BOJ adopts negative rates in ramped-up stimulus campaign, stuns markets: competitive devaluation

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(Earth is rising over the Moon's Surface), Source: https://www.facebook.com/RealEstateSA5000/photos/a.899877783394135.1073741829.899009183480995/920077631374150/?l=734b9eef72 ========================= News Analysis: BOJ's surprising steps stopgap antidote to domestic woes, may spark broader devaluations Source: Xinhua 2016-01-30 14:45:04 by Liu Tian, Xu Yuan TOKYO, Jan. 30 (Xinhua) -- The Bank of Japan (BOJ) on Friday surprised markets by announcing that it would introduce a negative interest rate to show resolution in the fight against prolonged deflation. The proposed remedy, however, may hold few substantial cures for Japanese economic structural woes and may trigger other currencies' competitive devaluation, which would ultimately send stocks lower here and inhibit capital expenditure, the exact opposite of the central's ultimate reflationary goal. Japan's top central banker Haruhiko Kuroda told a press conference on Friday that "by adding an option for easing from the perspective of interest rates, we will make full use of easing measures with three dimensions, quantity, quality and interest rates." Although the BOJ chief was reluctant to follow suit when the European Central Bank plunged into negative interest rates, he hoped that Friday's "shock move" will suddenly motivate lending and thus spending, so as to actualize policy effects at the earliest possible juncture. The central bank planned to introduce the minus interest rate from next month and said it will further cut the interest rate if necessary. By doing so, the bank is hedging that commercial banks will be further incentivized to lend to businesses to promote widespread investment and growth, and put the bank back on track to hit its 2-percent inflation target, although the timeframe for this has once again been pushed back. But the danger of this gamble is that the BOJ has no means to ensure that the funds flowing out from commercial banks will be successfully injected into the real economy. If not, the market will soon erase surging gains made after the surprise announcement and return to a protracted spell of retreat into territory. This, more so if a "deflationary mindset" continues in businesses and households here, and other countries' currencies are forced lower and the yen used as a safe haven, which drives stocks lower, pummels Japan's export sector, which in turn impacts production and ensures businesses keep their purse strings tighter. Furthermore, the policy, to some extent, exposed the fact that the BOJ's previous monetary easing measures have failed to help bolster the banks reflationary efforts, while the meager rise in the consumer prices index in 2015 and the delayed timeframe of achieving the inflation goal, has proved that the country may possibly reenter its well-known deflationary quagmire. The BOJ, in terms of its monetary base, decided in the meantime to continue to increase the base at an annual pace of 80 trillion yen (around 674.48 billion U.S. dollars) through aggressive purchases of government bonds. But analysts here pointed out that the introduction of the negative interest rate showed that the BOJ's capability to purchase government bonds has reached its limit since commercial banks here will be reluctant to deposit cash in the BOJ and make it more difficult to continue such purchases. The BOJ's dramatic move temporarily halted the Japanese yen's appreciation and forced its devaluation, with the currency's fast retreating from the 118-yen level to the 121-yen zone versus its U.S. counterpart, after the BOJ's latest easing measures were announced Friday. However, a constantly depreciated yen will finally damage assets held by common Japanese people. Meanwhile, another issue of the minus interest rate that needs to be focused on, involves recent policy moves by the U.S. Federal Reserve raising its key interest rate and the European Central Bank hinting it will further ease its policy this spring. The BOJ's move triggering the yen's retreat will exert more pressure on other central banks to also ease their currencies and the result could end up severely hampering the tepid recovery of both regional and global economies. Related: BOJ to introduce negative interest rates, delays inflation target amid oil price slump TOKYO, Jan. 29 (Xinhua) -- The Bank of Japan (BOJ) on Friday following the conclusion of a two-day policy board meeting said it would introduce negative interest rates from next month to encourage more lending and business spending amid projections the central bank will not clear its 2 percent inflation goal, as oil prices' slide and a global economic downturn threatens to further impact spending. The BOJ surprised markets here, with economists widely believing further easing measures announced Friday would be negligible if at all, by saying it plans