But why would there be a banking crisis if Greece leaves?

I\’m not sure I quite understand this:

That\’s because the threat of a disorderly Greek default – which could still take place inside the euro – has the potential to trigger a cascade of bank runs and knock-on crises across the eurozone whose impact could dwarf the Lehmans crash of 2008.

OK, it\’s Seumas on economics so obviously it\’s wrong.

But I\’m not sure that I actually get it. Why would a Greek default knock over the banking system?

The private sector holders (ie, the banks) of Greek sovereign debt all too a 70% haircut only a few weeks ago. I\’ve not checked but I think the new debt issued now trades at 50% or less of par.

So the purely private sector effect of a Greek Government default is going to be trivial.

Sure, all the Greek banks go bust in such a default. But there cannot be a single European bank that has not written down any such Greek banking \”assets\” to something equivalent to the value ofnthe sovereign paper, ie spit.

And it\’s not as if the banks haven\’t had 3 years to prepare for this either.

The ghastly losses will be in the official accounts: the ECB, the EFSF and so on, where Greek sovereign paper is being valued at par (I think). And the Target 2 system will go kablooie: but that again is central banks, not private ones.

As far as I can see, and I\’m sure I\’m overstating this but still, the risks and costs of a Greek default have now been almost entirely socialised. The private sector banks have already taken their lumps, written down their Greek assets and the difference between the current 15% of original par value and 0% in disorderly default is, umm, not very much.

Agreed, it all becomes rather more scary if Spain and Italy etc follow but Greece itself I just can\’t see it.

So, where am I going wrong?

15 thoughts on “But why would there be a banking crisis if Greece leaves?”

  1. Actually the Target2 system itself would be completely unaffected. The ECB would be technically insolvent, that’s all – but given the junk collateral that it accepted for the LTROs, it probably is already. We can have an interesting debate about whether central bank insolvency matters and what to do about it, but settlement through the Target2 system can continue without interruption if Greece exits. Imposing capital controls would probably require temporary suspension of Target2 settlement, though – at the moment it is being used to move capital out of Greece, as Gavyn Davies pointed out recently.

    The Greek banking system would be wiped if Greece leaves, but the solution for that lies in Greek hands, of course. The main external risk is to French banks, who have the highest exposures to Greek debt.

    I don’t accept that a Greece exit would be anything like Lehman. The whole situation looks more like Bear Sterns to me – by the time an exit happens all the money will have gone somewhere safe and Greece will be frozen out of everything anyway. The markets have already priced in Greek exit. I don’t think it would be the big disaster that the likes of Seumas are predicting. A Lehman moment would be Spanish default & exit.

  2. I agree with Frances. The thing is, Tim, if you’re right that flexible national exchange rates are a good thing, Greece should do OK with the drachma. Seeing this, the Spanish etc would want to follow them out. The result would be bank runs in Spain etc.
    The paradox is that the better off a country is with its own exchange rate, the more likely there is to be a flight of deposits out of southern European banks, and hence the greater the danger of bank runs.

  3. The prospect of an outright Greek default within the Euro, which Milne says is possible, is not particularly scary. However, if Greece does default, and Germany then refuses to keep on funding it, as surely it would, Greece is going to have to leave the Euro in order to keep its economy running. The scary thing is establishing the precedent that exit from the Euro is possible. Because if Greece can leave, why not Spain or Portugal or Italy? And if Spain can leave, why would you keep money in a Spanish bank? And if deposits start flowing out of Spanish banks, how is Spain to be kept in the Euro?

  4. The question is really if Greek exit leads to a crisis of confidence in the rest of the PIIGS and this then led to a general loss of confidence in counterparties. Since a big part of this in 2008 was down to a lack of transparency in derivatives (there was a huge outstanding on Lehman CDS, which netted out to diddly), and we have achieved somewhat more clarity, probably not so much of a problem. However, I suppose it’s possible that this will lead to questions about the solvency of systemically important institutions – notably big French banks.

    Bear Sterns was taken over by JP Morgan with no default. Will Grexit/default lead to Spanish default and thus be bigger? Or will it be the European equivalent of Northern Rock (takes out B&B and A&L) but is of little direct consequence, but is a canary in the mine to the later HBOS.

