Contagion from Greece is infecting the European banking system
Policymakers have been hoping to postpone a Greek debt restructuring until growth recovers, reforms have been put in place and banks have had a chance to better capitalize to cover potential losses. However, the lack of agreement and ability to act in a coordinated way by eurozone policymakers has allowed a crisis of confidence to develop, resulting in contagion to other countries and a banking-system infection. As a result, banks are less willing to lend to each other, as highlighted in the chart below by the widening in the three-month Euribor/EONIA spread, indicating a growing credit crunch.
European Bank Stress Up, But Below 2008
Source: FactSet, as of September 9, 2011. Europe Bank Stress=three-month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.
There's a question of which came first, the chicken or the egg here, but the interaction between banks and governments appears to be reinforcing this negative feedback loop. Reasons include:
- Banks have large holdings of sovereign debt which they may need to write down.
- Governments tend to be the backstop for banks.
- Yields on government debt are often the basis for loan rates.
- Banks themselves can have funding issues if they're using government debt as collateral for loans.
As a result, we believe European banks need more capital. Reasons include:
- Eurozone banks have low levels of capital. European banks remain highly leveraged, not having recapitalized or deleveraged to the same degree as those in the United States. According to Michael Cembalest, head of JP Morgan's private bank, European banking-sector liabilities are three-to-four times the size of European GDP, versus the one-to-one ratio in the United States.
- It's likely that sovereign debt (Greek in particular) will have to be written down further at many banks. While the proposed second bailout for Greece forced a 21% write-down of some Greek debt, markets are pricing in more than a 50% discount, in line with the haircut many believe is sustainable for Greece to support.
- There's a need to bolster confidence that banks can absorb losses. Banks' overreliance on short-term funding has exacerbated uncertainty and volatility, and investors need comfort before providing capital.
- Banks must have the strength to lendâthe lifeblood of economic growth.
Why not let Greece default and stop the contagion?
Some believe that separating Greece's solvency issues from liquidity issues elsewhere by drawing a line in the sand and recognizing that Greece needs restructuring may ultimately be a positive action. While this could be destabilizing in the near term, it's possible that by sizing asset values and removing uncertainty, markets could form a base from which to build.
The problem for markets is that we just don't know the broader implications of a Greek default on European banks or contagion to the other PIIGS. Banks across the eurozone own Greek debt, and Greece is only one of the three countries currently under bailout (Portugal and Ireland being the others), while the debt of the other two PIIGS (Spain and Italy) is currently being propped up by ECB purchases. An immediate default without a longer-term plan to "ringfence" banks and other sovereigns (like Italy) would be quite risky.
The question is whether the value of the debt of these other countries will also be marked down and whether Portugal and Ireland will decide to either default or ask for new conditions. Lastly, the lack of transparency in the credit default swaps (CDS) market means we don't know where all the liabilities exist.
Ultimately, it's unknown how much additional capital eurozone banks would require if contagion spreads, but it's believed that even including CDS exposures, US banks would feel little impact. The chart below shows the direct exposure of US banks to PIIGS' sovereign debt, relative to the European banks.
US Exposure to PIIGS Limited
Source: BCA Research and Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.). Debt as of December 31, 2010, and includes public and private. GDP as of June 30, 2011, and expressed in nominal terms.