to introduce a negative interest rate from Feb. 16, as falling oil prices have hampered the bank's reflationary efforts, with the shock move aimed at proactively defending against global economic malaise denting business sentiment here.Full story Bank of Japan further eases monetary policy TOKYO, Jan. 29 (Xinhua) -- The Bank of Japan (BOJ) on Friday said it would implement new monetary easing measures amid projections the central bank will not clear its 2 percent inflation goal. While delaying the timing of its 2 percent inflation goal, the central bank also cuts its inflation target for fiscal year 2016, stating it now expects CPI to increase 0.8 percent. Full story =============================================== ------------------------ DEFINITION of 'Negative Interest Rate Policy (NIRP)' A negative interest rate policy (NIRP) is an unconventional monetary policy tool whereby nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent. BREAKING DOWN 'Negative Interest Rate Policy (NIRP)' During deflationary periods, people and businesses hoard money (A supply or store of something held or hidden for future use.) instead of spending and investing. The result is a collapse in aggregate demand which leads to prices falling even farther, a slowdown or halt in real production and output, and an increase in unemployment. A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central bank's interest rate to zero may not be sufficient to stimulate borrowing and lending. A negative interest rate means the central bank and perhaps private banks will charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe. Examples An example of a negative interest rate policy would be to set the key rate at – 0.2%, such that bank depositors would have to pay two-tenths of a percent on their deposits instead of receiving any sort of positive interest. The Swiss government ran a de facto negative interest rate regime in the early 1970s to counter its currency appreciation due to investors fleeing inflation in other parts of the world. In 2009 and 2010 Sweden and in 2012 Denmark used negative interest rates to stem hot money flows into their economies. In 2014 the European Central Bank (ECB) instituted a negative interest rate that only applied to bank deposits intended to prevent the Eurozone from falling into a deflationary spiral. Theoretically, targeting interest rates below zero will reduce the costs to borrow for companies and households, driving demand for loans and incentivizing investment and consumer spending. Retail banks may choose to internalize the costs associated with negative interest rates by paying them, which will negatively impact profits, rather than passing the costs to small depositors for fear that otherwise they will move their deposits into cash. Though fears that bank customers and banks would move all their money holdings into cash (or M1) did not materialize, there is some evidence to suggest that negative interest rates in Europe cut down interbank loans. Read more: Negative Interest Rate Policy (NIRP) Definition | Investopedia http://www.investopedia.com/terms/n/negative-interest-rate-policy-nirp.asp#ixzz3ybyEE1ma Follow us: Investopedia on Facebook --------- Macroeconomics - The Consumer Price Index & Inflation Inflation Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same. Inflation can also be defined as a decline in the real purchasing power of the applicable currency. Consumer Price Index (CPI) The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This data is used to compare the prices for a particular month with the prices from a different time period. Example: The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year, dividing that difference by last year's CPI value and then multiplying by 100. So if the value of the price index for the current year is equal to 165, and last year's value was 150, the rate would be calculated as: Inflation rate = (165 - 150)/150 X100= 10 CPI Sources of Bias The CPI is not a perfect measure of inflation. Sources of bias include: ·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price increases may reflect quality adjustments that are still counted entirely as inflation. ·New goods - new goods may be introduced that will be hard to compare to older substitutes. ·Substitution - if the price goes up for one good, consumers may substitute another good that provides similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting discount or outlet stores. Read more: The Consumer Price Index & Inflation - CFA Level 1 | Investopedia http://www.investopedia.com/exam-guide/cfa-level-1/macroeconomics/consumer-price-index.asp#ixzz3ycdLQHk4 Follow us: Investopedia on Facebook ---------------------------------------- Thu Jan 28, 2016 11:59pm EST Related: Japan TOKYO | By Leika Kihara A line of waiting customers are reflected in a window as an employee counts money at the Bank of Tokyo-Mitsubishi UFJ foreign currency exchange in Tokyo October 10, 2008. Reuters/Yuriko