95418609 Risks and Repercussions of a Greek Exit

7/31/2019 95418609 Risks and Repercussions of a Greek Exit

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CROSS ASSET RESEARCH 31 May 20

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 39

* This research report has been prepared in whole or in part by equity research analysts basedoutside the US who are not registered/qualified as research analysts with FINRA.

EURO THEMES

Risks and repercussions of a Greek exit

A cost/benefit analysis. We think rationality will prevail and Greece will remain inthe euro area in the near term. The costs of an immediate Greek exit are still too

high for either Greece or the euro area. A disorderly exit would lead to a massive run

on bank deposits, a meltdown of the Greek banking system, and further aggravation

of Greeces large economic downturn. For the euro area, the main cost would be

contagion (see Will Greece abandon the euro?).

A Greek exit can still be avoided. Our base case is that a Greek exit can be avoidedeven if the left-wing Syriza party wins the elections on 17 June and forms a new

government. Its leader has indicated that he would prefer to stay in the eurozone,provided he can negotiate a radical overhaul of the EU-IMF programme. We believe

a programme could be agreed with some concessions by troika (EU, IMF, ECB) on a

smoother fiscal consolidation path and some delays to the speed of public sector

reform (see Will Greece abandon the euro?).

However, a disorderly exit cannot be ruled out. An "accident" after the June electionscannot be ruled out, leading to a disorderly exit for Greece and elevated stress for

the euro area as a result of contagion. The direct costs of a Greek default and exit

appear manageable (euro area government exposure to Greek public debt is

estimated at EUR290bn), but contagion risk could complicate the already precarious

financial positions of countries like Portugal and Ireland, and the systemically more

significant economies of Spain and Italy. The overall costs of a Greek event would

amount to multiples of direct costs (see If Greece exits, can contagion be contained?).

The euro area policy reaction to a Greek exit would likely entail: (a) stepping upthe Securities Markets Programme (SMP), potentially through a leveraged European

Financial Stability Facility (EFSF) or through the European Stability Mechanism

(ESM); (b) aggressive monetary policy action by the ECB; (c) moves towards a pan-

European deposit insurance scheme, although implementation would be lengthy;

(d) if all else fails, acceleration of EU economic and financial integration, including

support for the eventual adoption of Eurobonds.

Implications for European banks. Greek banks have lost almost a quarter of theirdeposit base over the past two years, despite having a deposit guarantee scheme,

suggesting that such schemes are not sufficient to deal with either systemic risks or

redenomination risks. We argue that even a European-wide deposit guarantee

scheme would not be sufficient to manage contagion risks (see Deposit risks).

Implications for rates and FX markets.In the event of a Greek exit, money marketswould suffer a renewed bout of stress, with Italy and Spain bonds likely selling off

aggressively, despite any policy responses that would be introduced (see A Greece

exit is not fully priced into rate markets). Global currencies would follow the pattern

since the Greek election on 6 May, only it would be much more severe: the EUR

would depreciate against the USD, JPY and GBP in particular (see EUR/USD likely to

fall independent of the Greek election result).

Contents

Macro View:

Will Greece abandon the euro? Contagion Costs:If Greece exits, can contagion be contained?

Implications for European Banks:Deposit risks

Implications for Interest Rates Markets:A Greece exit is not fully priced into ratemarkets

Implications for FX Markets:EUR/USD likely to fall independent of the Greekelection result

Economics

Antonio Garcia Pascual

+44 (0)20 3134 6225

[email protected]

Piero Ghezzi

+44 (0)20 3134 2190

[email protected]

Thomas Harjes

+49 69 716 11825

[email protected]

Fabrice Montagne

+33 (0) 1 4458 3236

[email protected]

Asset Allocation StrategyMichael Gavin

+1 212 412 5915

[email protected]

Credit Research

Jonathan Glionna

+44 (0)20 3555 1992

[email protected]

Equity Research

Simon Samuels*

+44 (0)20 3134 3364

[email protected]

Barclays, London

Rates Strategy

Laurent Fransolet

+44 (0)20 7773 8385

[email protected]

Foreign Exchange Strategy

Paul Robinson

+44 (0)20 7773 0903

[email protected]

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Barclays | Risks and repercussions of a Greek exit

31 May 2012 2

MACRO VIEW

Will Greece abandon the euro?

