Bank stress test results fail to ease pressure on the eurozone

Gold surged to fresh all-time highs, the euro slumped, bank shares stumbled and the interest rates demanded by private investors to take on Italian and Spanish government debt rose to critical levels yesterday – all clear signals that the banking stress tests published late on Friday have done little to convince sceptical investors. While the performance of individual banks was surprisingly good, the omens for systemic risk across the European financial system are much worse.

As European leaders continue to discuss their options ahead of a heads of government emergency summit this Thursday, Italian and Spanish borrowing costs scaled fresh heights, touching the punitive levels where a default or bailout becomes inevitable because of the size of the interest payments.

The problem for the eurozone's leadership, however, is that the sheer size of the Italian and Spanish economies – the third and fourth largest in the zone – would rule out most practicable options, and leave the euro itself locked into an existential crisis about which governments could do little even if they could agree a policy.

One of the few remotely realistic options open to them, and now gaining ground in Brussels, is to revive the idea of "euro-bonds" by which all eurozone nations' debts would be merged into one. That would mean higher interest rates for Germany and raise many political issues; but the total, overall levels of European debt and budget deficits look good by the standards of the US, the UK or Japan. It is a plan that has been championed by the Italian Finance Minister, Giulio Tremonti, and his opposite number in Luxembourg, Jean-Claude Juncker, who also chairs the euro group of finance ministers. Germany is still blocking it, however.

The yield on Italy's benchmark10-year bonds rose above 6 per cent and was up 27 basis points in trading, a substantial jump even by the volatile standards of recent weeks. Their Spanish equivalent hit 6.35 per cent, their highest level since 1997, ahead of debt auctions today and on Thursday.

Yet far from moving to some immediate decision on getting ahead of events in these potentially huge crises, Angela Merkel, the German Chancellor in particular has been criticised for an apparent obsession with the minutiae of a second Greek bailout.

Berlin has called for banks and insurers to take on €30bn of the new bail-out deal – worth around €110bn. But there are fears that the rescue might fail, leading eventually to a disorderly debt default by Greece. Mrs Merkel is also running into opposition from the Bundesbank over the idea of forcibly restructuring Greek debt.

"A haircut would reduce Greece's debt load. But it does not solve the fundamental problem: the Greek state and the country as a whole are still financially imbalanced," Bundesbank board member Joachim Nagel said yesterday.

Despite signals from the French banks and others that such a voluntary arrangement would be acceptable, the credit ratings agencies continue to maintain that any such move would constitute a "selective default". That, in turn, would trigger expensive "insurance" payouts under credit default swaps, and might cause some liquidity problems for the US and British institutions which have underwritten the bonds.

It would also mean that the European Central Bank would be unable to accept the bonds as collateral from private banks and would require the ECB's recapitalisation, at a cost of €30bn to eurozone governments. The ECB is bitterly opposed to a Greek default, selective or not.

The devaluation of government bonds – especially if the contagion spreads to Spanish and Italian government debt – would also mean another credit crunch as European banks are driven to contract their lending in the light of a massive depreciation in the value of their principal, supposedly safe, assets. That could damage economies across Europe.