The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.

• The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.

• As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.

• There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.

• The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.

• Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).

• The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).

All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.

When ideology meets economic reality (part III): Germany squabbles over the Financial Transaction Tax

The Bundesbank, The Deutscher Aktieninstitute (DAI), and even EU civil servants from the 11 participating countries have all warned against the FTT in its current form.

Today saw yet another German voice raised again the tax – this time from the very party that is meant to be its greatest champion. Nils Schmid, Baden-Württemberg's Minister of Finance – from the German social democrats (SPD)— wrote a letter to German Finance Minister Wolfgang Schäuble condemning the FTT in its current form as “rubbish.” Ouch.

Schmid’s intervention, says that "If the financial transaction tax is implemented as is currently planned, initial estimates show that it is likely to have a serious impact on certain segments of the market (money and capital)." He then calls for a “proper configuration” of the FTT.

So why is this important? Twofold:  first, it shows that in light of the overwhelming evidence of the negative economic impact of the FTT in its current form, the support for the proposal is quickly evaporating.

This now extends to the German political parties that have strongly endorsed it. Remember, the FTT is one of the SPD’s main campaigning issues, and served as the party’s quid pro quo for accepting the EU fiscal treaty. Although Schmid caveated his position, saying that he is not opposed to the idea of a FTT in theory, the point has most definitely been made.

Secondly, the FTT controversy has legs to become battleground ahead of the German elections in September. It is an issue that may split politics, both, within the parties and on a national level.

Officially, Schmid’s letter was met with a standard diplomatic line from the German Finance Ministry – which says it is taking concerns raised by Schmid and German banks “seriously.” They won’t say so in public, but the German finance ministry was most likely nodding approvingly…

Meanwhile, deputy chairman of the FDP parliamentary group ,Volker Wissing, saw his opportunity to strike – and took it, saying that Schmid's letter shows with which "naivety" and "rose-tinted blindness", the SPD had driven the demand for a financial transaction tax.

So far the SPD have remained stumm on Schmid’s intervention. But watch this space. If influential figures within SPD are the latest to start make noises about this, then surely, the Commission’s proposal cannot stand?

"If you had kept quiet, you would have remained a philosopher" - The Commission utterly fails to address flaws in the financial transaction tax

There's an old Latin saying, "If you had kept quiet, you would have remained a philosopher." Reading the Commission's defence of its proposed EU financial transaction tax (FTT), that phrase immediately sprung to mind. It's not the strongest piece, to say the least.

In our continuing quest for transparency, we have published the Commission’s direct response to the concerns raised by the 11 participating FTT member states (docs which we exclusively published last month).

The Commission's response ranges from weak to capricious to outright ridiculous. For example, when it says that "we're not aware of any credit crunch" in Europe. Right...

Arguably the most worrying part of this response is the tone. The Commission is essentially saying ‘we know better’ than financial markets. For example, in dealing with concerns over the impact of the FTT on short term trading, it suggests much short term trading is often “myopic” and that asset managers which trade predominantly in the short term should be subject to less investor demand in transparent markets, despite the success of money market funds and their importance for liquidity.

Now, 'financial markets' are diverse, far from perfect and certainly not always right. However, the Commission would be remiss to just dismiss concerns raised by governments inside and outside the FTT zone - but also actors from across the business and manufacturing community (in addition to virtually every bank in Europe).

We have long suggested that there are three key areas of concern which will have to be addressed before the FTT can even hope of being implemented without huge market distortions – the extraterritoriality, the impact on repo markets and the impact on government (and corporate) bond markets.

Many of the concerns raised by the 11 FTT states - and the Commission's response - related to these issues. Sorry in advance for the length of this post but here are the key points:

Extraterritoriality

As reported this morning, the Commission argues that a “business case” can be created for enforcing the FTT outside the FTT zone. Essentially, exchanges and clearing houses will be responsible for collecting the tax and if they don’t,  the firms in the FTT zone will not want to trade with them.

This is concerning development for a number of reasons:

• First, it will increase tensions and splits within the single market. Financial firms are unlikely to just roll over and accept this. In fact, given the size of the market outside the FTT zone, they could validly refuse to trade with those inside the FTT zone. In any case, the prospects of a scenario similar to that of escalating protectionism in trade dispute cannot be ruled out.
• It also seems very punitive, using alterations in the legislation (the joint and several liability) to enforce it in areas where the tax has already been rejected.
• This also assumes firms do not move out of the FTT zone to escape the tax. This seems unlikely in the first instance, while not being able to trade with those outside the FTT zone if they do not pay the tax (or having to pay their share yourself) seems to make staying inside even less appealing.

The Commission also accepts that double taxation is a concern. However, the proposed solution of setting up agreements on where the tax will fall, seems unlikely especially in the UK’s case since it has launched a legal challenge against the tax.

Impact on government and corporate debt

The Commission also fails to provide much comfort on the impact of the FTT on national debt and borrowing costs. It admits it has been unable to estimate the impact due to lack of info, but further accepts that “Member States might be better placed to have access to such information.”

This raises two questions:

• First, surely legislating on such a sensitive issue without fully knowing the costs on a key area, with many of countries involved in the midst of an economic crisis, is nothing short of negligent.
• Second, if member states are better placed to judge these issues, why does the Commission and the EU need to take the lead and push such a tax in the first place?

Furthermore, we doubt the concerns over ‘redistribution’ will have been assuaged as the Commission accepts that some money from the trading of government bonds will not go to the country that issued them.

This could be of concern for countries such as Spain, Italy or even France which have huge debt markets but whose debt is widely traded around the world and the EU but international firms. It also seems to punish small countries with less developed financial sectors, since the tax will be paid where the bond is traded firstly with the residence principle only kicking in afterwards.

Possibly more worrying is the response to concerns over the corporate debt market. The Commission seems to brush this off, adding that it is “not aware of any credit crunch” with regards to borrowing for businesses. This is despite the clear survey results showing businesses struggle to access credit in many European countries and the many, many press stories on the issue. It surely cannot argue that given the state of the economy, now is the best time to implement the tax.

Repo markets

As we have highlighted this is an area of serious concern. Unfortunately, the Commission continues to persist with a weak counter-argument insisting that repo markets can be easily replaced by secured loans or lending by central banks (while accepting the short term repo market will be all but destroyed by the tax).

