Washington D.C., September 16, 2012 — Members of the IIF’s Market Monitoring Group agreed to release the following statement:

Since the last MMG communiqué on June 29, announcements by European authorities—including the Euro Area Summit Statement, the ECB’s bond purchase program and the European Commission’s framework for a single supervisory mechanism for Euro Area banks—represent welcome and tangible steps towards restoring confidence in Euro Area sovereign debt markets and the European banking sector.

1. Timely implementation of the ambitious plan for the single supervisory mechanism would enable the European Stability Mechanism (ESM) to directly lend money to recapitalize banks without going via the sovereign balance sheet—a step towards mitigating the effects of the negative feedback loop between troubled sovereigns and banks. In tandem with the ECB’s bond purchase program, this constitutes a welcome move towards further fiscal and banking sector integration—helping stabilize market conditions and providing much-needed time for countries to implement necessary reforms.
2. The ECB’s plans to buy secondary market government bonds with no ex ante limits on purchases and pari passu status with other investors have been well received. However, the ex post conditionality required by the Outright Monetary Transactions (OMT) program—while desirable and necessary to spur needed reforms—could appear as an obstacle to some countries in need, deterring them from requesting support. This would prevent the activation of the OMT program. As markets have already priced in strong support from bond purchases on both primary and secondary markets, any delay in activating the OMT could lead to disappointment. Moreover, termination of bond purchases if a country is perceived to be not in compliance would likely result in a “cliff effect” and an abrupt market correction.
3. Despite commendable recent efforts by the Greek government to reach agreement with the Troika on the additional budgetary measures needed to assure compliance with the program, progress needs to be made urgently. Further delay to the review and approval of Greece’s program would be a key source of event risk and add to the strains on the Greek economy.
4. Progress on fiscal consolidation by countries including Spain, Italy, Portugal and Ireland has contributed to the marked decline in bond yields and spreads. Nonetheless, the challenges facing these economies remain formidable; concerted efforts on structural reform are needed to lay the foundation for more robust, sustainable growth. An exclusive focus on short-term fiscal consolidation, amidst ongoing deleveraging, could see the “growth deficit” worsen, eroding political support for Euro Area integration more broadly.
5. MMG members affirmed the importance of strengthened regulatory standards as part of the overall process of enhancing the framework for global financial stability. However, members also underscored that with regard to burden sharing or “bail-in” of equity and junior debt in banks undergoing resolution, it is important that the seniority ranking within the bank capital structure be respected—regardless of whether these banks have had earlier public assistance. While it is reasonable to expect holders of junior securities of banks requiring public recapitalization to bear losses, the burden placed on the private sector holders of these securities could be very significant. These concerns are reflected in historically wide spreads between European subordinated and senior bank debt CDS.
6. The status of senior debt (in terms of being “bail-in-able”) in banks undergoing resolution during the current crisis needs to be clarified. During the crisis, raising the risk of loss on senior bank debt could trigger contagion and risks for similarly situated banks in other countries. Such concerns have contributed to a renewed increase in senior bank bond spreads in potentially affected countries. Of note, Spain’s legislation to enable its “Subordinated Liability Exercise” (SLE) makes no reference to senior bank debt—a welcome development under the current circumstances.

MMG members also highlighted concerns about the potential impact of regulatory change on end-users of financial services:

7. Certain changes in financial regulation, at both the national and the international level, could have potentially negative consequences for a range of end users of financial services, including firms in the SME sector and households as well as large multinational corporate counterparties. The potential for firms (particularly smaller firms) to face higher borrowing costs and constraints on credit availability suggests that plans for corporate capital expenditures and hiring could be scaled back, with negative consequences for employment and economic growth. Financing for long-term investment could be particularly affected.
8. A number of regulatory changes, including Basel III’s CVA capital risk charge and reforms to OTC derivatives markets, are expected to make some derivative products materially more expensive—notably long-dated, non-standardized and tailored derivatives. As a result, the cost and availability of some products such as long-term hedges—which are vital for many industries—could rise significantly. This could prompt many firms to keep risks such as foreign exchange exposure on their own balance sheets, pushing these risks back to the corporate sector.

Note to editors:

The Institute of International Finance’s Market Monitoring Group (MMG) is an independent forum of private-sector leaders in international finance and experienced market practitioners. The purpose of the MMG is to consider and identify potential systemic risks and alert market participants and policymakers to these risks. The MMG is co-chaired by Jacques de Larosière, Chairman of Eurofi, former Managing Director of the International Monetary Fund and former Governor of the Banque de France, and by David A. Dodge, Senior Advisor of Bennett Jones, LLP and former Governor of the Bank of Canada.