Nakao The Bank of Japan ramped up its aggressive stimulus campaign on Friday, adding negative interest rates on central bank deposits to its massive asset-buying program, stunning financial markets that expected no action or a moderate increase in asset purchases. The central bank said the move was aimed at forestalling the risk of global financial turbulence hurting business confidence and reviving the "deflationary mindset" it is striving to wipe out with aggressive money printing. Asian shares jumped and the yen fell across the board and sovereign bonds rallied after the BOJ said it would charge banks for excess reserves parked with the institution, an aggressive policy pioneered by the European Central Bank. The BOJ maintained its pledge to expand base money at an annual pace of 80 trillion yen ($675 billion) via aggressive purchases of government bonds and risky assets conducted under its quantitative and qualitative easing (QQE) program. But in a narrow 5-4 vote, it also decided to charge a 0.1 percent interest to current accounts that financial institutions hold with the central bank. "The BOJ will cut the interest rate further into negative territory if judged as necessary," the bank said in a statement announcing the decision. Markets have been split on whether the central bank would ease policy as slumping oil costs and soft consumer spending have ground inflation to a halt, knocking price growth further away from the BOJ's ambitious 2 percent target. In a quarterly review of its forecasts released on Friday, the BOJ cut its core consumer inflation forecast for the coming fiscal year beginning in April to 0.8 percent from 1.4 percent projected three months ago. However, it expects consumer inflation to accelerate to 1.8 percent in the fiscal year ending in March 2018, taking into account the effect of Friday's measures. The decision came in the wake of data that showed household spending and output slumped in December, underscoring the fragile nature of Japan's recovery. Consumer inflation was just 0.1 percent in the year to December, invigorating expectations that the BOJ would eventually have to deliver further stimulus. Many BOJ policymakers have been wary of using their diminishing policy tools to counter what they see as factors beyond their control, such as volatile financial markets and China's economic slowdown. But pessimists on the BOJ board have worried that slumping Tokyo stocks may discourage firms from boosting capital expenditure, threatening the positive momentum the BOJ is trying to create with its heavy money printing. (Story refiles to correct spelling of bank in opening paragraph) (Reporting by Leika Kihara; Editing by Eric Meijer) =========================== MEDIA RELEASE 5/2016 27 January 2016 Embargo: 11.30 am (Canberra time) CPI December quarter 2015 rises 0.4 per cent The latest Australian Bureau of Statistics (ABS) figures show the Consumer Price Index (CPI) rose 0.4 per cent in the December quarter 2015, following a rise of 0.5 per cent in the September quarter 2015. The most significant price rises this quarter were in tobacco (+7.4 per cent), domestic holiday travel and accommodation (+5.9 per cent) and international holiday travel and accommodation (+2.4 per cent). These rises were partially offset by falls in automotive fuel (–5.7 per cent), telecommunication equipment and services (–2.4 per cent) and fruit (–2.6 per cent). The increase of 0.1 per cent for the housing group is the weakest movement since March quarter 1998 as price rises for rents (+0.2 per cent) and new dwelling purchase by owner occupiers (+0.1 per cent) have been subdued through the quarter. The 0.1 per cent rise for new dwellings purchase by owner occupiers is the weakest movement since March quarter 2014. The CPI rose 1.7 per cent through the year to the December quarter 2015, following a rise of 1.5 per cent through the year to the September quarter 2015. Further information is available in Consumer Price Index, Australia (cat. no. 6401.0) available from the ABS website: www.abs.gov.au Media note: When reporting ABS data you must attribute the Australian Bureau of Statistics (or the ABS) as the source. Media requests and interviews - contact the ABS Communications Section on 1300 175 070. This issue incorporates a feature article titled "Australian Dietary Guidelines Price Indexes". The article is available in Consumer Price Index, Australia (cat. no. 6401.0) available from the ABS website: www.abs.gov.au ================== The Federal Reserve started raising official interest rates in December. But in the stress tests that large U.S. banks have to undergo, the central bank is hypothesizing that short-term Treasury yields could drop below zero. The European Central Bank and, since Friday, the Bank of Japan are trying it with policy benchmarks. Though negative U.S. interest rates are for now only in the Fed’s worst-case scenario, they are becoming a plausible downturn assumption.

