GERMAN CHANCELLOR Angela Merkel and French president Nicolas Sarkozy are struggling to reconcile deepening divisions over the deployment of Europe’s bailout fund to provide capital to governments for bank rescues.
As the French and German leaders seek common ground at a dinner meeting in Berlin tomorrow night, European regulators are racing to develop stricter criteria to apply in stress tests on weakened euro-zone banks.
EU leaders are under pressure from the global powers to take decisive action at a summit on Monday week to tackle the escalating sovereign debt crisis. The stress test will be pivotal as it will determine how much new capital the banks need and it may yet include a sovereign default scenario.
In a sign of further strain last night, Fitch credit-rating agency downgraded Italy and Spain. Fitch attributed the downgrades – to A+ from AA- in the case of Italy, and to AA- from AA+ for Spain – to their weakened sovereign risk profile as the debt crisis escalates.
The move – following downgrades of Italy by Standard Poor’s and Moody’s – will increase the borrowing costs of the two countries at a time when the European Central Bank is buying their bonds to keep their debt at a sustainable price.
Dr Merkel signalled her support this week for the principle of further bank recapitalisations, something long resisted by Germany. While France also reluctantly agreed to go down that road, Dr Merkel and Mr Sarkozy are divided over the sourcing of capital for banks.
The chancellor says money from the European Financial Stability Facility (EFSF) should be deployed only as a last resort, after private and government sources of capital are expired.
Mr Sarkozy, fearful that state recapitalisations could threaten France’s AAA credit rating, wants the right to deploy EFSF aid quicker.
Dr Merkel set out her position clearly yesterday, saying any EFSF support for banks would have to be accompanied by a conditions-based programme for structural reform.
“The banks must first try to raise the capital themselves. If that doesn’t work, the member state should come up with instruments as we did in 2008-09, and only then when the country cannot cope on its own can the facility – the EFSF – be used.”
While Paris has been trying to play down divisions with Berlin, a senior European official said it was clear that France wanted “more flexibility” to use the EFSF earlier.
Capital weakness in euro-zone banks has emerged as a big concern for markets, as the shares of French and other lenders tumble amid growing anxiety about a potential Greek default.
European leaders have ruled out default but France is resisting pressure to increase the “voluntary” 21 per cent loss on Greek bonds which was included in a second bailout pact for the country in July.
The deal has since been reopened due to Greece’s deepening recession, fuelling anticipation of a loss or “haircut” of up to 50 per cent in an attempt to bring Greek debt down to a sustainable level.
France does not want to increase the haircut as its banks, the biggest holders of Greek debt, would have a larger consequent need for new capital.
Bank regulators are working to agree criteria to re-examine stress data compiled for an examination last summer.
Previous stress tests took no account of sovereign default risk. A senior European official said that may change, although there was no agreement on the scale of any supposed loss. “It won’t be a new stress test. It will be an updating on the basis of stricter criteria.”
Although the summer test was conducted on the basis of a requirement for a 5 per cent core tier-one capital, the latest examination may see the threshold increased to 8 per cent or 9 per cent.
The IMF, which believes euro zone banks may need as much as €200 billion, has been pressing for a 10 per cent limit. Irish banks are being recapitalised to a 12 per cent threshold.
The test criteria may not be agreed until the EU summit, but the examination itself will be swift.
