European leaders in surprise agreement to fund struggling banks

After tough all-night bargaining, European leaders agree to funnel money directly to struggling banks, and in the longer term to form a tighter union.

Stock markets surge on news of recapitalization plan

German Chancellor Angela Merkel, right, shares a word with Italian Prime Minister Mario Monti during a group photo at an EU Summit in Brussels. (Michel Euler/Associated Press)

After 18 disappointing summits since the start of the debt crisis, Europe's leaders appeared Friday to have finally come up with quick fixes and long-term plans that show they are serious about restoring confidence in their currency union.

Global markets sighed with relief, debt-saddled Italy and Spain appeared victorious and Germany's Angela Merkel faced potential criticism at home for conceding to pressure for an immediate deal.

Leaders of 17 countries that use the euro agreed to:

  • Allow two European bailout funds to pump money directly into troubled European banks, rather than make loans to governments to bail out the banks. The move rescues banks without putting strapped countries deeper in debt.
  • Use bailout money "in a flexible and efficient manner to stabilize" European government bond markets.
  • Let countries that have made economic reforms as require by EU authorities tap the European rescue funds without submitting to stringent bailout programs.
  • Tie their budgets, currency and governments ever tighter in a vast new economic union down the line.

Concerns remain

European Council President Herman Van Rompuy called it a "breakthrough." Global stock markets and the euro rallied hard.

Concerns remain. Most of the measures approved in the Brussels summit will take months to come into force. The €500 billion ($650 billion) firepower of the permanent bailout fund may not be enough. And given how shaky Spain's and Italy's finances are, and how jittery markets are, new roadblocks could send the continent back into crisis.

But some key points will kick in within 10 days: On July 9, eurozone countries will agree to give Spanish banks rescue loans and also allow the current, temporary European bailout fund to directly purchase Spanish government bonds.

The decision is a victory for Spain and Italy, whose borrowing costs have risen to near unsustainable levels despite their efforts to cut government spending and reform their labour markets.

In Germany, Chancellor Angela Merkel is likely to face a grilling from a skeptical German Parliament later. Heading into the summit, Merkel had stuck to her line that any financial help from Europe's bailout fund must come with tough conditions, so a separate decision allowing countries that have reformed their economies easier access to bailouts, without such stringent conditions, was widely seen as a defeat by the German press.

Conditional release

Merkel insisted the funds would still only be released when it was clear countries were undertaking serious reforms.

"We remain completely within our approach so far: help, trade-off, conditionality and control, and so I think we have done something important, but we have remained true to our philosophy of no help without a trade-off," Merkel told reporters in Brussels.

Van Rompuy dismissed talk that Merkel had lost in the negotiations.

German Chancellor Angela Merkel briefs the media at a European Union leaders summit in Brussels on Friday. (Guido Bergmann/Pool/Reuters)

"It was a tough negotiation," Van Rompuy said. "And you can't summarize this in winners and losers."

In addition, the leaders of the eurozone countries authorized the EU bailout funds to buy bonds of countries in order to reduce the interest rates the markets charge.

Leaders of the full 27-member European Union, which includes non-euro countries such as Britain and Poland, also agreed to a long-term framework toward tighter budgetary and political union, though those plans will require treaty changes and won't be realized for years.

Scale of deal unexpected

The scale of the moves were unexpected and provided investors a reason for optimism, even as analysts cast doubt on the plans' feasibility and noted that some fundamental problems with the common currency remain.

"I think the elements we put together will reassure the markets," said Eurogroup President Jean-Claude Juncker.

Mario Draghi, the head of the European Central Bank, was similarly optimistic.

"I'm actually quite pleased with the outcome of the European Council," said Draghi. "It showed the long-term commitment to the euro by all member states of the euro area. But also it reached tangible results in the shorter term."

Canadian Finance Minister Jim Flaherty, in Ireland to attend a conference, said European leaders have taken "significant strides" toward containing Europe's banking crisis and said he was "encouraged by some sense of scheduling." But he mused about the possibility of things unravelling so was urging quick action to implement the deal.

"I always worry about agreements reached in the middle of the night," he said, noting that much work remains to be done.

"I want to see clearly what is being proposed with respect to the direct recapitalization of  banks. If this is going to be a comprehensive program for the recapitalization of banks in the eurozone, that's very important and that is something we have been advocating for," Flaherty said.

Stocks surge

Stocks around the world surged Friday, with markets in countries on the front line of the crisis doing particularly well. Italy's FTSE MIB and Spain's IBEX indexes each rose three per cent.

Perhaps more importantly, the yield on Spain's 10-year bond dropped by 0.32 percentage points to 6.58 per cent. Italy's was down by 0.14 percentage points to 5.94 per cent. Both countries have seen their rates edge toward the 7 per cent level which is seen as unsustainable over the long term.

The importance of recapitalizing banks directly from the bailout fund became evident this month when Spain was offered €100 billion ($130 billion) for its shaky banks. Previously the bailout loan would have to be made to the Spanish government, which would lend it on to the banks. The prospect of having that debt on the government's books spooked investors, who began demanding higher interest rates to reflect the risk of a Spanish default.

Lending the money directly to the banks avoids putting more debt on the government's books.

Also boosting market confidence was the agreement to waive the permanent bailout fund's preferred creditor status for aid given to Spanish banks. So far, any money the fund puts into a bank would get repaid before any other investors.

When Spain agreed to take rescue loans for its banks, the news failed to boost confidence in the banks because investors worried that, if one of those banks collapsed, they would be last to get repaid. Eurozone leaders agreed to waive the bailout fund's preferred creditor status only in Spain's case.

Some analysts, however, noted that the size of the bailout funds some €500 billion would have to be increased to be a realistic backstop for public debt and banks across the continent. Italy alone has government debt of €2.4 trillion.

"These steps are the obvious ones to take to try to restore some confidence in the market in the short term," said Gary Jenkins, managing director of Swordfish Research in London. "Alone, they do not solve the underlying problems but they might buy a bit of time, which is probably about the best they can do right now."