The stress tests are required each year under the Dodd-Frank Act, and the 2016 parameters for big financial institutions were announced last week. They come in “baseline,” “adverse” and “severely adverse” flavors. The last is supposed to represent a severe global recession, and that’s where the Fed has told banks to model negative yields on short-term Treasury securities – emphasizing that it’s a hypothetical scenario, not a forecast.

Yet it’s no longer looking outlandish. There’s plenty for now to keep the Fed on a gradual path toward higher rates, including healthy U.S. employment and relatively steady growth. Even the uninspiring first estimate for GDP last quarter, which indicated a 0.7 percent annualized pace, still showed year-on-year expansion of 1.8 percent.

There are deepening wrinkles, though. Global market volatility should matter to the Fed only to the extent it reflects or causes real economic trouble, but the flickering of screens in real time may loom larger than that psychologically. Another concern is that actions like Japan’s decision to set a negative rate add to the reasons for the dollar to strengthen, potentially making U.S. exporters less competitive.

Either way, another downturn will eventually come to the United States, and the option of going negative may appeal to the Fed on policy grounds, whether or not Treasury yields are below zero. If Chair Janet Yellen and her colleagues haven’t managed to raise rates much by then, there may not be much juice in cutting official rates only to zero.

Yellen in November told a House of Representatives committee that if the economy took a turn for the worse, “potentially anything – including negative interest rates – would be on the table.” If the ECB, the BOJ and others have shown by then that charging depositors is even marginally effective, negative rates could shift from the severely adverse scenario into the Fed’s regular toolkit.

The U.S. Federal Reserve on Jan. 28 published the scenarios for annual so-called stress tests required of large U.S. banks under the Dodd-Frank Act.

In the Fed’s Comprehensive Capital Analysis and Review scenarios, the worst of the three cases, dubbed “severely adverse,” represents a severe global recession, corporate financial stress and negative yields for short-term Treasury securities.

The Bank of Japan unexpectedly cut a benchmark interest rate below zero on Jan. 29, surprising investors with another bold move to stimulate the economy.

Eight European Banks Fail EU Stress Test

9:47pm UK, Friday July 15, 2011

Tadhg Enright, business reporter
Eight European banks have failed a so-called stress test designed to show their ability to cope with economic shocks such as a sharp drop in economic growth or a decline on the stock markets.

The tests, which have been applied to Europe's 91 biggest banks, are designed to win back the confidence of investors and markets from which they borrow.

The four UK banks subjected to the tests - Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland - were shown to have passed the threshold of having reserves worth more than 5% of the value of their liabilities.
A further 16 banks were shown to have barely passed - having reserves worth between 5% and 6% of their liabilities - and have been encouraged to raise their capital ratios to more healthy levels.


Five of the failing banks are in Spain where the solvency of local savings banks, known as Cajas, have been in doubt throughout the financial crisis.

Two banks failed in Greece, where the bailed-out economy remains in recession as it struggles to escape from a mountain of debt.

One Austrian bank failed the test while a German bank withdrew from the process when it learned that it would also fail.

Like all testing processes, there need to be enough failures to make the success of others appear suitably difficult to achieve.

Tadhg Enright

The London based European Banking Authority (EBA) estimates that the failing banks need to raise a total of 2.5bn euros to meet capital requirements.

Bank officials will spend the weekend devising fundraising plans to win back the confidence of the markets before trading resumes on Monday.

Among their options are sell-offs of non-core assets, issuing new shares to raise money from private investors or negotiating government bailouts.

Banks that cannot raise new funds could lose the confidence of their customers, have their shares dumped by investors and be refused credit from debt markets, leading to their eventual collapse.



It is the second time that European banks have been subjected to the stress test and the EBA has applied tougher criteria after last year's test was seen by many as having been too lenient.

This year, banks were asked to demonstrate their ability to cope with a 0.5% drop in economic growth in the Eurozone and a 15% drop in stockmarkets.

They have also been asked to reveal how much debt they hold in troubled eurozone countries, such as Greece and Ireland.

Critics have argued that the criteria should have included a bank's ability to withstand a default by Greece on its debts, which many believe is an inevitable outcome to its financial crisis.


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===
Reuters
Europe's banks could cope with a Greek haircut

(Refiles to replace repeated "Italian" with "Irish" in third paragraph)




(The authors are Reuters Breakingviews columnists. The opinions expressed are their own)
Banks could cope with a Greek haircut
By George Hay and Peter Thal Larsen
LONDON, July 18 (Reuters Breakingviews) - Europe's banks can mostly deal with a fat haircut on their holdings of Greek sovereign debt. That's the conclusion of a Breakingviews analysis of data disclosed by lenders under the European Union's latest stress tests.
Officially, just eight banks failed this year's stress tests, with a capital shortfall of 2.5 billion euros. But the exam had a major flaw: it did not require banks to apply a haircut to the majority of their holdings of euro zone peripheral debt. That's at odds with reality: any revised bailout package for Greece is likely to force banks to recognise at least some losses on their debt.
The Breakingviews test shows what would happen under such a scenario. It takes the banks' holdings of sovereign debt in their banking books and applies a haircut to Greek, Portuguese, Italian, Spanish and Irish bonds based on where the countries' 5-year bonds were trading last Friday. The value of Greek bonds, for example, is slashed in half.
As a result, the Breakingviews test shows 27 banks failing the test, with an overall capital hole of around 25 billion euros -- 10 times the official number.
That sounds scary. But the biggest problem is in Greece itself, where the resulting capital hole is 13.6 billion euros. This is not much more than the 10 billion euros that Greece has already set aside to recapitalise failing banks.
There's also a knotty problem for Cyprus. The two Cypriot banks covered by the test would face a capital hole of 2 billion euros. Although that's 11 percent of GDP, the government's own debt is 61 percent of GDP so it could stump up the cash if it had to.
Portugal and Spain also take a hit under the Breakingviews test, with capital shortfalls of 3.3 billion euros and 6 billion euros respectively. But in the context of those countries' economies, that is not a huge amount.
Investors may quibble with some of Breakingviews' assumptions. In particular, some may feel the pass mark core Tier 1 ratio of 5 percent is too low. Raise it to 6 percent, and the number of failing banks jumps to 38, and the capital hole goes up to 45 billion euros.
The tests do not mean that euro zone leaders can just merrily let Greece default. They need to recapitalise their banks sufficiently to deal with such an event -- not merely to deal with the stresses envisaged in the official tests. And they need to put in other firewalls to deal with the second-order impact of a default.
But if they do that, a Greek default need not be a disaster.

