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Germany forfeits to Spain and Italy, agreeing to loan directly to banks

After weeks of refusing to yield, German Chancellor Angela Merkel agreed to allow eurozone bailout funds to be used to recapitalize struggling banks.

Germany ceded a victory to its southern neighbors Spain and Italy Friday – not in a football stadium, but in a make-or-break summit in Brussels as European leaders reached a landmark deal to stave off what many feared would be the beginning of the end of the common currency.

After days of closed-door and microphone diplomacy, German Chancellor Angela Merkel finally agreed to allow the 17-member eurozone’s bailout funds to be used to lend money directly to ailing banks, something she had ruled out only a day before.

Berlin‘s concession was made in exchange for more European Union oversight of banks and national budgets – a bank union, essentially. The agreement illustrates just how worried Europe – even Germany – is of a eurozone collapse. 

It will allow countries like Spain to recapitalize their ailing financial sectors without computing the loans as a government burden, something that will act as a shortstop against climbing sovereign interest rates. It will also strengthen Europe’s good banks, especially in countries like Germany and the Netherlands, which have been dragged down by broader eurozone concerns.

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The new guidelines give the European Central Bank more ammunition to intervene in financial markets, much like the US Federal Reserve does, which in turn gives more time for economic reforms to kick national economies back into gear, especially in too-big-to-fail Spain and Italy.

“I am actually quite pleased with the outcome of the European Council. It showed the long-term commitment to the euro by all member states of the euro area,” European Central Bank chief Mario Draghi said.

Leaders also agreed to use the rescue funds to buy sovereign bonds in both primary and secondary markets, allowing the ECB to directly intervene to lower market lending rates. But the measures won’t be available until countries create some kind of European bank supervisor position and a broader European banking union, the details of which are expected in October.

Ending the ‘vicious cycle’

The deep recession exposed bad banks, but when individual governments tried to fix the problem, the cost of borrowing climbed, further undermining economies and the banks themselves.

“It is a first step to break the vicious circle between banks and sovereigns,” European Council President Herman Van Rompuy said in a press conference after more than 12 hours of talks.

Italy and Spain, backed by France, pressured Germany to budge, arguing that any other issue was secondary because their economies, and Italy’s government, could not survive much longer paying nearly 7 percent interest rates on long-term bonds.

But it won’t come easy or free, both the ECB and Germany warned. “All these things, to be credible, have to be attached to strict conditionality,” said the ECB’s Draghi.

Spain, for example, will request up to 100 billion euros for its banking sector on July 9, processing the rescue as a government loan until the new bank union is running. At that point, the loan will essentially be absorbed by rescued Spanish banks, which will then come under strict control of European institutions. The Spanish government will also need to meet European conditions to get the money.

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“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,” Chancellor Merkel warned.

The exact workings of the banking union and the conditions that will be attached still need to be negotiated.