From the September 01, 2011 issue of Futures Magazine • Subscribe!

European financial regulation update

About 10 minutes into the 2003 comedy "Team America," spy chief Spottswoode brings his star recruit for a ride in a flying limousine.

"A limousine that can fly," says the recruit. "Now I’ve seen everything."

"Really?" asks Spottswoode. "Have you seen a man eat his own head?"

"No," the recruit answers. "But I’ve seen the European Financial Stability Facility."

He doesn’t actually say that, but he would have if he had seen the EFSF, which is the largest of the emergency lending facilities that the European Union set up last year to provide a safety net for faltering EU economies — primarily Portugal, Italy, Ireland, Greece and Spain, or the "PIIGS" if you prefer. It’s backed by 16 of the 17 Eurozone countries, and because it’s backed by sovereign debt, it’s another troubled Triple-A entity. In 2013 it will be replaced by the European Stability Mechanism, which also takes over the tasks of another emergency lending facility, the European Financial Stabilization Mechanism (EFSM).

But here’s where it gets weird: More than two-thirds of the financial backing comes from four countries: Germany (27%), France (20%), Italy (18%) and Spain (12%). Italy and Spain, the third and fourth largest economies in the Eurozone, also are among the five most financially troubled, yet are responsible for nearly 40% of the guarantees. As we go to press, France also is taking heat, and the other PIIGS are contributing to the bailout fund — calling into question the validity of more than 60% of the bailout fund. All European governments pumped billions into their ailing banks during the liquidity crisis, leaving public-sector bonds exposed to the credit risk of banks that are required to hold those same public-sector bonds as collateral.

On Aug. 2, the same day the U.S. government averted default, markets shifted their attention to Europe in general and the health of Greece, Italy and Spain in particular. The result: Risk premiums on Italian and Spanish bonds surged to record highs, and bank shares plummeted, bringing the euro down against the dollar and other currencies.

Within a week, the European Central Bank (ECB) had gone on a multi-billion-euro buying spree of Italian and Spanish bonds — a practice previously reserved only for Greece, Portugal and Irleand. That drove down the risk premiums on the debt of those two countries, but signaled increased volatility in the weeks ahead.

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