CONTEXT NEWS
-- Twenty-seven European banks would have to raise 25.7 billion euros of fresh capital according to a Breakingviews stress test of the sector's sovereign debt exposures.
-- Results of the official stress tests revealed by the European Banking Authority on July 15 found that eight lenders had failed to maintain a core Tier 1 capital ratio of 5 percent under a stressed scenario. The capital shortfall was 2.5 billion euros. An additional bank from Germany, Helaba, pulled out of the tests last week and is thought to have also failed.
-- The EBA test subjected banks' exposures of sovereign debt held in their trading books to a haircut based on a market shock. However, most banks hold government bonds in their banking books, which are not marked to market. Instead, the EBA required banks to set aside some provisions for lowly-rated sovereign debt in their banking books.
-- The Breakingviews test applied a haircut to banking book exposures for banks' holdings of Greek, Portuguese, Irish, Italian and Spanish sovereign debt. The haircut is based on the market price of 5-year bonds on July 15.
-- Greek debt is therefore haircut by 52.8 percent, Portuguese debt by 33.3 percent and Irish debt by 38.5 percent. Italian and Spanish bonds are haircut by 5.7 percent and 8.6 percent, respectively.
-- The aggregate haircut was then deducted from the banks' stressed Core Tier 1 capital ratio, after adding back provisions banks had set aside to cover potential sovereign losses. The calculation does not factor in any tax benefits from greater losses.
-- Under the Breakingviews scenario, all six Greek banks fall short of a 5 percent core Tier 1 capital ratio, with a capital requirement of 13.6 billion euros. Marfin and Bank of Cyprus would also fail and need 2 billion euros of extra capital.
-- Thirteen Spanish lenders fail the Breakingviews tests, up from 5 in the official exam, with a combined capital shortfall of almost 6 billion euros. Portugal's four lenders would require a total capital injection of3.3 billion euros.
-- EBA results: http://stress-test.eba.europa.eu/

((george.hay@thomsonreuters.com; peter.thal.larsen@thomsonreuters.com))
(Editing by Hugo Dixon and David Evans)


===

Reuters
EU banks' stress test hangovers aren't equally bad

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

By George Hay
LONDON, July 20 (Reuters Breakingviews) - Europe's banks have had their exam results, and they were hardly prize winning. Although only eight of the 90 banks that sat the European bank stress tests failed even to muster 5 percent core Tier 1 ratios, a further 16 did not get above 6 percent. The good news is that over half of the candidates tested can point to actions they are taking to recapitalise. The bad news is that some of these plans are more credible than others.
The teacher's pets are, for the most part, the Spanish banks. Although 5 of the country's 25 lenders participating in the test failed, they have an excuse. The European Banking Authority, which set the test rules, did not allow them to include generic provisions -- cash they have set aside to cover non-specific future losses -- towards capital. That looks harsh.
Adding back these provisions does wonders for Spanish banks' capital strength. Banca Civica came close to failing the test with a core Tier 1 capital ratio of 5.6 percent under stress. Include generic provisions and the ratio leaps to 9.4 percent. Mandatory contingent convertible notes issued by the Cypriot lenders, Bank of Cyprus and Marfin, are in a similar category. Though they did not meet the EBA's strict criteria, they boost each bank's capital ratio by over 3 percentage points.
HSH Nordbank's plans don't look nearly as robust. The German landesbank's 5.5 percent capital ratio under the test is improved by a 3.6 percent uplift from mitigating factors. But this comes from so-called "disinvestments and restructuring measures". Achieving these depends on HSH selling assets at the right price. National Bank of Greece's planned 2 percent uplift similarly hinges on disposals.
Shaky mitigation schemes are bad enough. But if euro zone peripheral government bonds had been marked to market prices, 27 of the 90 banks tested would fall below 5 percent, according to Reuters Breakingviews' own stress test. The problem may then be then not just be that banks' contingency plans aren't very robust, but that some of the lenders in trouble do not have any such plans at all.
-- Graphic: Effect of mitigating measures: http://r.reuters.com/tad72s
-- Breakingviews euro zone bank stress tests calculator: http://r.reuters.com/jyw62s

