Fudge to the rescue

Euro zone banks are being rescued with IOUs rather than cash. First, Ireland’s banks got euro 31 billion in so-called promissory notes from their government in 2010. Now Greek lenders are to receive euro 18 billion in bonds from the European Financial Stability Facility, the zone’s bailout fund. Spain’s BFA/Bankia group could be saved by the same fudge: It may receive euro 19 billion in the form of bonds issued by its own government.

There are some differences in these approaches. But, they are all driven by the same logic: The entity bailing out the banks – whether it is Madrid, Dublin or the European Financial Stability Facility – doesn’t have ready cash, doesn’t want to issue bonds in the market and so provides IOUs instead.

What good is an IOU? The answer is that it can be swapped with the central banking system for cash. In Ireland’s case, the promissory notes were pledged to the country’s own central bank for emergency liquidity assistance (ELA). In Greece’s case, the EFSF bonds —guaranteed by euro zone states that haven’t been bailed out — are to be swapped with the ECB itself. In BFA/Bankia’s case, it’s not clear what will happen. Indeed, Madrid hasn’t formally decided to go down this route.

These sorts of schemes can have a further wrinkle: The banks may not be allowed to sell the relevant bonds. That is certainly the case with Greece. The reason? The EFSF doesn’t want a huge chunk of its bonds to be dumped on the market, as that could compromise its ability to issue fresh paper. It wouldn’t be surprising if Madrid put a similar restriction on any bonds it gives Bankia as part of its recapitalisation.

As with a lot of financial engineering dreamt up in the euro crisis, fudge capital is clever. But, it isn’t a clean solution. The ECB is effectively helping governments with their funding — something that looks pretty close to breaching the Maastricht Treaty’s prohibition on the central bank financing of member-states. The central banks, of course, don’t give the banks permanent cash in return for the IOUs: They can withdraw the cash at short notice. But, that may sometimes be more a theoretical than practical option. The ECB has been authorising what is supposed to be short-term ELA to Irish banks for two years.

The ECB may be fairly relaxed about the Greek bailout as it will, at least, be receiving EFSF bonds. Its big test will be over BFA/Bankia. It won’t want to be saddled with another semi-permanent obligation, especially as the group is unlikely to be the last Spanish lender requiring a bailout.

The ECB, though, does have options. It could push the other euro zone countries to recapitalise Spain’s banks directly. That’s certainly what Madrid would like. If that fails, the ECB could demand that Spain gets its own bailout and puts real cash into its banks — though Madrid hates that idea.

Hopefully, fudge will be the bridge to a solid solution, rather than turn into treacle.