The costs of Greece exiting the euro are too high for either Greece or the euro area. A

disorderly exit would lead to a massive run on bank deposits, a meltdown of the Greekbanking system, and further aggravation of Greeces large economic downturn. For the

euro area, the main cost would be contagion.

Greece New government may reject the EU-IMF programme

The national elections in Greece on 3 May marked a turning point in the European political

landscape. For the first time, and in stark contrast to earlier national elections in Ireland and

Portugal, Greek political parties committed to policies agreed under an EU-IMF programme

failed to achieve a majority in Parliament. Support for the two main parties, New Democracy

(centre right) and Pasok (centre left), which have governed Greece for decades and

negotiated the recent EU-IMF programme, fell below even modest expectations. At the

same time, the left-wing Syriza party and more radical (left and right) parties that reject the

policies under the EU-IMF programme gained a significant share of the votes (see, Election

round-up: A vote for policy change in Europe). After failed attempts by the leaders of New

Democracy (18.9% of the vote), Syriza (16.8%), and Pasok (13.2%) to negotiate a coalition,

and by the Greek President to form another technocrat government with broad parliamentary

support, Greece is heading for another round of elections scheduled on 17 June.

It is difficult to predict the outcome of these elections, but the latest opinion polls suggest

that New Democracy is currently leading. However, Syriza, led by the young and charismatic

Alexis Tsipras, is not far behind New Democracy and could become the largest party. If this

were to happen, it would automatically get an extra 50 seats in the Greek Parliament, and

may amass enough support to form a government. Mr Tsipras has been adamant that he

would cancel austerity policies in Greece, reverse plans to reduce public employment, and

cancel interest payments and debt redemptions. (He has also said that he would prefer that

Greece remain in the eurozone, but only if the EU-IMF programme is radically overhauled.)

Other parties, including ND and Pasok, have stepped up their rethoric and are seeking to

cast the next elections as a vote on the future of Greece in the euro area. Polls still suggest

broad support amongst the Greek population for remaining in the euro area. However, the

elections on 3 May have shown that frustration and anger about past ND and Pasok policies

prevailed when Greeks cast their votes: they delivered a protest vote that may also be

interpreted as a popular rejection of the EU-IMF adjustment programme that is associated,

rightly or wrongly, with the miserable economic and social conditions that now prevail.

Developments within Greece are now in the hands of the Greek electorate; the countrys

continued membership in the European Monetary System hinges upon decisions that will betaken in the 17 June elections, and the response of other European governments to that

political outcome. But these political processes are being driven in large part by economic

developments, as they have been interpreted by politicians and electorates. Without

underplaying the importance of the elections, fundamentals suggest that Greece may remain

a concern for financial markets, regardless of who wins. The main difference the election

could make is whether Greeces day of reckoning happens very soon or somewhat later.


+44 (0)20 3134 [email protected]

Michael Gavin

+1 212 412 5915

[email protected]

Piero Ghezzi

+44 (0)20 3134 2190

[email protected]

Thomas Harjes

+49 69 716 11825

[email protected]

Fabrice Montagne

+33 (0) 1 4458 3236

[email protected]
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A grim economic outlook within the euro zone

2011 marked the fourth year of Greeces recession, in which real GDP has already fallen

nearly 15%. Unfortunately, the wrenching external and fiscal adjustments that are putting

intense pressure on the economy are only partly accomplished, and the end of the

downturn does not appear to be imminent.

Public finances remain far from equilibriumGreece ended 2011 with a primary (non-interest) deficit of 2.4% of GDP, and an overall

budget deficit of 9.1%. Even after the 2011 restructuring of privately-held public debt, the

debt is expected to reach nearly 164% of GDP by year-end, and is likely to continue rising in

2013 due to the shrinking economy and a primary deficit. (The still-high amount of debt is

due, in part, to the high cost of recapitalizing the Greek banks, which will add over 25% of

GDP to public debt in 2012 as a result of the large losses of Greek banks on their holdings of

government debt.) Under the existing programme, Greece will need to engineer a large

swing from deficit into a primary surplus of over 4% of GDP (a swing of roughly 6

percentage points of GDP), in order to stabilize its high level of public debt.

