Choice For EU: Bail Out Greece Or Bail Your Banks (WSJ)

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Choice for EU: Bail Out Greece or Bail Your Banks (Wall Street Journal, AUGUST 31, 2011):

The yield on Greek one-year government bills hit 60% Tuesday.

Not only does this suggest default is now all but certain and will come soon, it also implies that the terms of the default will be particularly brutal for investors, with recovery rates possibly even lower than the currently anticipated 50%.

European governments are being forced to face up to the significance of a Greek default. This is perhaps the underlying message from International Monetary Fund Managing Director Christine Lagarde’s warning that Europe’s banks “need urgent recapitalization.” She may have been warning about the costly alternative to a solution to the Greek sovereign crisis. But it could well be too late.

Finnish insistence on additional collateral against any further bailout loans it makes to Greece threatens to scupper Europe’s rescue vehicle, the European Financial Stability Facility. Without EFSF funds, Greece will almost certainly have no choice but to default on its obligations.

And default will damage Europe’s already fragile banks.

Getting to the nub of their exposure to Greece is tricky. On the face of it, their direct holdings of Greek government debt as a fraction of existing capital is probably not too scary. UBS estimates the exposure of European banks, except Greek banks, to Greek sovereign debt at €46 billion (£66 billion), with French and German institutions holding €9.4 billion and €7.9 billion, respectively.

Although these exposures are fairly significant for some banks—for instance, Dexia’s exposure to Greek government debt is estimated at 39% of its equity capital, and Commerzbank’s at 27%—most outside of Greece have much more manageable positions.

But these crises are seldom neatly contained.

“The problem with situations like this is that it is hard to quantify what the second- and third-round effects will be,” warns Stephen Lewis, economist at Monument Securities.

Any default would hit the Greek economy more generally and banks have considerably more exposure to Greece than simply to its sovereign debt. According to the Bank for International Settlements, European banks have a total exposure of €94 billion to the Greek economy, with French institutions on the hook for €40 billion and Germany’s €24 billion.

Given that in mid-August, the 32 members of the Stoxx euro-zone banks index had a total market capitalization of some €240 billion, Greece has the potential to put a huge dent in their balance sheets. What’s more, the International Accounting Standards Board is worried that European financial institutions have been fudging their exposure to Greece in their recent results by underproviding against potential losses on these assets. When the default finally hits and banks are forced to recognize their true positions, the results could look very ugly indeed.

But that’s not where it ends. These estimates don’t include the exposure to Greece by non-banking institutions such as insurers. As they’re damaged by the Greek fallout, domestic banks will be affected further still.

Ms. Lagarde argued that the “most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary.”

Unfortunately, the time for private-sector recapitalization has probably passed. European banks might have raised sufficient funds a year ago when the first round of stress tests left investors feeling a warm glow, but there’s much less enthusiasm about the banking sector these days.

And if investors are likely to be reluctant to pump more capital into banks, governments will be equally nervous.

It’s unlikely any will have forgotten the painful lesson Ireland learned when it offered its banking sector a blanket guarantee in the midst of the financial crisis. Not only did it fail to shore up the banks but they dragged the Irish economy down with them when they sank.

European politicians have been weighing the unpalatability of rescuing their banks relative to that of rescuing peripheral European economies. The advantage of the Greek rescue has been that it mostly involved promises and guarantees rather than actual taxpayer money. Bank recapitalizations, on the other hand, are likely to go straight onto the national balance sheets.

Of course, banks unable to recapitalize either through the private or public sector face the third alternative of having to limp along as best they can. This would result in a significant credit contraction, which would depress growth in core Europe.

And because one of the few positives for peripheral euro-zone countries has been to expand exports to the healthy bits of Europe, a slowdown in the core could cause a downward spiral throughout the single-currency region.

European governments are unlikely to reach a consensus on how to respond to their domestic banking problems. Some are likely to do everything they can to encourage a private-sector recapitalization. Others will use public funds. And still others will stand back, hoping the European Central Bank comes up with something.

What’s almost certain is that it will create further strain within the euro zone. Tensions over whether further lending to Greece can be collateralized are “just a foretaste of how serious the friction could be” once the issue turns to bank rescues, especially if a country feels it is disadvantaged by another, Monument Securities’ Mr. Lewis adds.

The post-Lehman banking crisis could yet prove to have been just the foreshock.

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