September 25, 2011 / 6:44 PM / 8 years ago

Scenarios: How euro zone can get more bang for bailout

WASHINGTON (Reuters) - Euro zone countries are considering ways to boost the firepower of their bailout fund without putting up more money.

Europe is under intense pressure from financial markets and other major world economies to come up with a more aggressive response to the crisis.

Investors say Europe need more muscle to defend its bigger economies, such as Spain and Italy, from market turmoil.

The United States has suggested leveraging up the existing 440 billion-euro European Financial Stability Facility, or EFSF.

Euro zone officials are thinking about how to do that once the fund’s new powers to buy bonds in secondary markets, make recautionary loans and recapitalize banks are ratified, which is expected by mid-October.

Below are some ways the euro zone could make better use of the money already available to the fund. Discussions are still at a preliminary stage and several options are being considered.

THE EFSF COULD BECOME A BANK

This is an idea presented by Deutsche Bank Chief Economist Thomas Mayer and Center for European Policy Studies chief Daniel Gros. They argue that 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.

PUSHING FORWARD THE ESM

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.

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 has proposed to push forward the launch date for the ESM from mid-2013 to early 2012 — basically as soon as all the euro zone countries will have ratified the already agreed upon legislation to create it.

EFSF AS AN INSURER FOR ECB BOND PURCHASES

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.

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.

EFSF AS INSURER FOR INVESTORS

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

Reporting by Jan Strupczewski, editing by Neil Stempleman

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