With sovereign stress showing no sign of abating and with the AAA ratings of countries like France apparently in need of protection, it is hard to imagine a re-capitalisation on the scale sought by the International Monetary Fund (IMF) taking place on a country by country basis.
To make matters worse, the IMF is still probably underestimating the actual amount needed to convince the markets the financial sector has enough of a capital cushion to deal with the defaults that are coming.
Is the European Financial Stability Facility (EFSF) the answer? Once EFSF 2.0 has been ratified by all 17 Eurozone members (still by no means a certainty) its new powers would in theory allow it to step in and help the financial sector. The problem is that Germany sees such a move as a last resort. Paris, on the other hand, is desperate for the facility to do the heavy lifting to preserve the French AAA.
Another issue is that the EFSF may not have the resources necessary and any leverage would also likely lead to a French downgrade. As one of the six AAAs backing the EFSF, such a ratings move would be counterproductive.
And why should taxpayers be forced to take on even more risk? The answer is that they should not, especially when bank bondholders remain untouched. Andrew Lilico of Europe Economics argues it is time to put these bondholders to the sword and I agree. Bondholders deserve more protection than equity investors, but they bet on banks that went bad and it’s time they stood up to be counted.
Ensuring that private sector involvement not only applies to sovereign but also bank debt could be one of the only ways to short-circuit the sovereign/bank negative feedback loop that is gripping Europe.
While there is no way of knowing with certainty that a plan for senior bank bondholders to take a haircut would not lead to disaster, it looks like one of the most manageable options. The banks would be restored to health and sovereigns would not have to take on even more debt. Even the European Central Bank might now be willing to see the logic of such a move.
Guy Johnson co-anchors CNBC’s European Closing Bell.