Latest EU Bank Bailout Proposal Is a Dud

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By Megan Greene

A European Commission proposal for bank rescues recently leaked to the Financial Times suggests that euro area officials may not be ready after all to break the destructive loop between banks and their sovereigns.

Why on earth was anyone surprised? Germany and its north European allies have never been willing to back a system in which they would have to accept risk for debts incurred by banks in other euro area countries. That's unlikely to change soon.

If the commission's proposal becomes policy, this would be terrible news for markets and the euro. The burden of supporting rotten banks will still be able to bankrupt states -- see Spain, Ireland and Cyprus -- and rotten states will still be able to bankrupt otherwise healthy banks -- see Greece.

There has been optimism lately that European Union leaders were finally on their way to cracking this problem of structural contagion, which lies at the heart of the euro crisis. That optimism has been reflected in the falling yields on Spanish government bonds since November. At the latest EU summit in December, leaders agreed that the European Stability Mechanism, the group's 500 billion euro ($667 billion) bailout fund, may be used to directly recapitalize banks in need once there is an effective single supervisory mechanism for the euro area in place.

Over the past few years, banks were recapitalized by their states, whether the governments involved could afford it or not. In the case of Ireland, Spain and Cyprus, this forced public debt to soar to such levels that the states themselves were either pushed or almost pushed into bailout programs. Direct bank recapitalization from a central euro area fund would bypass the state, so governments would not have to shoulder the burden from their sick banks and risk becoming insolvent themselves.

Yet what exactly EU leaders have agreed to do remains up for debate. In private, euro area officials have spoken of making a distinction between "expected" and "unexpected" bank losses, with the common bailout fund plugging the gap only for unexpected bank losses. How these two categories of bank losses might be defined or measured, if euro area leaders accept the idea at all, is unclear.

The European Commission’s latest plan attempts to keep Germany happy that it isn't underwriting bankrupt banks in the Mediterranean, while still producing the direct euro area bank capitalization that countries like Spain so desperately need. It does so by saying that countries that have to resort to the European Stability Mechanism to recapitalize their banks would have to guarantee the fund against making a loss. This shares the same flaw as previous proposals: It fails to break that destructive loop between banks and their governments.

The bottom line is that if a country is bankrupt and needs direct bank recapitalization from the euro area's common fund, then that same bankrupt sovereign would still have to serve as the final backstop for its banks, as it indemnifies the euro area fund for any losses.

So what, in terms of the fundamentals, would be different under the European Commission’s latest proposal? Not much. The proposals can of course change, but for now it should become that much harder for optimists to delude themselves that the negative feedback loop between banks and sovereigns is about to be cut.

(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. Follow her on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Jan/15/2013 16:10 GMT