CONTEXT NEWS
-- Just over half the banks stress-tested by the European Banking Authority on July 15 announced measures to increase their capital strength by the end of 2012.
-- The EBA's disclosure for each of the 90 banks tested shows that 47 assume that their capital position after a macro and sovereign shock would be augmented by various measures. These include generic provisions already booked, convertible bonds, and disposal programmes that have not yet been completed.
-- ATE Bank of Greece assumes the highest uplift from these mitigating factors, with a 6.8 percent benefit from provisions and equity-raisings. Oesterreichische Volksbank assumes a 5.3 percent increase, while Spain's Banca March envisages a 4.3 percent uplift.

((george.hay@thomsonreuters.com))
(Editing by Peter Thal Larsen and David Evans)


===

No bank tax in Franco-German deal on Greece



Options on the table to address euro zone crisis
3:45am EDT

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By Gernot Heller and Luke Baker

BERLIN/BRUSSELS | Thu Jul 21, 2011 4:44am EDT

(Reuters) - Germany and France have ruled out a bank tax after reaching a common position on a second bailout of Greece to prevent the country's debt crisis spreading through Europe, EU sources said on Thursday.

The accord came after seven hours of talks late into Wednesday night between German Chancellor Angela Merkel and French President Nicolas Sarkozy in Berlin, sources in both governments said.

European Central Bank President Jean-Claude Trichet joined Merkel and Sarkozy for part of their talks and one source said their agreement, kept secret to avoid offending other euro group leaders at a summit on Thursday, had his blessing.

"You should assume that there will not be a banking tax," the source told Reuters.

Another source involved in preparatory talks for the emergency summit of the 17-nation currency area confirmed that the banking tax proposal, raised last week, had been dropped.

While few details of the Franco-German deal emerged, the sources said it would include private sector involvement that should not cause either a default or selective default of Greek debt, a red line for the ECB.

The risk premium investors demand to hold peripheral euro zone government bonds rather than benchmark German Bunds fell on Thursday on news of the Franco-German agreement.

"There are huge expectations something will be done... the big disappointment could come from how quickly they can implement things. They can agree principles but implementation will take a long while," said Peter Schaffrik, a strategist at RBC Capital Markets.

The 115 billion euro second Greek rescue package would involve both more official funding from the euro zone rescue fund and the IMF and a contribution by private sector bondholders on which two senior bankers will make a presentation to leaders on Thursday, the sources said.

Baudoin Prot of BNP Paribas, the French bank with the biggest exposure to Greek debt, and Deutsche Bank chief executive Josef Ackermann, chairman of the International Institute of Finance, a banking lobby that has led talks among bankers, will attend, banking sources said.

The leaders are due to meet at 1100 GMT but the start could well be delayed as euro zone sherpas work to thrash out details of an agreement, officials said.

The aim is to make Greece's debt more sustainable and prevent fears of a disorderly default from poisoning access to the bond market for bigger states such as Italy and Spain.

SUPPLEMENT

The new bailout would supplement a 110 billion euro ($156 billion) rescue plan for Greece launched in May last year. Ireland and Portugal have since received similar rescues and Italian and Spanish debt has come under attack this month, spreading the crisis to countries that are too big to save with the EU's current fire-fighting instruments.

Worried about the impact on financial markets and wary of angering their own taxpayers, euro zone governments have struggled for several weeks to agree on major aspects of the plan, especially a contribution by private sector investors.

The euro rose moderately against the dollar in response to the Franco-German announcement. Providing fresh money to Greece and arranging for commercial banks to participate could face legal and technical obstacles.

The head of the European Commission, Jose Manuel Barroso, warned on Wednesday that the global economy would suffer if Europe could not summon the political will to act decisively on Greece.

"Nobody should be under any illusion: the situation is very serious. It requires a response, otherwise the negative consequences will be felt in all corners of Europe and beyond," Barroso told a news conference.

