would not insist that no losses be forced on senior bondholders of Spain’s worst-affected banks, the Wall Street Journal reported yesterday.“
This promises to become interesting, to say the least. Anyway, there is now at least some hope that someone will finally end up doing the right thing, regardless of the reasons.
The banking systems of Ireland and Spain compared, via the WSJ.
An Opportunity to Abolish the Central Bank
Bank of France governor Christian Noyer has made a few noteworthy remarks in an interview with German financial daily 'Handelsblatt' on the ECB's inability to lower the funding costs of banks in the euro area in spite of cutting interest rates to a historic low. According to Noyer, bank funding costs are now deeply intertwined with sovereign debt yields, a situation he calls 'unacceptable' as it hinders the 'transmission of monetary policy'.
He also opined on the chances for another LTRO and the fact that the ECB is uncomfortable with the enormous expansion of its balance sheet.
Furthermore he expressed support for a euro area-wide deposit insurance scheme, an idea that seems unlikely to fly given the different levels of deposit insurance funds currently set aside by various euro area governments and the increased risk such a scheme would pose to tax payers in countries with stronger banks.
“Euro zone banks are not fully benefiting from the European Central Bank's record low interest rates as funding costs in the market remain high, ECB policymaker Christian Noyer told German financial daily Handelsblatt.
In an unprecedented move, the ECB earlier this month cut the euro zone's key interest rate to a record low of 0.75 percent and lowered the rate it pays banks for overnight deposits to zero to help revive lending and growth.
But Noyer was quoted as saying on Monday that such changes had little effect on banks' funding costs.
"What we see is that we have a clear problem of transmission of monetary policy. In the eyes of the markets, the interest rate charged to individual banks depends on the funding costs of the sovereign and not on the rates set by the central bank."
"This means that the monetary policy transmission does not work. We tried to counter this phenomenon which is unacceptable for a central bank in a monetary union," Noyer said.
To ease banks' funding strains, the ECB has pumped more than 1 trillion euros into the banking system in the form of 3-year loans since December, but Noyer said the ECB could not keep such support measures in place indefinitely.
"For the future we cannot indefinitely rely on a system where the central bank is massively funding the banking system and massively receiving liquidity on the other side of its balance sheet," he said. "It cannot be such an intermediary in the long run."
Asked whether there would be another 3-year tender, he said: "For the time being we don't see the need, but we will see. I do not exclude it, but at the moment it does not seem to be needed."
Noyer, who is also the head of the French central bank, called instead for a deeper integration of the euro zone's banking system to help solve the debt crisis and said a special fund could pave the way for a deposit guarantee scheme.
"For the time being, the way to do it for me would be to set up a euro zone fund as a sort of reinsurance fund," Noyer said, adding the fund would back national deposit guarantee schemes, intervene if needed and would get its money back later. It would be funded by banks. "After one or two decades we could make a step to a simpler system, but that would be in a much more federalized euro zone."
As far as we are concerned, a failure to 'transmit monetary policy' due to market forces should be welcomed with open arms. Naturally, a professional central planner like Noyer doesn't like it, but these interest rates reflect reality and the view the markets have of the creditworthiness of the entities concerned.
Why should anyone wish for the central bank to be able to falsify these data? It is a positive side-effect of the way the euro-system is constituted that the central bank can no longer dictate interest rate levels at will. In fact, this would be an excellent opportunity to think about abolishing the central bank, since it has evidently become useless even by its own standards. Since the ECB is not happy with “indefinitely relying on a system where the central bank is massively funding the banking system and massively receiving liquidity on the other side of its balance sheet”, as Noyer asserts, and moreover can no longer influence interest rates, what reason is there to keep it going at all? None we can see.
Of course this idea won't be taken up. No powerful bureaucracy simply slinks back into obscurity – on the contrary, current plans are to greatly enhance the ECB's role and powers. Nevertheless, we may not get such an excellent opportunity again absent a break-up of the monetary union, which may of course still be in the cards.
Spain's 10 year government bond yield ticked slightly higher again on Monday, as the market weighed whether the ECB's new stance vis-a-vis senior bank bondholders was good or bad news for the sovereign - click chart for better resolution.
Italy's 10 year yield continued to climb further above the 6% barrier. Mario Monti's headache just won't go away - click chart for better resolution.
It remains a tale of diverging interest rates, as Germany's Bund yields continue to sink - click chart for better resolution.
