Rationale behind ECB opposition to burning bondholders

 

ECONOMICS:Ireland should address its woes to the head of the European Financial Stabilisation Facility rather than Trichet.

MICHAEL NOONAN returned from a meeting of his finance minister counterparts last weekend having been given another cut in the rate of interest on Ireland’s EU bailout funds. This had not been sought, but was given anyway. What he had sought was not given – the acquiescence of the European Central Bank in imposing losses on unguaranteed senior bondholders in banks being wound down.

Noonan had a meeting on the sidelines of the gathering with Jean-Claude Trichet, the president of the ECB which has always been the chief exponent of the “no default” position Trichet told Noonan of his inflexible determination to avoid any burning of senior bank bondholders.

The ECB has earned its fair share of opprobrium in this state for taking this position. To a very considerable extent, it has itself to blame. On the rare occasions that its members – other than Trichet – have deigned to give views on the matter, they have been jarringly condescending.

In an interview with this newspaper early last week, the bank’s departing executive board member, Jürgen Stark, expressed wearied impatience at the Government’s continued efforts to reduce the burden on Irish taxpayers.

But his haughtiness was as nothing compared to the inexcusable arrogance of his colleague, Lorenzo Bini Smaghi, who, in another newspaper in April, told Irish citizens from on high that they should not complain about bailing out bank bondholders.

A technocrat who speaks in this fashion to a people he is paid to serve is a disgrace to the European Union and should be fired. A technocrat who speaks in this fashion to a people he is paid to serve and is not fired is an affront to accountable government.

The ECB’s accountability mechanisms and its poor communications strategy are for another day, but the bank’s rationale behind avoiding default is worth setting out here.

The ECB’s failure to explain itself has made the injustice suffered by Irish citizens of picking up bank losses all the more difficult to bear. It also allows the perception to take hold that the bank is sadistically punishing Ireland or that it is doing the bidding of foreign banks at our expense.

Its rationale for not burning bondholders is as follows.

The ECB believes the euro zone’s financial system is so weak and fragile that a serious shock could lead to cascading defaults, bringing the entire edifice down and, with it, the continent’s real economy. It does not believe that default can be “orderly” in the current circumstances. Rather, it feels that those who believe an orderly default can be engineered hugely overstate the capacity of the authorities to manage such events.

For these reasons, it has been consistently and implacably opposed to default in either of the two largest and most important debt markets – those of government and senior bank bonds.

There has not been a sovereign default in a developed country since the middle of the last century. There has not been a senior bank bond default during the euro era. As a result, both asset classes have been considered by market participants to be effectively risk-free.

Economic and financial realities have eroded that belief but the ECB’s position since the beginning of the crisis has been that, if the authorities were to permit a default in either of those multitrillion euro debt markets, it would have serious consequences. At best, funding costs would rise for all issuers of sovereign and/or senior bank debt. At worst, it could trigger a panic that could precipitate total meltdown. Thus far, the ECB’s position has been supported by developments each time the euro area authorities have weakened their commitment to the no-default position.

In October last year, a Franco-German initiative to make government bonds issued from 2013 subject to default was launched. While the initiative was absolutely correct in principle, the effect on Irish and Portuguese sovereign bond yields was immediate, marking a clear inflection point. If there was a single moment that ended any chance of Ireland avoiding a bailout, it came with that Franco-German Deauville declaration on October 18th last year.

The decision by EU leaders in July this year to row back on previous commitments to prevent a default on Greek sovereign debt led to contagion in Italy and Spain. That began in early July when the change of position became clear. The situation deteriorated immediately after the new position was formalised on July 21st. When markets opened on July 22nd, Italian and Spanish bond yields soared. As the situation spun out of control, the ECB was forced to restart its bond purchase programme to prevent these countries being locked out of the market.

That is sovereign debt. What about bank debt?

Apart from Ireland, nobody else in the euro zone has sought to make seniors take their losses so there are no cases to which one can point as evidence. But an immediate neighbour’s experience has been watched very closely. Denmark last year introduced the toughest bank resolution laws in Europe. These laws, which govern the winding-down of bust banks, are more similar to those in the United States than those across the rest of Europe. In the US, senior bank bondholders have traditionally got their just desserts if the institutions they invest in fail.

When two Danish banks failed earlier this year, their seniors were burned. This raised funding costs for the entire Danish banking system.

From the euro zone perspective, the ECB is obliged to consider that if a default precedent were to be set in the senior bond market, then at the very least funding costs for all banks in the zone would rise. The savings for Ireland of a few billion euro would be offset many times over by the generalised increase in funding costs for the already-teetering euro zone banking system.

That there is good reason – in the collective European interest – not to burn seniors does not lessen the injustice of having Irish citizens pay for European bankers’ losses (although the hugely subsidised bailout loan is a partial de facto spreading of the burden).

One reason the burden has not been fully shared has been the absence of a mechanism to do so. The July 21st changes to the bailout fund – the European Financial Stabilisation Facility (EFSF) – may provide that. It got new powers to sort out banks. The Government should shift its focus from Trichet to the man who runs the facility, one Klaus Regling.