BRUSSELS (Reuters) - Efforts by euro zone countries to agree on how to recapitalize struggling banks appeared to be in disarray on Wednesday with conflicting interpretations of what was agreed by EU leaders at a summit barely three months ago.
The dispute between four AAA-rated euro zone countries on one hand - German, Finland, the Netherlands and Austria - and indebted states such as Ireland and Spain on the other, threatens to undo or severely set back efforts to allow banks to be directly recapitalized by the euro zone's rescue fund.
That will in turn undermine financial markets' confidence in Europe's ability to get on top of the debt crisis. Yields on Spanish 10-year government bonds moved back above 6 percent on Wednesday as developments in Spain dampened expectations that Madrid will soon ask for a bailout and secure central bank support for its debt.
Germany, Finland and the Netherlands gave rise to the confusion with a joint statement on Tuesday setting out the conditions under which they would be prepared to allow the rescue fund, called the ESM, to recapitalize banks.
But rather than sticking to the wording from the summit in June, when countries agreed that the ESM would be able to directly recapitalize banks once an "effective single supervisory mechanism is established", the three countries added an extra stipulation in their statement saying:
"The ESM can take direct responsibility of problems that occur under the new supervision, but legacy assets should be under the responsibility of national authorities."
Austria joined the three on Wednesday, saying there was no question of the ESM being allowed to assume old, bad debts.
The critical phrase is "legacy assets", which appears to imply that the debts of struggling Spanish and Irish banks - and potentially those of Greece and Cyprus too - will remain the responsibility of the respective governments, rather than being assumed by the ESM during the recapitalization process.
That is a problem because the very aim of direct recapitalization was to break the debilitating link between indebted governments and troubled banks - making sure that a government that is pursuing sound economic policies is not dragged down by its mismanaged banking sector.
If a way is not found to break the link between sovereigns and their banks, the euro zone will forever be in an uphill struggle to get on top of the crisis since government finances will always be saddled with vast amounts of bad banking debt.
The very first line of the statement agreed by EU leaders at the June summit was: "We affirm that it is imperative to break the vicious circle between banks and sovereigns."
But that same phrase was not used in the statement issued by Germany, Finland and the Netherlands, indicating perhaps some change of mind about how and when the link will be tackled.
Officials from the four AAA-rated countries, speaking on condition of anonymity, sought to play down the relevance of Tuesday's statement, saying there was nothing new in it and that direct bank recapitalization via the ESM remained the goal.
"We are still committed to breaking the negative feedback loop between sovereigns and banks," one official said.
Asked how, the official would not elaborate but said there would be "specific measures" for cases such as Spain and Ireland, where the government's decision to assume the debts of its bad banks drove the deficit to painfully high levels.
Another official insisted that the German-Finnish-Dutch statement did not reopen or undo what was agreed in June, going on to explain:
"Everybody understands that losses incurred some time ago will definitely not be borne by the European taxpayer in the form of a contingent liability."
The problem is, that does not appear to be how Ireland or other countries understood the June agreement.
Ireland's prime minister, Enda Kenny, expressed his surprise at the three-country statement, saying it was not up to a handful of finance ministers to rewrite an agreement drawn up by heads of state and government.
"The difficulty for Europe has always been that you follow through on the decisions that were made. The decision of June 29 was not an opinion, was not a theory," he said. "Those decisions stand, those decisions will be implemented."
While officials in Germany, the Netherlands, Finland and Austria may insist nothing has changed, financial markets clearly took the June statement to mean that any direct recapitalization of Spanish or Irish banks would shift the contingent liabilities off the governments' books.
Tuesday's statement did nothing to ease risk aversion fed by a broad range of factors linked to Spain's plight that prompted sharp rises in yields on Irish, Spanish and Italian 10-year government bonds as well as weakening the euro.
"If there is any risk that the Spanish bank bailout will be carried by the sovereign rather than any of it transferred so that it is directly funded by the ESM or the EFSF, it's an additional burden on the sovereign," said Elisabeth Afseth, fixed income analyst at Investec.
The likelihood is that some of the confusion and disagreement provoked by the statement will be ironed out at a meeting of finance ministers in Luxembourg on October 8 or at a summit of EU leaders in Brussels on October 18.
"This discussion is ongoing," said Olivier Bailly, a spokesman for the European Commission, when asked what the statement meant for the ESM and bank recapitalization.
"It's part of an ongoing debate where member states will clarify in the coming weeks the different details of the final design of this ESM instrument."
But the broader issue is that EU member states often struggle to communicate with one voice or agree on how to interpret their own agreements, creating confusion in financial markets and beyond, which will always tend to exacerbate the very crisis they are trying to resolve.
Additional reporting by Jan Strupczewski in Brussels, Michael Shields in Vienna, Padraic Halpin in Dublin and Ana Nicolaci da Costa in London; editing by Stephen Nisbet; Writing by Luke Baker