Adjustment of external payments is far from complete

Greeces current account deficit has been shrinking since 2008, but remains untenably highat roughly 10% of GDP. With no capacity to promote expenditure switching via

devaluation, the current account adjustment has been associated with a painful

compression of public and private spending. The adjustment would of course have been far

more abrupt if eurozone governments had not stepped in to finance the external payments

deficits that market participants are no longer willing to finance. The result has been

intensified dependence on official financing of external payments deficits. By now, the lions

share of the countrys international liabilities is official funding (c.EUR313bn), including

the EU (EUR126bn), the IMF (EUR22bn), and the Eurosystem (EUR165bn).

Banks remain under severe stress

As a result of the sharp and sustained drop in economic activity, non-performing bank loans

have risen to about 15%. More importantly, the large losses imposed by the February

restructuring of their government bond holdings have left banks with a large capital

deficiency. The new programme has set aside an additional EUR50bn for bank

recapitalization, which will (as noted above) be added to the public debt.

Greek debt is expected to reach

nearly 164% of GDP by year-end

Figure 1: Current account adjustment A work in progress Figure 2: Deposit outflows have intensified funding squeeze

-40

-35

-30

-25-20

-15

-10

-5

0

Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Current account balance (12-mo total, bn euros)

0

50

100

150

200

250

300

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Domestic residents deposits and repos (bn euros)

Source: Haver Analytics Source: Haver Analytics


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Moreover, the loss of capital markets access has left the central bank of Greece (through

the Eurosystem) as practically the only funding channel for Greek credit institutions. Most

of the outstanding funding is now provided through the Emergency Liquidity Assistance

facility of the Eurosystem (c.EUR100bn of the total c.EUR130bn provided by the

Eurosystem). The Greek banks funding squeeze has been intensified by a persistent outflow

of bank deposits since the crisis started in late 2009. From the end of 2009 to March 2012,

the banking system lost nearly a third of its domestic deposits. Anecdotal evidence indicatesthat the outflow accelerated in May, especially after the election results, and it may continue

given the elevated uncertainty and downside risks that confront domestic depositors.

A grim outlook

With large fiscal and external imbalances that have yet to be fully unwound, the immediate

outlook for the Greek economy remains grim. The economy is likely to shrink by more than

5% in 2012, the 5th consecutive year of contraction, while the rate of unemployment is

approaching 20%. Because the fiscal and external adjustment will likely last into 2013, we

(and the IMF) are forecasting yet another year of recession in 2013. Moreover, the public debt overhang is unlikely to be resolved in the immediate future. Under

the February 2012 programme, public debt is projected to peak at 167% of GDP in 2013,

but then rapidly decline to reach 116% of GDP by 2020 and 88% of GDP by 2030. However,

this downward trajectory is explained by programme targets that include a primary surplus

of 4.5% of GDP by 2014, real growth in the range of 2.5-3% over the medium term, and

privatization revenues of EUR45bn, which are spread over several years. We consider these

assumptions too optimistic. Under a more realistic baseline macroeconomic scenario, the

Greek public debt would stabilize, but at an extremely high level (Figure 3).

Figure 3: Debt sustainability not addressed by the February PSI (gross public debt/GDP)

0

20

40

60

80

100

120

140

160

180

200

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030

Base Debt relief (zero interest on all official debt for 20y)

Source: Barclays Research

Stabilization of the debt at such a high level satisfies one narrow and theoretical definition of

sustainability, but it would leave the Greek government in a precarious position; highly

exposed to fiscal shocks, and reliant upon official funding for decades to come. Figure 3

also illustrates how one form of debt relief, a forgiveness of all interest on public debt for 20

years, could create a more robustly sustainable trajectory for the public debt. But because

the public debt remains very high for a long period of time (above 125% of GDP at least

until 2020), even this form of debt relief may not be sufficient to restore confidence in

public financial stability over a reasonable period of time.


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Box 1: Debt sustainability analysis: medium-term assumptions

Our medium term baseline scenario includes a less aggressive fiscal consolidation path than

the February 2012 programme. Realistically, Greece could achieve a fiscal consolidation of

about 1% of GDP per year over the next five years, to achieve a primary surplus of about

2.5% of GDP by 2016. This is in stark contrast to the medium-term assumptions in the

programme, which expects Greece to achieve a primary surplus of 4.5% of GDP by 2014and sustain it at around that level through 2020.