This argument is flawed for numerous reasons:

• The market has access to these other instruments but see repo as preferable, the Commission still insists, however, that it knows better.
• Moving more lending to central banks is not desirable! European policy makers are working hard to restore usual financial markets and move lending off central bank balance sheets.
• Without normal functioning markets, monetary policy cannot have an effective impact, while in the eurozone money will not flow cross border and imbalances will continue to build up (any hope of an integrated banking union would be dead).
• Furthermore, all the risks will be taken onto the central banks’ taxpayer-backed balance sheet – surely this is a terrible form of risk being socialised but profit privatised.
• Secured loans do not provide the same level of legal protection as repos. Since collateral is purchased under a repo, if there is a default the collateral has already changed hands. However, under secured loans the claim would go back into normal (lengthy and costly) insolvency proceedings.

The Commission does raise the point that Repos can hurt financial stability, but surely this is more a case for effective supervision and regulation than taxing the market out of existence.

With widespread talk of the FTT being shelved for at least another year, perhaps it's time for the Commission to just admit defeat?

Where do EU member states stand on bank bail-in plans?

It’s been pretty tough to follow where countries stand on the latest proposals for the EU’s Recovery and Resolution Directive, not least because the debate has lasted three years with people mostly talking past each other.

But the Cypriot crisis has now focused minds and a deal is top of the agenda. The proposal will lay out rules for bank bail-ins and dealing with cross-border banks, while it also links closely with plans for a eurozone banking union. To clear up the differences, we have put together a table.

(The table is broadly ordered by how strongly the country is in favour of uninsured depositor preference and how strongly against flexibility it is. Hence Spain which is strongly for depositor preference and little flexibility is near the top, while Sweden which barely favours a bail-in plan and wants significant flexibility is near the bottom – click to enlarge):

As you can see, there are some big splits remaining. The ECB, Spain, Portugal and France (amongst others) want a clear depositor preference regime – where uninsured depositors are the last to be written down. On the other hand, Germany, the Netherlands and the UK want more equality between senior bondholders and uninsured depositors. Going even further, there are Sweden, Poland and Denmark - which have already clearly defined national schemes which do not fit well with the EU plans for a bail-in hierarchy.

Another area of disagreement is the amount of national flexibility. Sweden, the UK and the Netherlands are pushing hard for flexibility, particularly for non-euro members. This has some backing from Germany. Further disagreements over the timeline for implementation and the level of resolution funds needed remain a bit of a free for all.

The few points they do agree on include: complete protection for insured depositors, a broad bail-in scheme and (somewhat ironically) the fact that this legislation is urgent.

We will keep updating the table as the negotiations develop. There is a lot of talk of compromise but as of yet there is a long way to get there.

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?

“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and,
• using direct or indirect financial leverage.

Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”

Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?

• Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
• There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
• Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
• Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
• IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
• All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.

Thoughts on the EU proposals so far

• The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
• Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
• Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
• This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
• The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
• Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 

As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.

Game on - UK Government launches legal challenge against controversial EU Financial Transaction Tax

It has just been announced that at midnight last night the UK government submitted a challenge against the financial transaction tax to the European Court of Justice. The ground being that it impacts (taxes) firms and individuals located in the UK outside the FTT zone.

We’ve put together a very comprehensive analysis on what this challenge means and what could happen next. Read it here.

Here’s the summary of the key points:

Summary: The UK has today announced a legal challenge at the European Court of Justice against the EU’s controversial financial transaction tax (FTT). Despite the British Government having chosen not to participate in the measure, UK financial firms that trade with an institution in a country that does participate will still be taxed. This, the UK claims, violates EU law and is inconsistent with international tax norms.

The economic, legal and political implications of this move for future EU-UK relations are huge. As currently drafted, the tax could cost fund managers (UCITS) based outside the FTT-zone around €5.6bn while one third of all derivatives trades in the UK could be caught by the tax. Legally, it could set out the parameters for how a “flexible Europe” involving different levels of participation in the EU – which Prime Minister David Cameron has said he champions – will be governed. Politically, it’s a test of the extent to which the UK – as a non-eurozone member - can halt or change EU measures with a profound impact on its national interest. Therefore, it will be a key issue in the on-going debate about the UK’s continued EU membership, though other EU countries have also expressed concerns about the impact of the tax.

Some more signs of financial market fragmentation in the eurozone?

The European Repo Council of the International Capital Market Association (ICMA) released its bi-annual assessment of the European repo markets today. Admittedly, not the most exciting of intros but the survey does contain some interesting points regarding financial markets in the eurozone. As a reminder, repo markets are the main source of short term funding for banks (or at least they should be if markets are functioning normally).

The report highlights that repo funding fell by 11.9% during 2012 (based on a standard sample size). Interestingly, the fall slowed significantly in the second half of the year – there was only a 0.9% drop in the market from June to December. This is likely to have been down to the creation of the ECB bond buying programme, OMT.

There are a few other interesting points and conclusions which can be drawn from the report:

• As of the start of this year, European banks remain heavily reliant on ECB funding. The LTRO repayment has shown this has decreased somewhat. However, as we previously noted, if the repo market does not pick up the slack then we could see a de-facto tightening of monetary policy (the opposite of what the ECB is trying to achieve).
•  There is some evidence of an increase in cross border repos up from 48.1% to 50.5%. However, importantly, cross border repos between eurozone only countries remained steady – suggesting significant market fragmentation remains in the eurozone.
• The share of transactions which we were for a maturity of a year or more dropped from 13.3% in June to 5.9% in December, suggesting banks filled much of their long term financing needs at the ECB LTRO. This will be an interesting indicator to watch in the next survey to judge the impact of LTRO repayments.
• The ICMA also go to lengths to highlight the threat of the financial transaction tax (FTT) to the repo markets.
• Government bonds, especially from core eurozone countries, remained a key source of collateral for repo transactions. In fact, the use of German government bonds as collateral increased sharply. Usually, this would be seen as a sign of risk aversion and a flight to safety (i.e. negative for the prospect of recovery), however, ICMA suggests this is actually a positive sign since previously these bonds were being hoarded to improve balance sheet safety. Still, the over-reliance on core government bond highlights the shortage of safe assets in the eurozone and should be taken into account when considering why borrowing costs have remain low despite increased tensions in the eurozone once again.

Overall the survey seems to confirm fears that fragmentation remains in the eurozone financial markets, as does over-reliance on the ECB - at least up to the end of 2012. The real question is whether this has been reversed at all at the start of this year. Unfortunately, we’ll have to wait until the September survey for a conclusive answer on that point.