Britain's finance minister George Osborne, in an interview with the Financial Times published on Thursday, said failure could produce an economic crisis as serious as the recession which followed the global credit crash of 2008.

NOT CLEAR

Barroso said a solution to Greece's problems must include steps to ensure the sustainability of Greek public finances, private sector involvement in funding for Athens, more flexible use of the euro zone's bailout fund, repair of the region's banking system, and liquidity to keep the Greek economy going.

It was not clear how many of these steps were included in the Franco-German accord.

Four competing proposals have been circulating for private sector involvement: a rollover of Greek government bonds as they mature, a swap of bonds for debt with longer maturities, a buy-back of Greek debt at a discount to its face value, and a tax on European banks.

Germany and France had been at odds on these proposals, with Berlin promoting a bond swap and France suggesting a rollover or a tax. The ECB had complicated the argument by opposing any step that might cause credit rating agencies to declare Greek debt in default.

The IMF, whose new head Christine Lagarde will also attend, has told euro zone leaders they should put more money into their bailout fund, the 440 billion euro European Financial Stability Facility, and let it buy government bonds of weak states on the secondary market. Investors also hope it will be permitted to extend precautionary credit lines to countries at risk.

Germany has previously blocked allowing the EFSF to buy bonds, which would require changes in the fund's rules that would have to be ratified by national parliaments, and could fall foul of critics in Germany, the Netherlands and Finland.

Regardless of the details of the Franco-German accord, Thursday's summit is very unlikely to mark a complete resolution of the crisis, as Merkel herself acknowledged earlier this week.

A second bailout may simply keep Greece afloat for a number of months before a tougher decision has to be made on writing off more of its debt.

In any case, many economists believe the only way out of the euro zone's debt crisis in the long run may be closer integration of national fiscal policies -- for example, a joint euro zone guarantee for countries' bonds, or issuance of a joint euro zone bond to finance all countries.

Germany has firmly ruled out such steps, but Osborne said the second Greek bailout would only be a step toward a necessary fiscal union in the euro zone.

