Here’s Why Investors Are Already Dubious Of This New European Bank Recapitalization Plan

By admin on June 29, 2012

Mrs. Doubtfire

Wall Street has already begun weighing in with negative opinions on the new European deal to use bailout funds—the European Financial Stability Facility and the future European Stability Mechanism—to recapitalize troubled banks in Europe, despite the positive reaction we’ve seen in the markets so far today.

Morgan Stanley has criticized the plan as failing to take a “meaningful step forward.” The Bank of New York Mellon argues that this measure and others announced so far at the EU summit have failed to address continuing weakness in Greece. JP Morgan and Goldman Sachs have made similar arguments, predicting that the value of the euro will continue to fall.

Regardless of this angst, these new measures do indeed appear to be a positive development for banks, stemming interbank lending pressures that have threatened to upset stability in the euro area. But the problem with the new plan is that it still doesn’t go far enough towards fixing the financial plumbing of the European area.

The manner in which European sovereigns finance their borrowing remains distorted.

The Federal Reserve induces banks to buy Treasuries by offering them profits between their purchase price and the price at which the Fed decides to buy them bank as part of quantitative easing.

However, European banks must apply to the European Central Bank in order to be primary dealers in the market. Ultimately, this means that the ECB wields unnatural power of banks, coercing them to buy sovereign bonds potentially against their better judgement, particularly when the price of bonds is falling.

Therefore, use of the European bailout funds to finance new bank purchases of sovereign bonds does not fix the plumbing that allows for these subversive practices in Europe. Nor will increasing the power of the ECB stop such practices. Ultimately, the problem here is transparency and efficient European regulation of markets, so moves that induce more coercion fail to make progress towards achieving that goal.

That said, shady practices that allow European banks to muddle through the crisis have resoundingly positive short-term effects, seen already in the drop in Spanish and Italian borrowing costs. Therefore, investors are torn between what is good in the now and what is good in the future.

It will be interesting to see how this plays out.

NOW READ: Europe Goes Bonkers After EU Leaders Agree To Bank Recapitalization Master Plan >

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