30 November 2011

Horváth/Huizinga: The EFSF - unfinished business

The European Financial Stability Facility was set up 18 months ago as a response to the then Greek sovereign debt crisis. This column looks at the effect of the fund on the financial system, in particular bank shareholders, the holders of bank bonds, and the holders of sovereign debts.

The EFSF was set up to make loans to eurozone governments experiencing refinancing problems, with its own debt guaranteed by individual eurozone countries. As originally conceived, these credit guarantees were limited to €440 billion, but in July this year eurozone politicians agreed to increase the guarantee ceiling to €780 billion, providing the EFSF with an effective lending capacity of €440 billion.

In October, eurozone leaders decided to leverage up the remaining, uncommitted lending capacity of €250 billion to more than €1 trillion to be able to backstop the debt of a major eurozone country such as Italy. However, leveraging the EFSF has proven difficult, as investors have shown limited interest to provide the necessary funding.

The announcement of the EFSF in May 2010 was important as it signalled a willingness of Eurozone countries to financially support distressed sovereigns in a structured way. The earlier provision of €110 in bilateral loans to Greece in 2010 had only been on an ad hoc basis.

The authors consider the repercussions of the EFSF announcement for: (1) bank shareholders; (2) the holders of bank bonds; and (3) the holders of sovereign debts. The results are as follows:

1. Bank shareholders overall lost.
2. The holders of bank bonds gained overall, as evidenced by a drop of the average bank CDS spread by 23 basis points.
3. On average, the holders of sovereign debts benefited as well, as shown by a reduction of the average sovereign CDS spread by 54 basis points.

Banks with risky eurozone sovereign exposures, however, benefited regardless of whether they were distressed or located in the eurozone. Thus, the EFSF makes inefficient use of limited public resources to the extent that it aims to promote financial stability inside the eurozone. In recognition of this, the instrument set of the EFSF was expanded in July 2011 to include loans to eurozone governments with the purpose of recapitalising distressed banks. In principle, such a loan can be provided to a country that is defaulting on its general debt, or to a country that has negotiated a haircut with its creditors such as Greece. Hence, the proceeds of such a loan can be targeted to bank recapitalisation rather than to general debt repayment.  Acharya et al (2011) calculate that the cost of recapitalising EU banks now would be between €200 billion and €500 billion based on sovereign debt discount estimates. Thus, the current resources of the EFSF should be sufficient to honour requests from eurozone governments to recapitalise their banks.

The size of the EFSF – as of July 2011 – was insufficient to bail out both eurozone banks and eurozone sovereigns that are ‘too big to fail’. Hence, the decision of eurozone leaders in October 2011 to leverage up the EFSF’s remaining, uncommitted lending capacity of €250 billion to arrive at an enlarged lending capacity of at least €1 trillion. In recent weeks, the EFSF has worked to achieve this degree of leverage, but apparently unsuccessfully. In practice, leveraging up the available resources may only attain an effective lending capacity of between €500 billion and €750 billion. This implies that the EFSF would be too small compared to the size of Italy’s sovereign debt of €1.9 trillion. To bring about a larger EFSF, eurozone countries may need to increase their credit guarantees to the EFSF, even if this comes at a cost of deteriorating credit ratings for the guarantor countries. Larger credit guarantees to the EFSF are warranted, if they are accompanied by the acceptance of far-going EU oversight on budget and reform policies in recipient countries.

In the absence of an expanded EFSF, only the ECB has the capacity to backstop the eurozone sovereign debt market. Significant debt purchases by the ECB would imply a monetisation of the debt, leading to higher inflation and an erosion of savings everywhere in the eurozone.

This makes the EFSF route to backstopping the eurozone sovereign debt preferable to the ECB route. However, the EFSF route appears to require additional action by politicians, while the ECB does not. Eurozone politicians should hasten their efforts to expand the EFSF, even if this implies larger credit guarantees to the EFSF.

Full article

© VoxEU.org