  5. Is it the rate of default that is the key to this projection of disaster?

    Greece is undergoing a slow motion default – slow enough for investors to accommodate it. If other nations followed the default route they might choose to do it quickly without lengthy haircut negotiations.

  6. @PaulB
    Why wouldn’t banks just discount the risk of devaluation when lending to Spanish banks? Lend in euros expect pesetas back that are valued less than euros. Just discount it already. A cascade of bank runs is only possible when banks already believe other banks to be insolvent. Otherwise banks would just be happy to lend out the increased liquidity they obtain from people moving their deposits to those affected banks.

  7. Frances, I’m intrigued. What’s the difference between “technically” insolvent and insolvent?

  8. I’m surprised at you, Tim. What you don’t get is that if Greece defaults and Spain et al follow the whole Euro-socialist experiment crashes. Again. And they can’t countenance that. Again. Because it proves, again, that markets will out.

  9. “where am I going wrong?”

    depositors in ES/IT/PT have always assumed there is no redenomination risk. if greece leaves, this assumption is violated, hence deposit flight.

  10. Mario: yes, it would be quite possible for German banks to lend Euros to Spanish banks with the agreement that they would accept repayment in New Pesatas. But I doubt that the Spanish banks could afford the interest rates they would be charged.

    Looking at it from a different angle: it would be possible for a country to leave the Euro without redenominating existing bank accounts – this should cost the same as the extra interest on a loan that is going to redenominate. The question is whether its banks could afford it. Obviously they couldn’t unless their existing lending also remained in Euros. But if the man on the Salamanca ómnibus has to repay his loans in Euros while his salary switches to rapidly depreciating Pesatas, there are going to be a lot of defaults and the banks will fail anyway.

  11. BIF

    I’ve been party to a great number of debates recently about whether liabilities exceeding assets (the definition of insolvency) really matters where a central bank is concerned. And I have also been involved in the great debate (and massive misunderstanding) about the TARGET2 imbalances and what would happen in the event of a Greek exit.

    If Greece were to default and leave the Euro, the ECB’s asset representing Greece’s TARGET2 deficit might be worthless (this is not a foregone conclusion). If so, then there will be an imbalance with the corresponding liability representing the rest of the Eurosystem’s TARGET2 surplus with respect to Greece. I question whether this really matters. On paper it is a Eurosystem loss which should drain capital from the sovereigns. But it is of course balanced by the corresponding real flows from Greece into the rest of the Eurosystem, most of which are sitting in commercial banks (and some therefore also in national central banks). So I question whether “insolvency” of the ECB arising from writing off Greece’s TARGET2 deficit really means anything. And as long as the sovereigns stand behind it, a central bank can continue to run as an insolvent entity pretty much forever – and the insolvency would unwind itself gradually anyway because of income from seigniorage. Inflation would help, of course.

  12. Mario, PaulB

    I don’t think it is redenomination risk that is the problem. Depreciation of peseta against euro could be calculated and priced in ahead of redenomination, and reflected in interest rates (as PaulB says)

    The issue is bank solvency. The European banking system as a whole is only marginally solvent. Default and exit of a major sovereign such as Spain would bankrupt Spanish banks, for starters, and probably rather a lot of others too. That in my view is the real reason for deposit flight.

  13. Frances: I agree that the marginal (at best) solvency of many european banks is a serious problem. But I am surprised that you think that it’s credit risk rather than redenomination risk that’s behind the capital flight from Greece – I know that I would long since have moved my money out of the country for fear of a forced redenomination. My reading of the situation is that the eurocrats are scared of a spreading perception of redenomination risk.

  14. Paul,

    I don’t agree that the eurocrats are afraid of bank runs because of redenomination risk. Their proposal for pan-European deposit insurance would do nothing at all to address that. I think it is bank runs due to the risk of bank failure that they are addressing. To be fair, eurocrats cannot possibly admit that there might be redenomination risk, because that would amount to an admisison that a country can leave the Euro.

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