BCE European Central Bank

Will the European Central Bank’s “Bad Bank” Rescue the Eurozone?

EU leaders are bracing themselves for another tough week as the coronavirus continues to take its toll on Europe’s health and economy. On Monday, Italy’s borrowing costs rose again as investors anxiously await a crucial EU meeting on Thursday where member states will try to draft an agreement on how to tackle the economic fallout from COVID-19.

Italian Debt Has Investors Worried

Investors are beginning to fear that holding on to the Italian Government’s debt is becoming a riskier prospect as yields continue to rise whilst prices fall. The yield on Italy’s ten-year bond has increased by ten basis points (0.10 percentage points) on Monday morning to 1.881 percent. This is close to the one month highs from last week.

Investors are already selling off Spanish and Portuguese government debt as Spain’s 10-year yield rose by 3.5 basis points to 0.837 percent and Portugal’s 10-year yield increased by 2.7 basis points to 0.984 percent.

The EU is At Odds Over Coronabonds

The main reason behind all this economic uncertainty is the disagreement over coronabonds, which nations such as France, Italy, Spain and Portugal are in favor of because these bonds will allow debt to be spread across the eurozone to ease their financial burdens, but other member states such as Germany and the Netherlands are opposed to them because their voters will never tolerate their money being used to finance poorer countries.

Italian Prime Minister Giuseppe Conte joined his French counterpart Emmanuel Macron on Sunday in calling for the issuance of $1.6 trillion of joint bonds to help economies damaged by the coronavirus ahead of Thursday’s virtual meeting.

It is becoming clear that more money is required to revive growth in the eurozone, despite the EU providing a €3 trillion fund to soften the blow from the pandemic, European Commission (EC) President Ursula von der Leyen admitted.

According to Bloomberg, Spain proposed creating a European fund worth approximately €1.5 trillion on top of relief efforts EU member states have already agreed to. The fund would be financed through perpetual EU bonds to ensure that national public debt levels are kept in check. Grants would be made available to member states through the EU budget.

The ECB Proposes Creation of a ‘Bad Bank’

Yet another idea that is being floated is a eurozone ‘bad bank’ to deal with bad loans. This is a scheme that the European Central Bank (ECB) and the EC are pondering. The idea is that non-performing loans would be removed from banks’ balance sheets.

The plan is to eradicate all debts that were accumulated during the 2008 financial crisis. ECB officials believe that if EU leaders can agree to this scheme, it will prevent banks’ lending capacity from being hindered and stop another surge in bad debts. It sounds like a good idea in principle, but it has already encountered numerous problems.

Although von der Leyen admits that more money is needed to stimulate growth in the eurozone, the EC as a whole is not keen on a ‘bad bank.’ If one of the EU’s main institutions cannot budge on their position and there is no breakthrough in general on Thursday, this will send jitters throughout the market.

The EU is About to Make one of the Most Important Financial Decisions in its History

Yet proponents argue that the ‘bad bank’ idea will allow toxic loans to be sold into the market after a fixed time period, with the power to recoup any losses from the lenders themselves.

Whatever the outcome of Thursday’s meeting, there will be considerable pressure to please the Italian Government. Conte is under pressure from his Five Star Movement coalition partners that have long campaigned against unacceptable loan conditions.

If the EU’s final agreement fails to please most Italians, it could result in a surge of support for Matteo Salvini’s League.

The ECB’s ‘bad bank’ idea has some merits and disadvantages, but EU leaders will be making one of the most important financial decisions the bloc has made so far on Thursday. Italy’s reaction to Thursday’s meeting will be the most important one to monitor.