October 14, 2011 / 1:44 PM / in 6 years

Scenarios: How euro zone can get more bang for bailout

PARIS (Reuters) - The euro zone is under intense pressure from financial markets and other major economies to come up with a more aggressive response to its debt crisis and is considering ways to boost the firepower of its bailout fund without putting up more money.

The United States has suggested leveraging up the existing 440 billion-euro European Financial Stability Facility, or EFSF, in case it has to defend bigger economies such as Spain and Italy.

Euro zone officials are thinking about how to do that, now that the fund’s new powers to buy bonds in secondary markets, make precautionary loans and recapitalize banks have been ratified by all 17 countries using the euro.

Below are some ways the options under discussion. There now seems to be consensus among policymakers that the European Central Bank will not be involved in leveraging the EFSF.

Decisions on which options to choose are likely to be taken at the summit of EU leaders on October 23.


This is an idea first presented by Deutsche Bank Chief Economist Thomas Mayer and Center for European Policy Studies chief Daniel Gros and now backed by France. If the EFSF were a bank, it could refinance itself at the European Central Bank.

With its 440 billion euros, the EFSF could buy bonds of countries under market stress on the secondary market and then use these bonds as collateral to borrow cash from the ECB in the central bank’s liquidity operations, as other banks do.

In this way, the EFSF’s money would be multiplied without governments adding extra funds and the ECB would not be directly involved in financing the fiscal policy of governments.

The problem with this solution, already voiced by Bundesbank President Jens Weidmann, is that obtaining a banking license for the EFSF could be problematic -- the fund is hardly a bank, it is a special purpose vehicle set up to help finance governments.

EU law forbids the ECB to finance governments, directly or indirectly through a special purpose vehicle like the EFSF. Such a solution would also expose the ECB to losses in case of default of a country whose bonds it holds.

The European Commission, the IMF and the ECB all said this was an unlikely solution.


Some officials believe it could be easier to get a banking license for the European Stability Mechanism (ESM) -- the 500 billion euro permanent bailout fund that is to replace the temporary EFSF in mid-2013.

Rather than being a special purpose vehicle like the EFSF, the ESM will be a permanent financial institution with its own paid-in capital of 80 billion euros and 620 billion euros of callable capital.

This would also mean that it could make decisions more quickly than the EFSF, needing less approval from national parliaments.

It will also be able to handle its finances independently of national treasuries, similarly to the IMF, and unlike the EFSF -- easing the strain on national public finances.

But some central bank officials are equally skeptical about refinancing the ESM as the EFSF, since the ultimate purpose of both was the same -- to help finance governments.

Germany and the European Commission have proposed to push forward the launch date for the ESM from mid-2013 to mid-2012 -- basically as soon as all the euro zone countries will have ratified the already agreed legislation to create it.

The issue will be discussed by euro zone leaders on Oct 23.


This is an idea building on elements of the U.S. Term Asset-Backed Securities Loan Facility from 2008.

The EFSF and/or ESM could use its funds to cover potential losses the ECB could incur on its purchases of bonds of countries under market stress -- up to a certain amount.

In this way the ECB would have a guarantee it would not lose money on the bonds it buys to smooth out market turbulence under its existing program aimed to improve the transmission mechanism of monetary policy.

Depending on the assumed loss, the money at EFSF disposal could guarantee bond purchases many times its size. Like an insurer, it would only pay out in case of a default -- an unlikely scenario for Spain or Italy.

For example, the EFSF could say it would cover the first 20 percent of losses that the bank could suffer in case of a default -- multiplying the EFSF’s firepower fivefold to over 2 trillion euros.

The problem with this solution is that it would require the ECB to continue buying euro zone government bonds, which the bank does not want to do, as it can be perceived as helping finance government fiscal policies.


Instead of guaranteeing to cover potential losses for the ECB, the EFSF could insure bond purchases of other financial market actors.

The bailout fund could tell investors that it would guarantee, for example, the first 20 percent of losses in case of a sovereign default on bonds of Italy or Spain that investors would buy at a primary auction.

“Instead of buying 100 percent (of the government bond), the EFSF might guarantee, for example, 20 percent of the issued debt amount to private investors,” an EU source with close knowledge of the discussions said.

The scheme could win back confidence in the debt of weak countries, including in bonds already issued and which are often trading at a steep discount because of concerns about possible default. “By removing concerns when issuing new bonds you can remove concerns about the existing ones,” the source said.


The bailout fund could guarantee a certain level of yields at a primary auction for a country, by offering to pay any excess over an agreed level.

Additional reporting by Ilona Wissenbach and Julien Toyer, Glenn Somerville, John O'Donnell; Reporting By Jan Strupczewski, editing by Mike Peacock

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