EU tightens the noose on bank bonuses

As we noted in today’s press summary, a tentative EU deal was struck last night on bank bonus curbs, as part of the broader agreement on CRD IV (which implements Basel III). We’ve discussed this in detail before, so we refer you to that post for the background.

The deal looks much as expected, although a couple of changes have been added:

• Bonuses should be limited at a 1:1 ratio to salary, which can rise to 2:1 with explicit shareholder approval.
• Up to a quarter of variable pay can be discounted and issued in instruments deferred for more than five years, which could increase the ratio above 2:1.
• Bonuses in the form of long term equity or debt that can be bailed in if a bank fails will also be given more favourable treatment.

Surprisingly, the deal still includes plans to force subsidiaries of foreign banks in the EU to adhere to the bonus rules and, more importantly, forcing all subsidiaries of EU banks in the rest of the world to do so. This could hamper competitiveness and, we suspect, may still be subject to changes. This is also an area where the UK might have expected to receive a concession.

What happens now then? EU finance ministers meet next week and will discuss the proposals. Significant changes seem unlikely, which could mark a loss for the UK, which has vehemently opposed the rules from the start.

The real question for the UK is whether it should try to force a formal vote on the issue at the meeting of finance ministers. This would raise the prospect of voting down the UK on a financial services issue – that this has never happened before is often cited by the EU as a counterargument against UK concerns over EU financial regulation. If the UK is outvoted it would mark a potentially significant precedent for the UK's future relations with the EU.

It should be remembered though that this is only a small part of the large CRD IV package, which has been continuously delayed due to MEPs' demands for bank bonuses to be included. The UK has managed to secure favourable treatment on the key aspect of the legislation – the ability to adjust national capital requirements for banks.

As we have suggested before, the debate on bank bonuses seems slightly tangential in terms of the wider debate over bank capital and broader financial stability (indeed there are valid question about why it has been lumped in with CRD IV at all). For all the talk of needing bank bonuses to limit risk taking and moral hazard in banks, the EU has supported and approved €1.6 trillion in state aid to banks over the course of the financial crisis. Many countries have pushed for limits to capital requirements and supported the easing of the Basel III liquidity controls. The EU, and the eurozone in particular, has also consistently argued for and supported bank bailouts and refused to countenance imposing losses on bank creditors, instead shifting the burden to taxpayers.

Trying to limit moral hazard by tackling excessive bank bonuses is all well and good, but it is a drop in the ocean when it remains clear that states and central banks will continue to bailout banks at any cost.

Do the Cypriot elections pave a clear path to a Cypriot bailout?

How big of a problem can a country accounting for 0.2% of eurozone GDP possibly be? Well, potentially pretty big it seems.

As expected Nicos Anastasiades, the centre right candidate, was yesterday elected President of Cyprus winning 57.5% of the vote in the runoff election – the highest vote share in 30 years. Anastasiades, along with other eurozone leaders, has said he is keen to move quickly towards finalising the Cypriot bailout which was first requested in June 2012 – meaning it has been in the pipeline for 8 months. Usually the fresh election of a reform minded government with a large majority paves a clear path for a bailout. While, it is true that the previous communist President Demetris Christofias has been an obstacle to finalising a bailout by refusing to countenance any privatisations, the path to a bailout is still littered with hurdles.

The first hurdle is the banking sector which needs a massive recap of €10bn (50% of GDP). Over the past decade it has swelled to seven times the size of Cypriot GDP, mostly off the back of a huge inflow of foreign (mainly Russian) money attracted by the low tax rate and reported lax financial regulation. Unfortunately, despite requiring a significant restructuring and overhaul, for which taxpayers should not foot the bill, there is a very limited amount of bank debt to ‘bail-in’ (circa €3bn against €128bn of assets). This leaves few options. One is writing down depositors, although the threat of contagion and the unprecedented nature of this means it remains someway off for now.

The second issue is fiscal. Cypriot debt has been increasing rapidly, already standing at around 84% of GDP. Adding the burden of a €17bn bailout would take it to 140% - far from sustainable. However, restructuring the sovereign debt is not much easier than the bank debt. Around half is issued under UK law, meaning the Cypriot parliament cannot simply pass a law restructuring it (as Greece did). The other half is predominantly held by shaky Cypriot banks making any write down counterproductive as these banks would simply need an even larger recapitalisation. The rest takes the form of official loans to EU countries and institutions – unlikely to take losses, as Greece has proven.

The confluence of the above problems ultimately makes this a very tricky political decision. The Cypriot bailout and the presence of large Russian deposits and lax financial regulation (in Germany’s view at least) is now becoming a topic in the upcoming German elections. As we noted in today’s press summary, a DPA poll over the weekend showed that 63% of Germans are opposed to a Cypriot bailout whereas only 16% are in favour. The SPD has also made this a point on which to differentiate themselves from the governing CDU. On the other hand the politics in Cyprus are also tricky. Many in the country are expecting a show of solidarity from the eurozone given that half of the bank recap needs are a result of Cyprus wilfully taking part in the Greek debt restructuring. And is Cyprus really systemically important, given its tiny size? Many would say it is not, however, as the problems above highlight there is substantial potential for contagion, not least because any radical solution would challenge the view that Greece is “unique and exceptional”.

Taken together, this represents a minefield of issues to negotiate when formulating the Cypriot bailout. Unfortunately, the technical and legal challenges balanced with the fragile turnaround in the eurozone mean that at this point in time it looks likely that eurozone taxpayers will be forced to foot the bill once again – albeit with very strict conditions and a significant financial overhaul. Potentially the most worrying thing about this bailout is how familiar the problems all seem. The banking issues are similar to those in Ireland and Spain, the fiscal challenges to those in Greece and the political ones, well, to everywhere. One thing that the Cyprus issue makes abundantly clear is that the eurozone lacks any new tools to overcome these very familiar problems. Of all the issues mentioned above, that may be the most ominous for the future of the euro.

Another positive step for Ireland?

Well we finally have a deal on one of the longest running sagas in the eurozone crisis – the Irish promissory notes deal.

See here for some good background on the whole issue.