Our fiscal baseline assumes that the moderate parties (New Democracy and PASOK) form a

government and an agreement on the revised programme can be reached. In any event, the

new government is highly likely to renegotiate a less aggressive fiscal consolidation targets.

Obviously, if the radical left parties were to form a government after the 17 June election, it

is likely than the pace of fiscal consolidation would be even less aggressive. In that scenario,

the fiscal path assumed in the baseline would have to be revised downwards and,

consequently, the debt dynamics would look even more challenging.

Our growth assumptions also differ from the EU-IMF programme, as we expect real GDP to

shrink by 6% instead of 4.8% in the programme. Macroeconomic conditions have

deteriorated, mainly as a result of the uncertainty about a potential exit. Private

consumption and investment will contract further than originally envisaged, as well as

exports. We expect economic activity to recover only very gradually over the next 5 years to

reach a real GDP growth of 1.5% instead of 3% assumed under the programme, which also

assumes that real GDP will remain above 2% through 2020 (while we assume a growth of

1.5% on average).

The debt dynamics would look very different if Greece were to restructure or default on the

outstanding debt, but over half of that debt are official loans from the EU and IMF (see

Figure 4), and much of the remainder is held in the domestic banking system and by the

ECB. As we have seen, debt held by the domestic banking system cannot be written down

without breaking the banks and requiring a government-financed bank recapitalization. And

official creditors including the ECB have so far resisted a restructuring of the Greekobligations that they hold.

Figure 4: Holdings of Greek public debt

Before PSI Post PSI, end 2012

IMF loans 20 28

EU loan package 1 53 74

EU loan package 2 0 88

ECB SMP + Investment portfolio 55 46

T-bills 15 15

Sub total 1 143 251

Banks (o/w Greek banks c.EUR40bn) 70 (40) 22 (13)

Insurance 10 3

Central banks/official institutions 38 12

Other investors (real money, etc) 70 22

Greek Social Security fund 18 6

Sub total 2 206 0

New exchange bonds from PSI 0 65

Total Greek debt 349 316



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In short, the economic outlook over the next two years is cloudy. No immediate end of the

recession is in sight, fiscal adjustment is far from complete, and the unresolved debt

overhang means that Greece may ultimately need to obtain official sector debt relief (in NPV

terms) or leave the eurozone.

A Greek exit would be very costly for Greece

The only possible justification for a policy framework that delivers a prognosis of this sort is

that outcomes would be even worse under alternative policies. If the alternative policy is

rejecting the EU-IMF programme and exiting the eurozone, a strong case can be made that

the costs would be higher than the benefits, at least in the short run.

In the short term, costs of exit would likely be very high compared with benefits

A Greek exit in the near term would be disorderly almost by definition, as this would likely

be triggered by a failure of a Greek government to reach a compromise with the rest of the

euro area on a programme. The EU and the IMF would then stop funding Greece, and this

would (most likely) imply that the ECB could not continue the provision of emergency

liquidity support to Greek banks. While this decision might be taken by the Governing

Council of the Eurosystem (by at least a 2/3 majority), given the serious implications, it willbe essential to have the political backing of the European Council and the IMF. Indeed, once

Greece is locked out of the Eurosystem without an EU-IMF programme, it would quickly run

out of cash and be forced to exit the EMU. Expulsion from the EU does not appear to be a

legally viable option and Greece could decide to remain within the EU.

Nevertheless, Greece would be going it alone from a position of economic and financial

weakness, not strength. The curtailment of official financing of the government and the

balance of payments would enforce a more abrupt adjustment of both imbalances. Even if it

is accompanied by a cessation of public debt service, the pace of fiscal adjustment in such a

scenario would need to be even larger than contemplated by the existing programme

(though it might be facilitated by a burst of inflation over the medium term). The sudden

cut in government expenditure would likely aggravate social unrest, which could lead to a

government crisis. If history serves as any guidance for the Greek case, few governments

have survived traumatic exchange rate devaluations.