(additional reporting by Emmanuel Jarry in Berlin, Philipp Halstrick in Frankfurt, Emilia Sithole-Matarise in London; writing by Andrew Torchia and Paul Taylor, editing by Janet McBrde) ============================== EU bank stress-test winners still short of capital Most European banks passed the exam, at least on a headline level. But the accompanying disclosures make them look less robust up close. Investors can use the new clarity to push for extra capital buffers. These would help lenders cope with the risks of euro zone deflation. Italy’s bank debacle could be useful for Renzi Italian banks’ poor showing in Europe’s stress test has sparked protest from the Bank of Italy. But for reforming Prime Minister Matteo Renzi, shocks to the system aren’t unhelpful. He can use the mess to reform ailing lenders so they can support the shaky economy. Breakingviews TV: Stressed out? Dominic Elliott and George Hay say Europe’s bank review has done just enough to avoid looking like a whitewash. Watch the view Europe's bank stress test warrants a narrow pass The analysis has enough nasties to avoid appearing a whitewash. And it has a big loser: Monte dei Paschi is a massive 2 bln euros short, amid other predicted failures. But while the bigger lenders passed and the air has been cleared, it may yet fail to spur credit supply. World's oldest bank faces radical treatment Monte dei Paschi will struggle to plug its 2 bln euro stress-test hole and stay independent. Investors in the last cash call got burned. The clean solution would be a takeover. But with buyers in short supply, a breakup may be required. It’s a big setback for the Bank of Italy. 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To find out more about Reuters Breakingviews click here =============================== ECB fails 25 banks in health check but problems largely solved Sun, Oct 26 16:18 PM EDT image 1 of 2 By Laura Noonan and Eva Taylor FRANKFURT (Reuters) - Roughly one in five of the euro zone's top lenders failed landmark health checks at the end of last year but most have since repaired their finances, the European Central Bank said on Sunday. Painting a brighter picture than had been expected, the ECB found the biggest problems in Italy, Cyprus and Greece but concluded that banks' capital holes had since chiefly been plugged, leaving only a modest 10 billion euros ($12.7 billion) to be raised. Italy faces the biggest challenge with nine of its banks falling short and two still needing to raise funds. The test, designed to mark a clean start before the ECB takes on supervision of the banks next month, said Monte dei Paschi (BMPS.MI) had the largest capital hole to fill at 2.1 billion euros. The exercise provides the clearest picture yet of the health of the euro zone's banks more than seven years after the eruption of a financial crisis that almost bankrupted a handful of countries and threatened to fracture the currency bloc. While 25 of the euro zone's 130 biggest banks failed the health check at the end of last year with a total capital shortfall of 25 billion euros, a dozen have already raised 15 billion euros this year to make repairs. A recent investor survey by Goldman Sachs found they believed the ECB ought to ask lenders to raise an additional 51 billion euros of capital for the tests to be credible. Although investors may take heart, it remains to be seen whether the exercise can spur banks to lend more as the region's economic growth stutters to a virtual halt. (Spur: A short or stunted branch of a tree.1. To ride quickly by spurring a horse. 2. To proceed in haste.) European Central Bank Vice President Vitor Constancio said the results could encourage banks to lend. "There is some pick up (in demand), but it is still slight," Constancio told Reuters. "All this now can really start to change the environment and we hope it will also change the reality." Alongside Italy, regulators said three Greek banks, three Cypriots, two from both Belgium and Slovenia, and one each from France, Germany, Austria, Ireland and Portugal had also missed the grade as of end-2013. Analysts generally gave the results a cautious welcome, saying they marked the beginning rather than the end of a banking clean-up in Europe. "I consider the stress test as an important partial success, which will help reduce uncertainty," said Marcel Fratzscher, president of Germany's DIW economic institute. "However, important challenges remain unsolved. The stress test alone will not end the credit crunch for small and mid-sized companies in Southern Europe." Some were more critical. "This seems as if it has been pretty unstressful," said Karl Whelan, an economist with University College Dublin. "The real issue is the size of the capital shortfall and that is very, very small. I don't feel a whole lot more reassured about the health of the banking system today than last week." The exercise nonetheless provided a snapshot of banks' vital statistics and forced them, for example, to revise the amount of risky loans - which have not been serviced in 90 days - upwards by 136 billion euros to 879 billion. CLEAN-UP AHEAD The exercise, which saw officials trawl through more than 40 million individual bank figures, had two parts – a strict review by the ECB of assets such as loans, followed by a wider test of how banks would cope with a new economic crash. It is the fourth attempt by Europe to clean the stables of its financial sector and has been billed as much the most rigorous. Previous efforts failed to spot problems, giving lenders in Ireland a clean bill of health shortly before a banking crash drove the country to the brink of financial collapse. "It is credible," said Nicolas Veron of Brussels think tank Bruegel. "But it is only the start of a longer sequence of cleanup that will extend well into 2015." The ECB's passmark was for banks to have high-quality capital of at least 8 percent of their risk-weighted assets, a measure of the riskiness of a banks' loans and other assets, if the economy grows as expected over the next three years, and capital of at least 5.5 percent if it slides into recession. Banks with a capital shortfall will have to say within two weeks how they intend to close the gap. They will then be given up to nine months to do so. UNBLOCKING LENDING The ECB staked its reputation on delivering a thorough assessment in an attempt to draw a line under years of financial and economic strife in the bloc. For many banks, the biggest impact of the tests was not in identifying capital holes but in finding that their assets, such as loans, had been overvalued. In total, the ECB said banks had been valuing their loans and assets at 48 billion euros more than they are really worth. This was because they had not recognised 136 billion euros of bad loans. That accounted for 11 billion of the 25 billion euros banks were collectively short of at the end of last year. It also eroded 37 billion euros of capital amongst the banks that passed. Among the major listed banks, the biggest hits were to Greece's Piraeus bank, whose core capital fell by 3.7 percentage points after the ECB adjusted the bank's capital to reflect the new asset valuations. Monte dei Paschi's capital was reduced by almost a third. There was also a big impact on Austria's Erste Bank. The adjustments put many banks in an uncomfortable position. Thirty-one had core capital below the 10 percent mark viewed by investors as a safety threshold, while a further 28 were had ratios just 1 percentage point above. The ECB will not immediately force lenders with overvalued assets to take remedial action but they will have to hold more capital eventually, leaving less room to expand, lend or pay dividends. For overall lending, the more fundamental question is whether the demand for credit is there in a moribund euro zone economy. (Moribund: 1. Approaching death; about to die. 2. On the verge of becoming obsolete: moribund customs; a moribund way of life.) (Additional reporting by John O'Donnell and Paul Carrel in Frankfurt, Huw Jones, Steve Slater and Clare Hutchison in London, Carmel Crimmins in Dublin and Michelle Martin in Berlin. Writing by Mike Peacock and John O'Donnell, editing by Alexander Smith and David Evans) ======================================