Europe’s bank recapitalisation: The creation of a new stigma?

The solution put on the table during the European leader's “power meeting” last week will not change the long-term issues for Europe’s banks, and especially not the Spanish ones. Investors anticipating whether this signifies the start of a recovery from the European debt crisis are sorely mistaken. Financial markets have however thus far responded very positively to the news, sending most European indices higher by 4-5 percent on average.

The proposed solution basically means that banks will be directly capitalised by the European rescue funds (European Stability Mechanism and European Financial Stability Facility) without having to ask for help from their respective national governments. This is a great relief for Spain because it means that the government will avoid accruing additional debt and its bond yields rising to dangerously high levels. So, in one clean sweep it appears regulators have finally recognised what I have previously argued as crucial, namely breaking the negative spiral created between deteriorating sovereign debt quality and banking systems - the vicious circle of debt.

The proposed setup however is not problem free. It comes with some new and important challenges that are mostly linked to the potential distrust it creates.

Main risks of new solution
As I see it, the main risks associated with the current proposal have to do with the great decoupling of risk and incentive. The direct recapitalisation model for European banks can only work if there is total transparency regarding the amount of capital needed. I have previously raised my doubts regarding the stress test results in relation to the concentration of risk and the assumptions regarding the capacity of Spanish banks to again make profits. With the new solution, Spanish regulators have little incentive to reveal all losses since the banks' capital needs will largely be decoupled from Spain's borrowing costs. Furthermore, Spain's banks and its government will have a mutual interest in increasing lending and reigniting the property market, a risky venture which involves credit risk being largely carried by the ESM. Sound like a non-alcoholic (yet spiked) cocktail?

The total time needed for the proper monitoring facilities to fall into place is also unknown. So the question is: will the rescue operations be in good time? The EU Summit result shows that the European leaders are already cutting corners to enable a quick rescue of Spain's banks (EUR 100 billion will be dispersed immediately without the proper monitoring in place). What happens though if Spain needs more money?

Bottom line, the proposed solution for recapitalising European banks is creating an inherent moral hazard. As time runs out, corners have to be cut to save banks while the implementation of proper monitoring facilities must wait. There's no doubt this is a proper "all-in bet", but will international investors call the bluff of the knights in shining armour (disguised policymakers and regulators)?