Key points of the deal (from Irish PM Enda Kenny’s speech):

·         Last night the Irish Bank Resolution Corporation (IBRC, formerly Anglo Irish bank) was liquidated. The loans it had taken from the ECB through the Emergency Liquidity Assistance (ELA) were therefore terminated and the Irish Central Bank (ICB) took control of the €25bn in promissory notes and the €3.4bn for the most recent interest/principal payment.

·         The Irish government has agreed to swap these notes for 40 year Irish government bonds.

·         The principal repayments will take place between 2038 and 2053. The average interest rate will be 3% compared to 8% on the promissory note.

·         The Irish National Treasury Management Agency (NTMA, which owns NAMA and formerly IBRC) will see its borrowing requirement over the next decade fall by €20bn. The Irish government deficit will be reduced by approximately €1bn a year.

Essentially then, the IBRC was wound down, allowing/forcing the ICB to take control of the promissory notes which were used as collateral for the ELA which it had been providing, in turn allowing the IBRC to continue servicing its bondholders, depositors and any other obligations. It was then agreed to swap these notes for the longer dated lower interest ones.

It seems to be a fairly reasonable idea and a good work-around of a tricky situation. It certainly provides a reduction in the burden with a much lower interest payment and no principal payment for some time.

The main ECB concerns were: monetary financing if the collateral was allowed to be swapped for lower value (longer dated collateral), the further write-down of bondholders and setting a bad precedent for other eurozone members. Most of these have been addressed, although there are a few issues outstanding:

The first issue was mainly a concern while IRBC existed. That said, if the ICB took control of the bonds when the ELA was terminated as the IBRC was liquidated, why were they suddenly willing to exchange them for the new bonds? Surely, these longer dated lower interest bonds have a lower net present value than the previous promissory notes? This may be because the ICB and the Eurosystem tend to hold such assets at nominal value, but it’s hard to argue that the ICB hasn’t taken a loss in some terms.

The second seems to have been dodged as the remaining liabilities will be covered by the Deposit Guarantee Scheme and Eligible Liabilities Guarantee Scheme (see FT Alphaville here for more details) and transferred to NAMA. That said, the role of NAMA now that the ELA has been terminated isn’t clear. Will it still finance these liabilities, if so, how? Surely, it would need to use the new bonds to borrow from the ECB to finance the remaining IBRC liabilities. This isn’t an issue as such, but needs clarification since it impacts: who is holding the new bonds, what interest is being paid and who it is paid to.

On the third issue, the ECB seems to accepted that this is a fairly special case and that setting a precedent is not much of a concern – or is at least less of a concern than the consequences of not giving Ireland a deal on the promissory notes.

A few remaining issues then, but nothing major and no deal breakers – although the monetary financing issue could potentially flare up in our view.

Ultimately, some deal was needed on this front both to reduce the impact of financing the Irish bank bailout on the Irish budget and to maintain political support for the extensive reform programme being undertaken in Ireland. Another positive step in the recovery of the Irish economy it seems. That said, the deal does not succeed in significantly reducing the overall cost of the Anglo Irish Bank bailout and the cost of the bank bailout will continue to weigh on Irish debt - i.e. plenty of challenges remain.

Easing of the Basel III rules - a test case on conflicts of interest?

A lot has been written over the past few weeks regarding the easing of the Basel III banking rules, which we've been meaning to cover but didn't get round to doing.

The specifics and details have been well covered so instead we'll look at some of motivations behind the changes. In our view, the change provides an interesting insight into the potential conflicts between monetary policy and financial supervision – something we have discussed at length with regards to the ECB being turned into the single financial supervisor for the eurozone (see also Felix Salmon’s blog for a wider discussion of this issue).

The changes, which are fairly technical and complex, focus on easing the burden of banks in creating what is known as the Liquidity Coverage Ratio (LCR). This is essentially a liquidity buffer which banks will be required to hold to ensure that they have enough cash (or cash like assets) on hand in a crisis to cover themselves for 30 days. The time frame in which the banks must have this buffer in place has now been increased by 4 years as well.

Again we won’t go into the detail of whether this change undermines the attempts to make banks safer but we would highlight that many banks already meet the adjusted standards, albeit with significant support from central banks (a point we’ll expand on in second) – given the on-going banking troubles in Europe and the US this is naturally a concern.

Monetary policy vs. financial regulation

More interesting from our perspective is the motivation for this change. As Bank of England Governor Mervyn King said:

“Most banks are completely overflowing with liquid assets…[Which] reflects the way in which central banks around the world have expanded balance sheets to provide economic stimulus. That won’t always be the case in the future.”

“Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.”

So it seems that the ultimate motivation for the move is to make it easier for central banks to remove themselves from non-standard monetary policy measures (such as QE or the LTRO) without fearing a massive drop in lending.

Clearly, both these concerns fall into the realm of monetary policy, rather than supervision or regulation. Obviously, a collapse in bank lending would be bad for everyone, so the measures are tied to some notion of short term financial stability, but surely these comprehensive Basel III regulations – which will set the basis for financial regulation over the next decade or more – should be taking a much more long term view than this. There are very real concerns that in the long term this could hamper the safety of banks and their ability to withstand future crises without taxpayer help.

A further motivation for the changes seems to be an attempt to encourage demand for a wider variety of assets by allowing them to be held as part of the LCR. Again this is all well and good, but it is the job of monetary policy to manage such demands and should not become ingrained in long term regulation. It is hard not to see this as a sop to the current crisis and immediate economic problems. (On the other hand we would note that this does help ease concerns that the requirements for banks to hold more sovereign debt would worsen the sovereign-banking-loop, although again increasing the risk on banks’ balance sheets is not a desirable trade-off.)

As mentioned above, the easing of regulations may make it much easier for central banks to exit their non-standard monetary policy measures without causing market distortions. The lack of a clear exit strategy is something which we have continuously warned of within regards to greater ECB intervention and the problem still applies. Obviously, finding the best way out is important but not at the expense of a safer banking system. Furthermore, taking such substantial action, such as that seen during the crisis, should not be done lightly and altering regulations to ease the potential problems or side effects of such actions could lead to a situation where the final cost of such actions are not fully considered. It is not hard to imagine similar pressure being applied to the ECB’s monetary policy, particularly if the eurozone crisis escalates again, while easing supervision would provide an easy out rather than managing the imperfect one size fits all monetary policy.

