The Greeks’ ability to hold Europe hostage continues to amaze. The surprise referendum was probably not the last delaying tactic of the Greek government. But for the good of Europe, it is time to end the hostage crisis. This can be done by employing the EFSF for a thorough “sovereign cleansing” of the banking system in the eurozone.
The root cause of Greece’s ability to procrastinate is well-known. Eurozone banks were allowed to invest in public debt without any restrictions, notwithstanding the increased credit risk of these securities since the introduction of the euro. At this moment Eurozone banks hold € 2564 bln in public debt (ECB, 9/2011). This amount is higher than their capital and reserves (€ 2198 bln). Greek and Italian banks also hold more public debt (respectively € 516 and € 59 bln) than capital (respectively € 383 and € 47 bln). By far the largest part of their public debt holdings originates from the domestic government. As a result, sovereign debt problems immediately spread to the banking system.
As long as this situation persists, Europe will lack a credible threat towards Greece or Italy. The contagion risk from default is just too big. A credible threat requires that European banks are disconnected from high-risk sovereigns. The EFSF can provide the means to accomplish this. Currently, the EFSF is aimed at providing funds or guarantees for new sovereign debt issues. But this amounts to an open-ended commitment that probably will not do enough to discipline governments. It is better to use the EFSF to remove high-risk sovereign debt from the banking system and thereby end the hostage crisis. Here is how this can be done:
- Turn the EFSF into a bank that can tap the ECB.
- Let a leveraged EFSF buy all high-risk sovereign debt (e.g. with a credit rating below AAA) which is currently held by eurozone banks.
- Eurozone banks are prohibited from holding high-risk sovereign debt (again below AAA).
- Once this has been done, the EU can credibly decide to stop any further funding of uncooperative GIIPS countries and if necessary refer them to the IMF.
In this way, the EFSF is turned into a “bad bank” in which all high-risk sovereign debt which formerly was held by eurozone banks is concentrated. I estimate that the total size will be € 1500 bln at a maximum. The capital will come from what currently remains in the EFSF (ca. € 250 bln). This amount will cover any first losses. Additional losses would be covered by the shareholders of the ECB. While this is a huge amount of money, the plan’s advantage is that it sets an upper limit to the GIIPS exposure of Northern countries. This is not the case when the EFSF or the ECB are used to refinance future GIIPS debt. The plan’s biggest advantage is, however, that it would end the hostage crisis, as high-risk sovereigns are no longer able to infect the eurozone banking system and are thus forced to secure their continued access to the capital markets by implementing credible economic and fiscal policies.