The rewards and risks of eurozone rescue

So where are we on this bloomin' deal to save the eurozone and, in theory, the world?

Well, the German government has been busy hosing down expectations that this weekend's eurozone summit will deliver anything more than progress, presumably so that investors don't defenestrate themselves on Monday morning at the blinding realisation that many of the currency union's structural flaws are not amenable to overnight remedies.

It would however be extraordinary, and fairly terrifying, if a deal isn't announced to recapitalise the banks, along the lines I outlined last Thursday.

As I mentioned, the European Banking Authority has recommended that banks should be forced to increase their reserves against losses, so that they would have core tier 1 capital equal to at least 9% of their risk-weighted assets, on a Basel 2.5 measurement, after marking down to the market price the loans they've made to the Greek, Italian, Spanish, Portuguese and Irish governments.

The EBA, the senior banking regulatory body for the EU, says this devaluation of sovereign debt should apply to loans held in the banks' trading books and in their banking books. That may sound hideously technical, but it simply means that banks can't ignore the losses on loans to Greece, for example, simply by parking the loans in the part of the bank where market prices aren't typically used for valuations.

Of course, a consistent policy of pricing to market, irrespective of where the sovereign debt is held, would force banks to raise significantly more capital as protection against potential losses than the previous approach of ignoring the banking-book holdings.

Unexpected disasters

In fact, as far as I can gather, the EBA believes its proposal would require European banks to raise not far off 200bn euros ($275bn; £175bn) of additional capital, rather more than the 100bn euros that analysts seem to expect.

Apart from anything else, no sensible bank will meet the new target with no room for manoeuvre. Most banks, if told their capital ratio should not be lower than 9% will, in practice, go for a capital ratio of 10% to provide a cushion against unexpected disasters.

Now, because eurozone governments seem to be incapable of the kind of decisive, evasive action we saw in the UK and US with their emergency recapitalisations of banks in the autumn of 2008, European banks will probably be given six to nine months to hit the new targets.

This has prompted fears among analysts such as the respected team at Morgan Stanley that some banks will comply by lending less and selling assets, which could starve households and businesses of vital credit, and could tip the eurozone into a nasty recession.

I am told that European regulators are acutely aware of this risk and they are likely to prohibit banks from adopting plans to achieve the new capital ratios based on shrinking the availability of loans.

So far so reassuring.

What of the other elements in the eurozone rescue?

Greater confidence

Well, it now seems pretty likely that there will be an agreement for the bailout fund, the European Financial Stability Facility, to have the power to guarantee new loans to countries such as Spain and Italy that are struggling to borrow: the EFSF (a proxy for eurozone taxpayers, especially German taxpayers) would be in line for the first 20% of losses on these loans, so commercial investors could lend to Spain and Italy with greater confidence they would get their money back.

Which is clever, because it means that the EFSF should not be too hamstrung by its current firepower of around 300bn euros (the 440bn euros that has just been agreed minus emergency credit to Greece and minus possible finance for recapitalising the weakest banks from the weakest countries).

An EFSF with the power to guarantee sovereign debt would have the ability to provide five times 300bn euros or so in emergency loans, or around 1.5tn euros.

But if that route of guaranteeing new Spanish and Italian debt is taken, it throws up a tricky technical problem.

The price of existing Italian and Spanish bonds or debt could fall, because those bonds would be seen as more risky than the new guaranteed bonds, and that would force increased and painful losses on the banks that hold that original debt, which would at a stroke undermine the strengthening of banks through the recapitalisation.

This kind of technical issue can be sorted, of course, but whether it can be mitigated in the course of one very tense weekend of negotiations by government heads and finance ministers who aren't investment bankers, well that seems unlikely.

Finally, I am being cautioned that there will be no agreement by Sunday night on a further write-off of Greek government debt, beyond the 21% reduction in what Greece owes, which is built into the existing pact with private-sector creditors on a debt reconstruction.

Or to put it another way, those who firmly believe that the Greek economy can't possibly recover unless and until the Greek national debt is cut by perhaps 60% will see nothing in the forthcoming European summit that puts the country properly on the road to recovery.

That said, there may be consensus on a mechanism for doing a possible future deal with Greece's private-sector lenders on further write-offs of what they are owed. This would be a plan for a process that could lead to an adequate reduction in Greece's debt burden.

Which is all very conditional and elusive. But that may not come as a great shock to students of eurozone decision-making.