We must note that these regulations are produced by the Basel Committee and the BIS, not the ECB, so it is far from certain that the ECB will act in a similar way (although many of the central bankers involved do overlap). Additionally, the ECB will not be directly responsible for regulation but supervision, although there is substantial flexibility within this bracket and the people involved will still have a large say on regulation at the European Banking Authority (EBA). 

Our main point is that there will be very similar pressures and very similar powerful lobbies, which seem to have had a substantial impact here. This of particular concern for the ECB, where the Chinese walls could well prove insufficient, with the ultimate power for both supervision and monetary policy residing with the Governing Council.

We would suggest the previously mostly theoretical conflict of interest between financial supervision/ regulation and monetary policy just got a little bit more real.

A vote of confidence? Banks start repaying ECB long term loans

This morning saw the start of the on-going process of repayments of the loans given by the ECB to European banks under the Long Term Refinancing Operation (LTRO) (see here for details).

The ECB announced that 278 banks have already pledged to repay €137.2bn. This compared to the 523 banks in total that borrowed around €190bn in net liquidity from the first LTRO at the end of 2011. The amount repaid was above expectations – below we assess why this may have been and what it could mean for the eurozone.

Why have banks decided to repay so much so early?

- A big motivating factor is reputation. It is clear that banks which repay early can highlight that they have access to market funding at low levels and have a sustainable business model.

- Although the loans seem cheap with the low ECB rate they require lots of collateral (to which haircuts are applied). This cost mounts up and some banks (particularly in northern countries) can now borrow on the markets more cheaply. ECB funding is also secured (against the aforementioned collateral) this ties up lots of banks assets, many may prefer to seek unsecured market funding, even if it is a bit more costly.

- Having huge amounts of excess liquidity just parked at the ECB is not efficient or effective. It also distorts bank balance sheets and may detract from other goals such as deleveraging or recapitalisation (more on this in a minute).

What does this mean, if anything, for the eurozone?

- There are fears over a two-tier banking system between those stronger banks funding themselves on the market and those reliant on the ECB. We would add that this furthers the divergence in the eurozone since the split is broadly along the existing strong/weak country divides.

- If the move is to aid banks in deleveraging this could perversely have a negative effect on the eurozone, with banks decreasing lending and reducing demand for euro (particularly peripheral) assets.

- That said the net impact on liquidity is limited, with excess liquidity in the system still at almost €700bn. It may need a further €200bn to be removed before the impact is substantially felt in terms of borrowing costs and demand for assets in the eurozone.

- There could well be a confidence boost from the higher than expected repayment. However, if this furthers a strengthening in the euro there could be growing concerns that it could begin to hamper exports in the weaker economies (a key driver of growth when both public and private sector are limited spending). This also furthers tensions within the one-size-fits-all monetary policy.

So, there are some clear reasons for repaying the loans early, although what it means for the eurozone and the impact it could have is far from clear (this is partly because the actual impact of the LTRO beyond helping banks fund themselves is far from clear). 

One more thing: many analysts are now making a song and dance about the reduction in the size of the ECB balance sheet - seeing it as a great positive. Which it is of course. But strangely, the same people always made the point that the ECB's expanding balance sheet, really wasn't that importance. So which is it?

In any case, as we said at the start, this is a rolling process and the full impact will not be clear for some time. The most important point to watch now is the location of the banks which announce that they have repaid. If it turns out to be solely northern banks, we could see some divergence emerging in the banking system, at just a time when eurozone 'bank union' plans are trying to unify it.

Draghi getting ahead of himself: are we really seeing a “normal situation” in eurozone financial markets?

In his monthly press conference on the 10 January 2013 ECB President Mario Draghi struck a relatively upbeat tone on eurozone, in particular arguing that the eurozone was returning to a “normal situation, from a financial viewpoint”. Don’t get ahead of yourself there, Mario.

True, he also warned against a slowdown in fiscal consolidation and structural reforms due to political complacency, but hinting that we’re now back to a normal finacial market situation seems particularly premature.

Firstly, to state the obvious, the ECB is still massively propping up the financial system in the eurozone. The ECB balance sheet stands at a massive €2.96 trillion up from around €1.5 trillion at the start of 2008. The ECB’s liquidity provision to banks across Europe has slowed in recent months but it remains exorbitantly high, to the point where many banks (particularly in struggling countries) are almost exclusively relying on the ECB for funding. In fact ECB exposure to the PIIGS totalled €1.08 trillion in November 2012. This is by no means normal (or at least shouldn't be).

There is also still significantly limited activity in the interbank lending market, with overnight volumes still near record lows (click graph to enlarge).

Data from the BIS also highlights that longer term bank lending and investment from stronger to weaker states continues to be dramatically below its peak (click to enlarge).

There are many other indicators, such as the limited lending to both businesses and households across the eurozone and the divergence in borrowing costs within different economies (for corporates as well as sovereigns).

Still, the situation in the Eurozone has clearly improved. Some factors, such as the capital outflow from southern to northern countries, have stabilised while others, such as the outflow of deposits from certain banking systems, have shown positive improvement. But we are still miles from being in what many would regard as a “normal situation”.

So when can we expect a “normal situation” to return? Well, with interbank channels having been absent for so long it is hard to expect a rapid turnaround. The ECB is also not expected to exit its massive liquidity provision anytime soon (and even when it does, it will likely be a gradual process), so this will continue to dictate the market. Plenty of other factors (economic growth, unemployment, social stability) also continue to fuel imbalances in the eurozone, so don’t expect cross-border lending or investment in struggling eurozone economies to return to pre-crisis level in the next few months or even years.

This is where the banking union is supposed to come in. However, as we have noted before, the current plans don’t a cross border backstop or a cross border resolution structure for failing banks, for example, so won’t really help in that respect.

Unfortunately, Draghi’s prematurely upbeat comments may have the perverse effect of encouraging the kind of political complacency which he warned about later on in his press conference.

ECB's Chinese wall still full of holes?

We've had a look at the latest compromise proposal to turn the ECB into the eurozone's single banking supervisor. It has been put together by the Cypriot Presidency in a bid to finalise a deal at today's meeting of EU finance ministers. Below are some of our initial thoughts (we may update in due course).

