Friday, June 29, 2012

Welcome to the Banking Union

Just a short not on today's news:
I think that the statement with respect to secondary market support for Spanish and Italian government bonds is not the most important point from last night (it is not that far away from what the EFSF/ESM could do already). The most important point for me is that the EU summit effectively established a Eurozone banking union with a central banking supervisor who has access to a fund (ESM) for direct banking recapitalisation and who can itself provide unlimited amounts of liquidity. As stated, the bailout for Spanish banks will ultimately end up in this  new bank recap facility. As a result, it should then not count anymore towards the Spanish sovereign debt. This is clearly a game changer with respect to the negative feedback loop prevailing between banks and the sovereigns in the periphery where weak banks weigh on the sovereign and weak sovereigns weigh on banks. (On the downside, such a super-ECB can also commit super mistakes)

Additionally to quote from the statement: "The Eurogroup will examine. the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally. " If similar cases will be treated similarly, Ireland and Greece could also see parts of their bailout money (the money which went to the banks) being shifted off their balance sheets and hence leading to a sharp reduction in their indebtdedness (and with that also lower interest expenses).
As such it helps to solve parts of the overindebtdedness problem of several countries.

To be sure, this summit has done nothing to promote near-term or long-term growth (the growth pact is not really much new money and in total amounts only to 1% of GDP). For the long-run developments of the Eurozone it is important that the peripheral countries continue on their path of structural reforms to improve trend growth (without higher growth over the longer-term, debt-GDP ratios will not come down except via inflation or default). Furthermore, it seems clear that the EFSF/ESM capacity will most likely not be enough. However, that is not an acute problem but one to be solved at a later stage (in another emergency situation) and where last night gives confidence that it can be solved either via increasing the capacity or giving the ESM a banking licence and hence access to the ECB to leverage the paid-in capital.

The summit has certainly reduced the systemic risks prevailing in the banking sector. As a result, the elevated risk premia priced into Eurozone assets can fall again (and on the other side, the safety premia priced into Bunds should fall as well). I personally see bond markets of the semi-core countries (AT, NL, BE, FR, FI) as the ones which are best placed in terms of risk-reward and expect spreads of this group of countries to converge and to trade much closer to Bunds.

A last word for the ECB: I continue to expect an ECB rate cut (with a lower repo-depo spread). Furthermore, I do not see a reactivation of the SMP programme (this is no clearly in the EFSF/ESM court). However, the ECB will continue to do everything to keep solvent banks liquid as it has done vigourously since last December (and soon it will also have access to the money to keep the banks solvent).

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