The Wilder View

Core Euro Area Banks Still Very Exposed to Contagion from a Greek Exit

Today Megan Greene (@economistmeg) wrote a rather insightful post linking this weekend’s German proposal to Greece’s eventual exit from the EMU – the leaked proposal is to (1) make Greek debt service a top priority, and (2) for Greece to rescind national fiscal sovereignty to the European level (links included in her post). At the end of the post, she argues that the ECB’s recent liquidity measures may have produced ‘unintended consequences’ by speeding up the time frame of Greece’s exit through offering banks unlimited liquidity.

Perhaps this aggressive proposal by Germany is one of the unintended consequences of the ECB’s three year long term refinancing operation (LTRO). If eurozone banks have as much access to cheap, three-year ECB funding as their collateral allows, perhaps Germany and the troika have decided that eurozone banks can survive a Greek default.

Perhaps naively so, I look at the BIS statistics and see quite clearly that the Germans and the troika would be wrong as regards the Eurozone banks being able to sustain contagion effects of a Greek default and/or exit. Exposure levels remain too high as a share of equity.

Better put: if I look at key core bank exposure, German, French, Dutch, and Belgian, to the Periphery economies as a share of total equity, these banks could go bankrupt if a Greek exit/default spreads to broad Periphery exposure.

Belgian banks especially are in the the red, with total periphery exposure being valued at just over 2X equity. This means that if the Belgian banks were jointly forced to write down all periphery holdings to 49% of what they are holding on their books – according to the IMF 39% of European banks hold their sovereign exposure to maturity, where sovereign exposure is a subset of the BIS data above – their equity would be completely wiped out and technically insolvent. French and German banks are in slightly better shape, but still exposed at holdings of 1.4X and 1.1X equity, respectively.

Banks have improved solvency ratios, as Q3 2010 periphery holdings as a % of equity were higher:
Germany 166%
France 202%
Netherlands 120%
Belgium 291%

Unless the German, French, Dutch, and Belgian governments are planning to inject equity into their banking systems – they haven’t announced such a grand plan to date – banks remain overly exposed to periphery asset valuations. Thus, I can only conclude the following: the Germans and the troika either (1) have a plan to quickly recapitalize the banks across Europe, or (2) could be making a huge mistake.

Source data: BIS, table 9D; ECB for total equity; and ECB for FX conversion.

2 Responses to “Core Euro Area Banks Still Very Exposed to Contagion from a Greek Exit”

Jennifer K.January 30th, 2012 at 10:36 am

Rebecca, I enjoy reading your articles but exposures do not equal losses and a 49% writedown rate is enormous. If we assign a 30% default rate to the Belgian bank exposures – keeping in mind that such a default rate is enormous and in line with exits from fixed exchange rate regimes – and assume NO recovery value, equity will be reduced by 67%. In the grander scheme of things and given how far down the hole we are, this is not an intractable problem. The banks can be nationalized, recapped with bonds, and or have capital ratios suspended or adjusted to include the "bond-like equity". Such a decision to recap the banks could easily occur during or after a trigger event has occurred (i.e. it does not necessarily have to be premeditated).
The more immediate problem that cannot necessarily be finessed with promissory notes and accounting is liquidity, and the ECB LTROs and collateral easing are big supports.

Rebecca WilderJanuary 30th, 2012 at 11:33 am

Hi Jennifer K.

I contend that the LTRO is not a sufficient condition for firewall, especially against a Greek exit (which is the point of the article by @economistmeg and myself). True, the other backstops – warrants, direct equity injection, nationalization (at the EU level only) – would shore up the solvency risk. But premeditated or not, it hasn't happened yet, so why do the Germans and the troika seemingly think the banks are safe?

I would agree, though, that LTRO and easing collateral conditions is a big support, and has removed some near-term solvency risk from the table. But it's not the answer to the valuation of the asset base, hence solvency risk, on bank balance sheets, and is unlikely a sufficient firewall. Now, rumors abound that could help – IMF funds, for example.

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