Arguably, measures aimed at reaching a clear separation between the ECB's monetary and supervisory tasks - Germany's main concern - are the most interesting part. This is what the proposal under discussion says:

Composition  of supervisory board
Chair (can’t be a member of the ECB Governing Council)
Vice-Chair (is a member of the ECB Executive Board)
3 ECB representatives (with voting rights, but can’t perform ECB monetary policy-related duties at the same time)
National supervisors of participating member states – i.e. including non-euro countries that want to join

Decision-making 
Simple majority (Chair can cast vote in case of draw)
QMV for regulations on matters “having a substantial impact on credit institutions” – although there is no clear definition of what “substantial” impact is or who determines it.

What does the Supervisory Board do? 
Tables draft decisions and submits them to ECB Governing Council for adoption, “pursuant to a procedure to be established by the ECB” – so the details have yet to be fleshed out. Governing Council has up to ten days to object to draft decision, but has to give written justification – and is encouraged to voice any monetary policy concerns in particular.

If a decision taken by the Supervisory Board is changed following objections by the Governing Council, a non-euro country can express its disagreement (a safeguard, given that non-euro countries don't sit on the Governing Council).The country also can notify the ECB that it will not abide by the relevant decision if it is still not happy with the outcome. However, in this case the ECB will "consider the possible suspension or termination of the close cooperation with that Member State" - so if a country objects to a single proposal it runs the risk of being excluded from the banking union.

This draft then, contains some progress on the make-up of the boards and a bit more in terms of how they will interact, but the crucial decision making process still lacks some detail. Particularly over the exact interaction between the Governing Council and the Supervisory Board if the Council objects to a proposal.

It is also clear that ultimate power resides with the Governing Council and although non-eurozone countries do have somewhat of a get-out-clause, the separation between monetary policy and financial supervision still seems limited. (As we suggested would always be the case due to the legal constraints).

Much work to be done, especially on the finer points.

Looking to the New Year?

With trouble flaring up in Greece once more and the backstop of the ECB’s bond-buying (OMT) in place, Spain has slipped off the radar slightly. It now seems likely that any request for a sovereign bailout (of one form or another) will be pushed back until the New Year.

However, interestingly, Spain returned to the debt markets this week despite having its funding costs covered this year. It successfully sold almost €5bn worth of short-term debt on Tuesday and almost €3.9bn of medium and long-term debt yesterday.

This could mean many things, not least that the Spanish government is concerned about its cash position or the potential for unexpected costs (a regional or bank bailout for example), but we’re willing to give Spain the benefit of the doubt and see it as prudent planning to get a head start in covering its funding needs next year. This comes as somewhat of a relief given that gross Spanish funding needs could run between €150bn and €200bn next year.

On a separate, and slightly less positive note, the European Commission has, in a working document, questioned why the Spanish government has, in substance, refrained from intervening in those Spanish regions which are "clearly at risk of missing their fiscal targets in 2012" - despite legislating earlier this year to give itself such power? It is an interesting question, we would hazard a guess that the Spanish government is not ready to face the political consequences of such an action.

We can’t exactly blame them on this front but it raises the question of where their threshold is and what the repercussion of such an action would be.

As per usual from Spain then, a bit of a mixed bag, but at least it seems to be planning for next year. Now if only it took a longer term approach to its banking sector and labour market reforms…

IMF weighs in on the debate surrounding the ECB

There’s been another interesting report put out by the IMF today in the form of its ‘Article IV consultation on the euro area’ (essentially an economic assessment of the eurozone).

The IMF was particularly vocal on the role of the ECB stating:

“Because inflation is low and falling, the ECB has room for lowering rates, and deploying additional unconventional measures would relieve severe stress in some markets.” 

They’re not wrong there, any conventional inflationary pressure for the eurozone as a whole is definitely abating. But the policy implications of such a move are important. The IMF itself puts forward some alternatives, including:

Further liquidity provision. This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed—including a broadened collateral base and/or a lowering of haircuts—to address localized shortages. The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links (see Box 5).

Quantitative easing (QE). The ECB could achieve further monetary easing through a transparent QE program encompassing sizable sovereign bond purchases, possibly preannounced over a given period of time. Buying a representative portfolio of long-term government bonds—e.g., defined equitably across the euro area by GDP weights—would also provide a measure of added stability to stressed sovereign markets. However, QE would likely also contribute to lower yields in already “low yield” countries, including Germany. 

As you’ll notice both recommendations come with clear caveats – strengthening the sovereign banking loop with the LTRO and the fact that QE would need to be spread across the entire eurozone. We’ve discussed both at length on this blog and in our research but a refresher never hurts.

The LTRO has certainly driven the sovereign banking loop much closer, engraining this connection at the heart of struggling economies (far from ideal) while encouraging the nationalisation of financial markets once more. All this prompted the well-known and incredibly complex banking union discussion. The IMF also notes a further problem with more LTROs, asset encumbrance. A complex issue but essentially banks are running short of quality assets to post as collateral to borrow from the ECB (see graphic below). So even if further LTROs were offered they may not be able to take advantage of them. If the ECB went down this route and faced this problem it would have little choice but to widen its collateral rules or reduce the valuation ‘haircuts’ (which decide how much banks can borrow against certain collateral) thereby taking even greater amounts of risk onto its balance sheet.

 
In terms of QE we’d point you to our report from December and the table below. Ultimately, it would have to be a huge spate of QE to provide enough of a boost to the countries in trouble, but that would also create a huge amount of money flowing into countries such as Germany (which is already concerned about an asset and property bubble).

We’ve argued before that a more significant role in the crisis for the IMF wouldn't be the worst thing in the world. Generally it has provided a more realistic assessment of the situation. Unfortunately, in this case, the problems outlined above are only the technical ones relating to a greater role for the ECB, the political obstacles remain almost insurmountable in the short term. As with the UK government, we’d recommend the IMF engage but avoid spending too much time of policies which are politically nearly impossible and technically challenging.

Bad news for Italy and Spain from the IMF

The IMF released a few new reports on the global economy today and a raft of new data. There is plenty of interesting stuff in there which we are still pouring over, but a couple of graphs caught our eye straightaway.

First up is a graph from the IMF's Global Finacial Stability Report (update) looking at the now infamous Target 2 imbalances in the eurozone. We've steered clear of this debate for the most part recently, but the graph (below) very clearly highlights an interesting phenomenon:

The chart demonstrates the huge level of capital outflows from Spain and Italy at the start of this year. This is mostly a result of investors and depositors pulling funds out of these countries and moving them into alternative assets, often in northern European countries. The latter fact is confirmed by the ensuing increase in Target 2 imbalances, suggesting this money is moving to elsewhere in the eurozone 'Eurosystem' but has yet to be settled (as is the nature of Target 2). The importance of this movement shouldn't be underestimated. It speaks to the increasing sovereign bank loop as domestic banks step in to cover the outflow of capital, raiseing questions over how long these governments can issue debt if investors are so intent on pulling capital out of the country. It also makes one wonder over the stability of banks (especially in Spain) if they are facing deposit outflows and lowered demand for their financial instruments from foreign investors. In other words, a worrying graph for these countries.

