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

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 criticised 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 main problem with the principles of the new plan is that it still doesn’t go far enough towards fixing the financial plumbing of the European area.

The plan is an attempt to temporarily reduce borrowing costs for Spain and Italy, which it is doing, at least temporarily.

But it doesn’t address one of the root problems in Europe, which is that the European Central Bank attempts to reduce countries’ borrowing costs by effectively coercing banks to buy sovereign bonds in a behind-the-scenes way.

Let’s briefly compare this to the U.S.

In the current system of quantitative easing and Operation Twist, the Federal Reserve gives banks an incentive to buy Treasuries because they buy them more cheaply at auction than they sell them back to the Fed under Operation Twist. This is very up front and out in the open.

In Europe, banks must apply to the European Central Bank for permission to be primary dealers—the firms that coordinate bond sales in the market. Ultimately, this means that the ECB wields far more power over banks than the Fed according to a source consulted by Business Insider, as it holds the power to withdraw the banks’ ability to be primary dealers (something which makes them a lot of money). Thus, the ECB can essentially coerce financial firms to buy sovereign bonds potentially against their better judgement.

Further, the lack of capital markets in Europe also means that financing in general is a lot less transparent. The public knows fewer details about investments and what goes on at banks because less of this data is public.

Therefore, use of the European bailout funds to finance new bank purchases of sovereign bonds does not fix the transparency problems that plague sovereign borrowing in Europe. Indeed, the new plan essentially exacerbates them. One of the most significant obstacles in the future of a functioning Europe is transparency and efficient European regulation of markets, so moves that induce more coercion fail to make progress towards achieving that goal.

That said, the 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.

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

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