Politicking and Progress in Europe

Those waiting for something big to come out of Jackson Hole got their wish Saturday when new IMF chief Christine Lagarde said that without “urgent recapitalization” of European banks, the global economy would derail. Her harsh assessment made waves worldwide, but the ECB and EU quickly shot down her prescription, saying banks are plenty capitalized—especially given post-Basel III increases.

For now, we think the EU and ECB have the better view of things. As we’ve written, European banks have substantially improved liquidity profiles and reduced leverage in recent years, which makes them more shock-resistant, reducing the potential for a run on the bank. But longer term, PIIGS debt restructuring likely involves some write-downs, and it only takes a few to impact overall banking health.

European policy makers can help mitigate the impact of these write downs ahead of time by approving the EFSF credit line enhancement, which would allow the EFSF to help finance financial institutions’ recapitalization through loans to governments, including member countries with no EU-IMF adjustment program in place—basically, a sort of European TARP. As with much of Europe’s ongoing saga, its hurdles are largely political, not fiscal—but they’re not immaterial. The EFSF changes must be ratified by national parliaments, and they face significant opposition in some nations—particularly in Germany, where Chancellor Angela Merkel is facing a rebellion within her own party and cabinet. Opponents fear the proposed changes would be tantamount to a fiscal union without democratic accountability. How this plays out remains to be seen—the bill is expected to pass its scheduled September vote in Germany, but continental politicking could yet lead to uncertainty over the progress.

Meanwhile, in Greece on Monday, that nation’s second- and third-largest banks announced an all-share merger—and Greek stocks cheered the news. The new entity will be Greece’s largest bank, and it plans to raise €3.9 billion through the private sector, bringing its core Tier 1 capital ratio to 14%. The merger wasn’t surprising, and more will likely follow as banks seek more private funding. Greek banks face €10 - €15 billion in expected write downs as part of October’s “voluntary” bond swap, and though the government has a €10 billion recapitalization fund, the banks prefer to find private funding solutions before tapping state support.

And private capital appears attainable for merged banks—a decided positive—though further haircuts may eventually require state funds. But Greek bank nationalizations would hardly be earth-shattering. In fact, if mergers continue based largely on private funding, it could be an incremental positive surprise. Greece also needs to secure additional private sector participation in the upcoming bond swap in order for the second bailout to stay alive. As of this writing, they have 70% participation locked in and another month to increase that to 90%. Given progress thus far, they appear to be on track, but there may be additional noise on this front as the deadline approaches.

And though European chatter has heightened overall, we still believe wider euro risks are largely mitigated through 2013, and the EFSF’s current framework provides funding until then. Still, political posturing will undoubtedly continue in the interim, and we wouldn’t be surprised if this stoked further market volatility along the way.