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From sovereign crisis to banking crisis: transmission channels and policy responses for Greece and the eurozone
The global financial crisis of 2007 started within the financial sector. Sooner or later, governments became involved: they provided financial assistance to banks, adopted additional measures to prevent their economies from collapsing, and tightened supervision. In Greece, however, it was the other way around. Greek banks are (relatively) small, retail-financed and conservative, in relation to their Western European counterparts. Still, this was not enough to save them from the severe impact of the Greek sovereign debt crisis. With the sovereign crisis spreading to the entire euro area, it is more topical than ever to explore the transmission mechanisms that turned the Greek crisis from a sovereign crisis to a banking crisis, in order to design appropriate policy solutions.
Why were the banks affected?
1) Exposures to Greek public sector debt
Greek banks’ exposures to public sector debt are the main transmission channel. Exposures include loans granted to the Greek government (and other public sector entities), holdings of Greek government bonds (GGBs), and loans to various entities (usually connected with the public sector) secured by Greek government bonds. To illustrate the significance of the problem, the direct holdings of GGBs by Greek banks alone currently amount to 40bn euros.
As a result, the quality of the main assets of Greek banks has deteriorated significantly, having a severe impact on the banks’ balance sheet. Further, given the low marketability of these assets, Greek banks are facing serious liquidity problems. For instance, because of the significant devaluation of the underlying assets, Greek banks were forced to discontinue the origination and sale of securitized products through special purpose vehicles. To make things worse, Greek banks have lost access to borrowing from the wholesale funding markets (i.e. the ECB, interbank markets and other institutions), since the value of their assets as collateral has plummeted, and therefore find it very challenging to roll over the maturing debts. Greek banks have reacted by initiating a major project to dematerialize the largest syndicated loans granted to the public sector, in order to make them more marketable and eligible as collateral for wholesale lending.
In addition, on 26 October 2011 the Euro Summit decided on a voluntary haircut of 50% for Greek sovereign debt. This means that current lenders (including Greek banks) will engage at a voluntary exchange of GGBs with a nominal discount of 50%, which actually means that banks will have to write off 50% of government debt.
2) Loss of confidence
Loss of confidence of investors, depositors and the wholesale markets has deprived Greek banks of their main sources of capital and liquidity. Whereas the capital of Greek banks generally remains strong (with an average of 12.2% core tier 1 ratio), their share prices are plummeting, resulting in very low market prices. Deposit withdrawals have been continuous since 2009 and on average each year Greek banks are losing 13% of their deposit base. Finally, as was mentioned above, the wholesale markets are practically closed for Greek banks.
3) General economic conditions
The generally bad economic conditions have resulted in a dramatic increase in non-performing loans (NPLs) for Greek banks. This means that a large proportion of loans granted to private and corporate clients in Greece are not repaid timely, so they must either be written off or restructured. Further, Greek banks have been forced to reduce their lending activities for various reasons. Greek banks have become more risk-averse and, because of their liquidity problems, have limited ability to lend. There is also limited credit demand from clients in Greece, due to the unfavourable economic environment and reduction in economic growth. The combination of increased provisions for NPLs and trading losses for Greek banks created a loss for the entire Greek banking system in 2010.
Impact on Central and Eastern European banks
Before the crisis, the largest Greek banks engaged in a significant and systematic expansion to Central and Eastern Europe (CEE), by establishing subsidiaries or taking over local banks. The CEE subsidiaries generally remained profitable during the crisis and this benefited their respective groups as a whole. However, the CEE activities are significantly smaller compared to the core activities located in Greece and it remains to be seen whether they will be sustainable under the current economic climate. Greek banks are under severe pressure to dispose of non-core assets in order to increase their liquidity, and some of them have begun partial disposals of certain CEE subsidiaries. Even for the Greek banks that maintain their activities in CEE, it is doubtful whether they will be able to continue providing the same amount of funding.
Various measures were taken at national and EU level to support Greek banks. Broadly, at national level these include the establishment of a Greek Financial Stability Fund; Greek government guarantees on bonds issued by the Greek banks; purchase of preference and/or common shares of Greek banks by the government; restructuring and disposals of government-controlled banks; and tighter supervision. At EU level, the ECB has adopted exceptional measures to provide liquidity to Greek banks. Also, the EU member states have committed to assist in the recapitalization of Greek banks, which will be necessary as a result of the 50% haircut on Greek sovereign debt.
As the sovereign crisis is spreading to the entire euro area, there are concerns that this can lead to a new round of banking crises. The Greek experience has demonstrated the strong connection between sovereigns and banks and the easy transmission of stress from one sector to the other. Recognizing this, the EU has agreed on exceptional measures to protect the banking sector from the sovereign crisis: additional capital requirements have been introduced, as well as a system of public guarantees to ensure banks’ access to term funding.
An EU approach seems necessary, given that the sovereign crisis has taken EU-wide dimensions. However, the intense efforts to stabilize eurozone economies do not seem to have persuaded the market; on the contrary, it seems that the crisis is deepening and constantly calling for stricter measures. The Greek banks’ case has at a minimum demonstrated that sovereign and banking crisis go hand by hand, feeding into each other. This lesson should not be overlooked in the regulatory reforms at EU level.