France's 10 year yield also keeps diving and its spread over Germany's Bund yield has narrowed somewhat in recent days. Yet another 260 year low in French government bond yields was reached on Monday - click chart for better resolution.
French and German 10 year yields compared – the spread that has opened up since the crisis peak in November of 2011 is declining a bit, but it has yet to close - click chart for better resolution.
Jens Weidmann In Defense of Monetary Rectitude
Italian yields may have come under pressure due to the fact that Italy's finance minister Vittorio Grilli admitted that the economy would contract by at 'a little less than 2%' this year. This is still more optimistic than the estimates put out by the Bank of Italy and the Confederation of Industry. Grilli also complained that the markets are not cutting Italy any slack for its efforts to bring the deficit under control. Perhaps these efforts are simply insufficient?
The constant stream of complaints emanating from Italian government sources regarding the high interest rates Italy has to pay have left at least one man completely unmoved: Bundesbank chief Jens Weidmann.
Evidently he is far less concerned than Christian Noyer about the 'inability to transmit monetary policy' under the circumstances. In an interview with the financial magazine 'Börsenzeitung', Weidmann opined that there is no reason to help Italy bring its borrowing costs down. Moreover, he felt that Spain's bank bailout conditions should have been extended to the economy as a whole, not merely to the banking system. On Greece, he sagely noted that 'extending the time line won't make the austerity program more popular'.
Weidmann also remarked on the ECB being unable to solve the euro area's problems by providing more liquidity and that ECB buying of sovereign bonds would merely lessen the pressure on governments to institute reform.
“Italy’s borrowing costs don’t justify asking the euro area’s rescue fund for help, Bundesbank President Jens Weidmann said.
“Of course I can understand why a country would want to lower its refinancing costs,” Weidmann said in an interview with Boersen-Zeitung e-mailed to Bloomberg News by the German central bank he heads. “But because of the last-resort aspect of financial aid in the currency union, that alone can’t be a justification for granting it.”
“If Italy stays the course on reforms, it’s on a good path,” Weidmann told the Germannewspaper. Asked whether the euro area’s third-largest economy needs to tap the planned European Stability Mechanism, he said, “No, I don’t see Italy in that situation.”
On Greece, Weidmann said stretching the timeline for the country’s economic overhaul under the conditions of its two bailouts “won’t increase the political acceptance” of the austerity measures. Ireland and Portugal have achieved “remarkable progress” while receiving rescue funding, he said.
With the debt crisis in its third year, Weidmann said he is concerned that the ECB can’t meet expectations to stem the turmoil “because the underlying problems can’t be solved with ever more liquidity.” Sovereign-bond buying by the ECB “weakens the incentives for solid budget policies,” he said.
As always, words of wisdom from the Bundesbank chief, although he also defended the ECB's recent rate cut, which has been widely decried as an ineffective cosmetic measure. Given a big decline in excess reserves held at the ECB's deposit facility following the cut in the deposit rate to zero, there was however definitely a noticeable effect. Where that money went is something over which the ECB has of course no control, and we don't think it went where the central bank would have liked it to go.
Excess reserves on deposit with the ECB. Following the cut in the ECB's deposit rate to zero, excess reserves deposited with the central bank have plunged by more than €400 billion to €386 billion. Where this money went no-one really knows, but it probably didn't go where it was supposed to go - click chart for better resolution.
Addendum: More Weak Data From the US
Neither the Empire State business survey (pdf, although it came in 'better than expected') nor US retail sales data released on Monday managed to create any warm fuzzy feelings. Below are the charts showing the current state of affairs:
Empire State Business Survey: better than expected, but by no means ground for celebration.
US retail sales ex food, year-on-year. This indicator is beginning to look recessionary – click chart for better resolution.
As an aside to this, Ambrose Evans-Pritchard has evidently taken the recent slew of weakening US economic data as a reason to go off on another rant exhorting Ben Bernanke to swing into action and crank up the printing press once more.
The misguided belief that the economy can be 'helped' by printing more money simply refuses to die. The exact opposite is of course the case: while inflationist measures can create a bit of a 'feel good' atmosphere for a short period of time, this effect will diminish the more often they are resorted to, while underneath the seeming 'recovery' in business spirits even more scarce capital and wealth will be destroyed. Evans-Pritchard is clearly among those who continue to confuse money with wealth.
Charts by: WSJ, Bloomberg, bigcharts, NY Fed, St. Louis Fed.
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