The second interesting graph comes from the IMF's Fiscal Monitor and it provides no less of a worrying picture for Spain:

Specifically the table suggests that the IMF does not now believe that the level of Spanish debt will stabilise within the next five years. That is significant - the IMF is now predicting that Spain will face a further five years of an increasing debt burden. It also confirms our macroeconomic predictions in our recent report on the Spanish bailout and the potential negative impact it could have on Spanish debt sustainability (at the time seen as overly pessimistic by some):

Not much good news for Italy or Spain (alas, as per usual). With the 20 July meeting now looming large some definitive answers are needed, at least in terms of the Spanish bailout.

A great way to run down a bailout fund?

Ahead of the summit today the proposals for the EFSF/ESM to start purchasing sovereign debt began rearing its muddled head again, with some indication that this is actually one of the few things that could be agreed at the summit. We hate to be party poopers but as we have already noted (at length) this is a confused idea and will likely provide little help relief to those countries embroiled in the eurozone crisis. Below we outline some of our key concerns with the plan:

• The capacity will be tested: this role was previously filled by the ECB. Markets know that the ECB can provide an unlimited backstop and will rarely test its resolve in keeping yields down. However the EFSF only has around €250bn left, while the ESM has a lending cap of €500bn (as we have shown though this will also not be fully operational for some time). In any case markets are likely to test the resolve of these funds, meaning they may spend more than is needed and may be less effective than the ECB was. 
• Will deplete the funds of the EFSF/ESM: further to the point above, the money in the bailout funds will be severely depleted reducing the capacity for them to fully backstop countries which may need full bailouts. Particularly a worry if Portugal needs a second bailout, Greece a third and Spain possibly a full one on top of its bank rescue package. 
• Subordination: if ESM purchases bonds other debt of the recipient countries will become junior. This increases market jitters. Would be less of a concern if these purchases solved any of the issues but they only simply delay them at best.
• Secondary market purchases: if the buying is on the secondary market, the benefit is limited in terms of countries actually being able to issue debt. Still rely on domestic markets and the sovereign-banking-loop in problem countries may become more entrenched. 
• Primary market purchases: if done in primary market, then this will be a direct transfer between countries and could lay the groundwork for debt pooling, something which could cause political outcries across northern Europe. 
• Risk transfer: holders of peripheral sovereign debt will likely see this as an opportunity to sell off their holdings at a higher than expected price, shifting risk to the eurozone level. 
• De facto Eurobonds: the funds will issue bonds to raise money to buy debt off struggling countries. Building on the two points above, this means that investors will sell national debt and buy European backed debt, again essentially creating a de facto European bond and debt union. 
• Conditions: must come with clear conditions otherwise could be self-defeating (removes incentive to reform). Furthermore, if, as is currently the case, countries must enter an adjustment programme to allow the EFSF/ESM to buy its bonds, there could be significant stigma attached (again reducing the benefit).  It could also mean other countries picking up the slack if a government does not properly implement its own fiscal policy (however, without a clear say on the spending programmes).

All in all then, a very mixed bag. At best this plan could provide some temporary relief to high yields but the side effects could be large and frankly these funds just aren’t big enough to fulfil this role (and their other roles) on a consistent basis. Besides, even if some time is bought they are still yet to outline to what end it would be used – better then to agree on this before starting to run down the one of the few backstops still in place to the eurozone crisis.

Are the rumours of a new(ish) eurozone backstop true?

The press have got very excited over suggestions from European leaders at the G20 meeting in Los Cabos, Mexico, that they will activate the EFSF to buy eurozone government bonds from the secondary market in an attempt to reduce borrowing costs for Italy and Spain - a function which the fund has always had but has never been used (since the ECB has filled this role with its bond buying programme). Berlin has already moved to deny this, but there could be truth in it - not least because it's legally possible but also because we've seen over the past few weeks that the ECB has refused to buy bonds despite the persistent rise of Spanish borrowing costs. It has become increasingly clear that Spain cannot withstand these interest rates for long - something needs to  be done.

If true, this could prove a important change. Despite always being possible, bond buying from the EFSF has up until now only been theoretical. When it comes to the unenviable task of backstopping Spanish and Italian government debt, the ECB has now officially passed the buck to eurozone governments. Over the last two years, the ECB has effectively managed to manipulate government bond yields by buying a limited amount of government bonds – some tens of billions a month at its peak (although with mixed success). In August last year, for example, the mere willingness of the ECB to buy Italian government debt may have prevented a full-scale run on that country as political uncertainty ran wild. But there’s a key difference between the ECB and the EFSF – while the former has deep enough pockets to move markets, the EFSF’s lending capacity is inevitably limited, meaning that making it into a lender of last resort for a country the size of Spain (let alone Italy) could prove risky. The ECB could stand behind Spain and Italy with, at least in theory, the ability to massively expand its balance sheet and thereby quarantine these problem countries. But the EFSF only has €250bn left to lend – to top up its lending capacity, it will need to pass 17 hostile national parliaments, which ain’t gonna happen anytime soon.

This is to say that, if the buck has indeed been passed from ECB to the EFSF, then the Eurozone’s firewall just became a lot weaker - many have rightly previously questioned its capacity to purchase bonds and fund lending programmes to struggling countries simultaneously. Furthermore, the EFSF treaty states that secondary market intervention can only take place at the request of the recipient country and will come with some conditions (although probably not a full reform programme). Clearly this will come with significant stigma (once you go down the path of any external aid it is hard to return, as Spain is now finding out), while it is hard to imagine a country signing up to extra conditions just to manage its secondary bond market (especially since the ECB was previously doing this without any clear conditionality).

