Preserving the Greek financial sector: options for recap and assistance
- could the ESM play a productive role in a likely rescue of Greece’s embattled banking sector?
by Silvia Merler on 13th July 2015
I wish to thank Guntram Wolff and Alberto Gallo for useful comments
In short:
· Regaining the stability of the Greek financial sector is key, as a meltdown could lead to Grexit. The stability of the Greek financial system currently relies on the provision of ECB liquidity, which in turn is only available to solvent banks.
· While Greek banks were found to be solvent and well capitalised in the AQR, the deterioration of the economic situation over these months has been such that this assumption may now be questionable. The quality of capital is also put at risk by the heavy reliance of Greek banks on Deferred Tax Assets instruments.
· The draft text discussed in the Eurogroup yesterday suggests that the potential package for Greece would include 10 to 25bn for the banking sector in order to address potential recapitalisation needs. Rumours this morning suggest the banks would then become part of a new asset fund and sold off to pay down debt. Recapitalisation can be done in different ways, with different consequences. Here, I compare four possible scenarios to recapitalise the Greek banks.
· Europe disposes of an instrument to recapitalise the Greek banks limiting impact on the Greek debt, while at the same time awarding the ESM more control on the banking system. This instrument is the ESM tool for direct recapitalization, born with the initial aim to break the sovereign-bank vicious cycle and never used as of today.
· The back of the envelope calculations included here will show that the problem with the instrument as it currently stands is that it would require, before the ESM can step in, a very significant bail-in of 8% of total liabilities. Given e structure of Greek banks’ liabilities, meeting this requirement would need a 100% haircut on junior and senior (non-government-guarantee) bonds plus very high haircut on uninsured deposits (up to 39% in one bank).
· On the basis of the exercise performed here, the best solution to recapitalize the Greek banks would be to make use of the ESM direct recap but in a way that allows it to make an actual difference, i.e. limiting bail-in to what is currently mandatory under the amended State aid requirement.
Greek banks: illiquidity or insolvency?
Time is the scarcest commodity in Greece, at the moment. Stabilising the Greek financial system is vital at this juncture. Without the ECB liquidity provision, Greek banks are unable to convert their assets into the cash that their depositors are demanding to withdraw. At present, with a cap on ELA and a consequent limit on cash withdrawals and transactions, Greece is already in a limbo. The euros held in Greek deposits are entirely fungible with the euro held elsewhere only up to 60euro per day. If the ELA were to be terminated – as likely in the absence of a deal – the banks would effectively run out of cash and collapse. A significant part of heir assets – which is currently pledged as collateral for the ELA – would be seized, as the banks would have no cash left and would certainly not be in a position to repay the ELA funds. At that point, the banks would need to be heavily restructured, as their asset side would have collapsed. In the absence of financial assistance coming through rapidly, this would entail either massive bail-in or recapitalisation from the government. But since the government is cash strapped and cannot inject euros into the banks, a banking sector melt down would probably force a redenomination of asset and liabilities, thus automatically leading to exit.
The stability of the financial sector hinges on the ECB liquidity provision, which in turn requires the solvency of Greek banks. The AQR’s results – showing that Greek banks were adequately capitalized last year – have allowed justifying ELA until now. But since then the economy has deteriorated and the level of NPLs has increased markedly. Walsh and Wolff (2015) show that the four major Greek banks have been under severe stress following the market turbulences caused by political uncertainty, with their market value plummeting. Using 2014 balance sheet data they show that the existing book equity would be significantly reduced in all four banks by a large loss on non-performing exposure. The resulting book value would be relatively close to the actual market value of these four banks – suggesting that further losses may be priced in (and therefore considered likely) by the markets.
The quality of capital is also called into question due to the high share of Deferred Tax Assets (DTAs)/Deferred Tax Credits (DTCs) included the Core capital calculations and the specifics of the Greek DTC conversion law. The Greek law initially required that if a bank calling on the DTC as capital failed to produce profits in the future, the government should provide the equivalent of the tax refund in government bonds. However, the EBA asked Athens to amend the law, so that the government contribution would need to be in cash. In light of the developments over the past few weeks, Greek banks are unlikely to post profits, and the Greek government is cash-strapped. Therefore, the dependence of capital ratios on DTAs is especially problematic and the features of the Greek conversion law suggest that an important part of capital could be de facto wiped out by the circumstances, if not by supervisory action. DTAs in fact amount to 42% to 57% of CET1 in Greek banks (Table 1).
Table 1 – DTAs and capital of Greek banks
Source: RBS and other market research; author’s calculations
A default of the Greek government on the ECB-held bonds – which is growing in likelihood – would negatively affect banks’ balance sheets and potentially undermine all government-guaranteed debt. As of May 2015, government bonds accounted for 3% to 5% of total assets of the four banks considered here. A default of the Greek government would render meaningless the guarantee on government guaranteed instruments, including government guaranteed bank bonds, which represent a significant part of senior debt issued by Greek banks (table 3). A default would further negatively affect the Greek economy, which has suffered from payment delays by the Greek finance ministry during the last 6 months. This would in turn affect the NPL numbers. Such an event would certainly increase further the ECB haircut on ELA collateral, thus tightening the liquidity constraint.
The draft text discussed in the Eurogroup today suggests that the potential package for Greece would include 10 to 25bn euros for the banking sector, in order to address potential recapitalisation needs. In this piece I look at potential scenarios for recapitalising the Greek banking system, starting from a hypothetical loss assumption. As highlighted above, recapitalisation would give a strong backing to the continuance or even extension of full ELA provision by the ECB. My idea is to compare the implications of different recapitalisation options, with a special focus on the ESM direct recapitalisation instrument. Summary results are as follows:
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