Opening Pandora’s Bank Vault

A Greek exit from the euro could cripple banks across Europe | A chain reaction ... that ultimately breaks up the entire euro zone”

Elena Logutenkova, Liam Vaughan, and Gavin Finch

European banks have spent the past two years increasing capital buffers, writing down Greek bonds, and using central bank loans to refinance regional operations in southern Europe in anticipation of some cataclysmic event such as a Greek withdrawal from the euro. All that preparation may not do much good. With more than $1.2 trillion in Spanish, Portuguese, Italian, and Irish debt, Europe’s lenders still face deposit flight risk and rising defaults elsewhere. “A Greek exit would be a Pandora’s box,” says Jacques-Pascal Porta of Ofi Gestion Privee, an asset manager in Paris. “It’s a disaster that would leave the door open to other disasters. The euro’s credibility will be weakened, and it would set a precedent: Why couldn’t an exit happen for Spain, for Italy, and even for France?”

Should Greece return to the drachma, its currency probably would suffer an immediate devaluation of as much as 75 percent against the euro, spurring widespread defaults on foreign loans, economists at UBS say. If European leaders couldn’t make a credible argument that Greece was an isolated case, depositors in other nations might decide to withdraw euros from banks or shift them to countries seen as safer. “The more policy makers continue to openly discuss an exit, the more likely that people in Spain, Ireland, and Portugal pull money out of their local banks,” says Andrew Stimpson, an analyst at Keefe, Bruyette & Woods in London. France’s Société Générale estimates that a Greek exit could mean more than $1.1 trillion in loan and currency losses in the U.S. and Europe.

Banks in Greece, Ireland, Italy, Portugal, and Spain saw a decline of €81 billion ($103 billion), or 3.2 percent, in household and corporate deposits in the 15 months through March, according to the European Central Bank. On March 30, Greece had €160 billion of bank deposits, down almost €75 billion from the peak in 2009, central bank data show. Lenders in Germany and France saw an increase in deposits of €217 billion, or 6.3 percent, in the same period.

UBS has told its wealthy clients that there’s a 20 percent chance of Greece leaving the euro within six months. To prevent contagion, countries in the euro zone would have to form a full-fledged political and fiscal union immediately and implement uniform guarantees on bank deposits throughout the area, UBS says. The chances of that happening? Effectively nil. A Greek exit could trigger “a chain reaction of bank runs and soaring risk premiums on government bonds of weaker countries, and that ultimately breaks up the entire euro zone,” UBS economists Thomas Wacker and Jürg de Spindler wrote in a note to investors.

Citigroup analysts in May said the likelihood of Greece abandoning the euro over the next 18 months stands at 50 percent to 75 percent. “Banks’ risk-management departments have probably taken into account a Greek exit and most would likely have a plan,” says Robert Liljequist, a fixed income strategist at Swedbank. “The big problem is that nobody really knows what would happen in the markets if the country leaves the currency.”

The ECB’s unprecedented provision of €1 trillion in three-year loans to financial institutions in December and February helped calm financial markets in the first quarter by removing concern that banks, unwilling to lend to one another, would run out of cash. Lenders in Spain and Italy also used the funds to buy sovereign debt, reducing government borrowing costs.

The rebound was short-lived as doubts about the health of Spain’s banks and questions over Greece’s future returned. In May the Euro Stoxx Banks index fell below its March 2009 levels, and the euro is at its lowest against the dollar since mid-January.

With Spain in a recession and unemployment at more than 24 percent, bad loans in the country jumped to 8.4 percent of total lending in March, the highest since 1994, the Bank of Spain reports. The government has embarked on its fourth effort in less than three years to rebuild confidence in the financial industry. On May 9 the state took control of Bankia, the lender with the most Spanish assets, and on May 11 it ordered banks to set aside an additional €30 billion as a cushion against losses on property loans.

ECB President Mario Draghi on May 16 acknowledged that Greece might leave the euro area and signaled that policymakers won’t compromise on their key principles to prevent an exit. He’s not alone in contemplating what was once unthinkable. German Minister of Finance Wolfgang Schäuble has indicated that a departure would be manageable, and Bank of France Governor Christian Noyer has said “whatever happens in Greece” won’t place any French financial institution in difficulty. A year ago, Schäuble said a Greek exit would create an “exceptionally difficult” situation that would be “hard to control,” while Noyer called the possibility of a Greek default a “catastrophe.”

What’s changed is that banks in Germany, France, and the U.K. have insulated their southern European units against losses. They have cut holdings of sovereign debt issued by weaker countries, and they have used ECB money to replace their own funds backing subsidiaries in the region. Deutsche Bank tapped what it called “a small amount” of ECB cash to help fund corporate and retail business in continental Europe. Barclays took €8.2 billion in three-year loans from the central bank to provide “funding stability” for its units in Spain and Portugal. BNP Paribas used ECB money to shore up its Italian unit. Lloyds Banking Group says it’s using central bank money to “ring-fence” its Spanish operation. “If you’re a U.K. lender and you’ve lent €10 billion to your Spanish subsidiary and Spain exits, you’re suddenly only going to get paid back in 50 percent-devalued pesetas,” says Philippe Bodereau, head of European credit research at Pimco. “And you’re on the hook for €5 billion.”

The bottom line A Greek exit from the euro could trigger a run on European banks, which are sitting on more than $1.2 trillion in loans to southern Europe.


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