FT: ECB warns against private role in bailouts

13 October 2011

The European Central Bank has issued its strongest warning yet about the dangers of German-led demands for private sector involvement in eurozone bailouts, including for Greece.

Such moves “may put at risk the financial stability of the currency area as a whole” and trigger a need for “large scale” bank recapitalisation steps, the ECB warned in its monthly bulletin on Thursday.

Its comments reflect the central bank’s alarm at eurozone leaders’ attempts to oblige banks to contribute more to Greece’s rescue – which it fears is sending a disastrous signal to investors in other crisis-hit eurozone countries.

The ECB failed in July to stop eurozone leaders agreeing a notional 21 per cent haircut for private Greek government bond holders. But as Greece’s debt woes have escalated, Berlin has pushed to reopen that deal and seek a bigger contribution from the financial sector.

Private sector involvement (PSI) initiatives have been used before to resolve sovereign debt crises around the world, the ECB acknowledges. But the bulletin article argues that the impact is likely to be different within a monetary union, where financial systems are closely linked. “The application of PSI to one member country may put at risk the financial stability of the currency area as a whole”, it warns. As well as hitting investor confidence across the monetary union, there would also be direct effects on the balance sheets of banks in other countries. “This could trigger a need for large-scale bank capitalisation.”

The ECB says if Greece is pushed into default, it will refuse to accept Greek government bonds as collateral in its liquidity providing operations. That would prove catastrophic for the Greek banking system – so eurozone governments have had to promise to provide “credit enhancements” that would ensure Greek bonds continue to be accepted by the ECB. That in turn implies additional potential costs for governments.

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