There are additional questions over what this means for the permanent eurozone bailout fund, the ESM, which is meant to be up and running this summer. Presumably, it will have to take over this bond buying role once it comes into force. The same problems apply here as do with the EFSF, but the ESM is also senior to other debt, meaning that as it buys up debt of a country other holders of this country's debt become subordinated - this can result in further market uncertainty making it counter productive. Ultimately, if the ESM is to serve as a lender of last resort in any way, it almost has to be equipped with a banking license in order to allow it to lend and borrow freely, without being hostage to national parliamentary politics or very limited in size. Giving the ESM a banking license is a hot potato in Germany, but will Berlin have any choice if the markets start to question the firepower of the fund?

On the current path, presenting the EFSF/ ESM as lender of last resort – for Spain in particular – but without equipping it with the cash to actually allow it to fulfil this function, could set the stage for a showdown between markets and the funds - in that scenario we can only see one winner.

Do not adjust your television set, this is not a Spanish rescue (despite looking an awful lot like one...)

Well, that was the line that Spanish Economy Minister Luis de Guindos was spinning yesterday. Sorry Luis, this is essentially a Spanish rescue - external funding sources filling a gap which the state can't (check), monitoring of a large chunk of the economy (check), involvement of all the big international organisations (check - EU, IMF, ECB etc.), the list goes on.

Meanwhile, the oft absent Spanish Prime Minister Mariano Rajoy held a press conference today, declaring the package a 'victory' for the euro and stating that if it were not for the current government's reforms it would have been a full bailout package. If this is a victory (finally dealing with a glaring problem after four years) then we don't want to see a defeat, but at least Rajoy made a public appearance this time. That said, in the midst of the worst crisis his country has faced since the financial crisis hit, Rajoy is now jetting off Poland to watch Spain vs. Italy (a mouth watering prospect admittedly but his timing could take some work), while the likes of the Education Minister are heading to Roland Garros to watch Rafael Nadal - the Spanish government not quite in crisis mode then, we're not sure if that should inspire confidence or not...

In any case, as we predicted over two months ago, European assistance to help Spain deal with its banks is now official, so what does this rescue mean for Spain and the eurozone, below we outline some of the key points and our take:

The plan
Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the bank restructuring fund) but will still be a state liability (it will not go directly to the banks). However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector.

Open Europe take:
Firstly, the ESM will not be in place in time to provide the loan (the treaty is yet to be ratified by numerous countries and has faced many delays) so at least initially it will come from the EFSF. As others have pointed out, this is important because ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with (as it removes the threat of legal challenges based on clauses in other Spanish sovereign debt which could be triggered if it suddenly became junior), however, Finland has already raised concerns over its exposure and role in the rescue - an issue we tackle in more detail below.

The lack of additional fiscal conditions is fair given that Spain is already subject to a deficit reduction programme and that this is ultimately a financial sector problem. There are questions over conditionality and moral hazard though - we would like to see bank bondholders and shareholders sharing more of the burden (bail-ins) to ensure the necessary reforms take place. As things stand its hard to see how the banks will 'pay' for this capital, particularly given the Spanish regulators previous failures (during and after the property bubble).

De Guindos confirmed that the funds would be counted as Spanish debt, so Spanish debt to GDP could be about to jump by 10% in the near future and given its current path this could put Spain over 90% debt to GDP (the level beyond which sustainability becomes questionable) much sooner than had been anticipated. This will require adjustments in its reform programme and lead to increasing market pressure.
 
Size - is it enough?
This is the key question - the total amount has been put at "up to" €100bn. That is much higher than was suggested by the IMF assessment released on Friday night, which suggested €40bn.

Open Europe take:
It sounds like a big number, but upon closer inspection it may not stretch as far as many expect. Consider that Bankia requires €19bn, while three other very troubled cajas need around €30bn (Banco de Valecia, Novagalicia and Catalunya Caixa) meaning half the money could already be eaten up, leaving only €50bn for the rest of the huge banking sector.

This compares to around €140bn in doubtful loans, and a total €400bn exposure to the bust real estate and construction sector. Doubtful loans to this sector total around €80bn currently, but we expect house prices to fall by a further 35%, broadly meaning that the number of doubtful loans could easily double. On top of this we have further losses on mortgage loans as well as losses on other corporate debt and a decrease in the value of Spanish debt held by banks. So huge number of issues - putting a clear figure on it is difficult due to the difference between tier one capital and 'loss provisions' (tier two capital). But even if this €50bn is given in tier one capital and stretched to increase provisions its hard to see that it will be enough given the huge exposure to mortgages and the bust sectors, especially at a time when growth is falling further and unemployment continues to rise.

Finland and Ireland - flies in the ointment?
If the EFSF is used (which looks likely) the Finnish government is obliged to ask for 'collateral' as it did with Greece - the noises coming out of Finland suggest it will, especially given its objection to 'small' countries bailing out 'larger' ones. Ireland has also suggested that if Spain is able to avoid fiscal conditions on its bank bailout then it could request similar treatment (i.e. a loosening of 'austerity').

Open Europe take:
The Finland issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will help the (True) Finns who are already launching a campaign against further bailouts. It could also lead to legal challenges - as we pointed out with Greece, it could trigger 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain. Not guaranteed, but a legal grey area which adds to the confusion.

As for Ireland, they have a fairly strong case here. Ultimately, their fiscal troubles stemmed from bailing out their banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system - this will only add to this ill feeling. Given Ireland's perceived 'success' in Germany some flexibility may be forthcoming but we doubt enough to assuage Irish anger.

Impact on the UK?
The IMF will only play a 'monitoring' role, meaning the UK will not be liable for the money provided to Spain. However, given the links between the UK and Spanish banking systems it is imperative that the problems in the Spanish financial sector are finally dealt with - whether that will happen this time around is yet to be seen but given the points above it is not off to a great start.

Impact on the eurozone - Open Europe concluding remarks:
Markets responded positively to rumours of external aid for Spain on Friday afternoon, but, given the points above, a huge amount of uncertainty remains which will keep markets jittery and increase pressure on the eurozone. That is far from needed given the uncertainty surrounding the Greek elections. Given the ongoing assessment of the actual needs of Spanish banks the rescue will now enter a state of limbo as attention turns back to Greece, in the meantime Spain is likely to find it difficult to access the market (since this is broadly an admission it cannot raise any substantial funds itself).

Questions will also arise over the strength of the eurozone bailout funds - Spain guarantees around 12% of them, surely its guarantees are now worthless or would do more harm than good. Additionally, now that one of the larger countries has asked for support pressure will intensify on Italy (particularly with the falling support for the technocratic government and the slow pace of reform).