Recently, we’ve been hearing increased talks between European finance ministers about the prospect of recapitalizing European banks, many of which are severely exposed to the bonds of struggling euro zone economies. Word on the street is that write-downs of Greek bonds could be much higher than the initial 21% estimate and could actually be a lot closer to 50%!
Coupling this with potential haircuts of 40% for Portuguese and Irish debt, and 20% for Italian and Spanish bonds, this may cause the sovereign debt problem to develop into a full-fledged banking crisis!
If these banks were to go under due to undercapitalization, it could lead to a credit crunch as liquidity would dry up quickly. This in turn could set off widespread panic and send the entire European economy into a downward spiral.
Of course, nobody wants this, and that’s why some are suggesting that a TARP-like program may be set up.
The Troubled Asset Relief Program (TARP) was a program implemented by the U.S. government during the 2008 financial crisis that allowed the U.S. Treasury to purchase toxic (bad) assets from banks and other financial institutions. This allowed them to stabilize their balance sheets and kept them from going under.
So we’ve answered the question of “What?” but the question of “How?” remains.
How will they fund all these plans?
Many believe that funding will be provided for the weaker, peripheral countries through national governments and the European Financial Stability Fund (EFSF). On the other hand, government money will most likely suffice for stronger nations as they probably won’t need to tap into the EFSF .
However, Germany has other plans in mind. If Germans had their way, banks would have to go through other options before they access the EFSF. The powerhouse country wants banks to convince bank shareholders to inject money first, and if that doesn’t yield enough funding, Germany wants them to turn to their national governments. Only after these two options have been exhausted should they resort to the EFSF rescue fund.
Still, there are some that are calling for the revival of the SoFFin bank-rescue fund, which allows banks to apply for new capital and stay in business. The SoFFin fund was a program implemented by the German government, but it came to an end last year. It was designed to grant guarantees on debt and purchase assets to stabilize the financial system.
No matter which route European officials decide to take, it could be enough to uplift market sentiment. The fact that they’re finally taking concrete steps to save the banking industry from crashing may provide relief and boost investor confidence. In turn, this could do wonders to reverse the recent bout of risk aversion and give the euro a much-needed lift.