Here’s How European Leaders Agreed to Combat Debt Crisis

European leaders have agreed to a plan to combat the region’s debt crisis that will impose steep losses on investors holding troubled Greek bonds and boost the firepower of the euro-zone rescue fund to at least one trillion dollars.

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Meeting at a summit in Brussels, European leaders continued negotiations well past midnight, with banks and other major investors in Greek bonds ultimately agreeing to take losses of up to 50%, a concession meant to prevent the Greek government from defaulting on bills it cannot pay, the repercussions from which would have been a significantly larger shock to the European financial system than the steep haircut.

European government leaders also agreed that the European Financial Stability Facility would be allowed to help countries such as Italy and Spain, which find themselves deep in debt, to borrow at least a trillion dollars by providing them with a kind of insurance that would make their bonds more attractive to investors.

The deal between 17 members of the single-currency region came only hours after leaders of the 27-member European Union said banks would be asked to raise up to $150 billion in new capital as a buffer against possible losses on their holdings of European government bonds, many of which may have declined in value.

World leaders have been pressuring Europe to produce an ambitious plan for addressing the region’s debt crisis. Failure to reach an agreement on a new Greek bailout at yesterday’s summit would have led many to seriously question whether Europe’s leaders would ever be able to act decisively to stem the spreading contagion.Speaking early this morning, European Commission President Jose Manuel Barroso said the set of measures proves that “Europe will do what it takes to safeguard financial stability.”

Efforts to enhance the EFSF also took a big step forward yesterday when German Chancellor Angela Merkel won a strong endorsement from the country’s lawmakers for her plan to reinforce the fund.Italian Prime Minister Silvio Berlusconi went to the summit yesterday with plans to change the country’s pension system and take other steps to balance the budget for which European leaders had been pressing him for months. Berlusconi’s proposed changes have been accepted by European leaders who say they now expect Italy to carry them out, thus reducing its debt load.

Under the deal, governments will also be made responsible for ensuring that banks have the funds they need to operate, as many European banks currently rely heavily on short-term loans to conduct their business, which in the case of the French-Belgian Dexia bank, resulted in collapse. The plan urges the European Central Bank, the European Investment Bank, and other agencies to “urgently explore” a guarantee system that will help banks wean themselves off short-term loans.

The plan will require banks to set aside capital equal to 9% of their assets. However, one concern is that, rather than raising capital, banks will increase their relative capital ratio by decreasing their total assets, which could mean reducing how much money they lend to businesses, consumers, and governments, a move that would only further hinder economic growth.

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To avoid such an eventuality, the bank capital plan calls for heightened oversight by regulators to ensure banks do not dump assets or restrict new loans. Regulators “must ensure that banks’ plans to strengthen capital do not lead to excessive deleveraging, including maintaining the credit flow to the real economy,” reads the EU’s statement. Banks will have until June 30 to meet the new requirement.