Potentially even more disruptive for economic activity could be a massive run on bank

deposits: depositors would run on the banks as they would fear a forced conversion in a

reintroduced drachma. In the absence of Eurosystems support and without bank and

capital controls to limit the outflows, the exit would lead to a meltdown of the Greek

banking system, further aggravating the large economic downturn, quite possibly forcing

massive government intervention in the banking system.

The reintroduced drachma would likely depreciate significantly and hence many local

companies (clearly those in the non-tradable sector) and households would need to default on

their foreign currency debt, now including euro-denominated liabilities. Many of the domesticcontracts that are now denominated in euros would also become unviable and need to be

restructured. Non-performing loans would surge because of: 1) the negative balance sheet

effects for firms and households; and 2) the local currency needed to pay euro debts would

increase with the devaluation, exceeding the increase in local currency revenue. Likewise, the

government would also be forced to default on its euro-denominated liabilities.

Redenomination away from the euro will also cause massive transfers between agents,

adding to the above-mentioned transfers between debtors and creditors. Households with

local accounts and savings will suffer substantial losses while cash-rich agents with


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accounts abroad will be the big winners and could take advantage of the chaos to seize

capital and production capacities. Given the weak state of the government, these

redistributions will likely benefit to the already oversized unofficial sector.

In short, the existing contracting framework and financial infrastructure would be broken,

and would need to be rebuilt. Inflationary finance would likely be used, to some extent at

least, to replace the official finance that now supports Greece. Politically difficult fiscal andstructural reforms would still be required to make the country more competitive, and

promote economic growth.

Over the longer term, exit by Greece would have some offsetting benefits

While the costs of exit seem likely to be very high in the short run, there would of course be

some long-term benefits, as well as costs. Devaluation would provide a faster route to

international price competitiveness than the grinding internal devaluation that will be

required within the eurozone. The IMF estimates the need for a 15% improvement in cost

competitiveness on a unit-labor-cost basis. International evidence suggests that internal

devaluations, that is, improvements in competitiveness that are achieved by reductions in

domestic wages and prices rather than a devaluation of the nominal exchange rate, are hard

to achieve. In the Greek case, the difficulty is compounded by inflexible labor and productmarkets, by the public debt overhang (which is aggravated by slow growth or even deflation

in the nominal tax base), and because other stressed European economies are also trying to

engineer similar improvements in competitiveness, making it all the more difficult to achieve

the required improvement with neighbours who are important trading partners. However, if

higher inflation triggers higher wages, the positive effects of large devaluations on

competitiveness are very limited.

Like other participating countries, Greece entered the eurozone because it offered important

long-term advantages created by integration into a continental monetary and financial

system with commonly governed EU institutions. By leaving the eurozone, Greece would

not only suffer enormous short-term dislocation, but it would also forego the longer term

structural advantages of membership, especially if an exit from EU would follow.

Greek exit would also be very costly for the euro area

We consider the potential direct and indirect costs for Europe of a Greek exit in considerably

more detail in subsequent sections. Here we extract the elements of that discussion that are

relevant for the eurozones decision whether or not to take actions that might precipitate a

Greek departure from the monetary area.

Direct links appear manageable

The direct trade and financial links of Greece with the rest of the euro area are meaningful,

but the direct economic fallout from a Greek exit appears manageable given the size of the

Greek economy (only about 2% of eurozone GDP). Most of the worlds financial exposure to

Greece has been shifted to public balance sheets. The exposure of the euro area officialsector is somewhat above EUR290bn, and very sizable in absolute terms in France (about

EUR60bn) and Germany (about EUR80bn); losses would also be politically very sensitive.

Recovery rates on this exposure would probably be low, but even a total loss would be

manageable from a fiscal policy and debt sustainability perspective; in fact, most of the

existing sovereign exposure is already included in gross debt figures. Assuming final

recovery rates in the range of 20-50%, the loss, or involuntary transfer to Greece from other

member states and the ECB could roughly amount to EUR150-230bn, or 1-2.5% of euro

area GDP (see Greece: Euro area official sector exposures in excess of EUR290bn).
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Liabilities of the Greek private sector to the rest of the world are considerably smaller, at

about EUR130bn, not all of which is owed to European creditors. In the event of a Greek exit

from the eurozone, many of these liabilities would probably need to be written down

dramatically. The main concern is not the overall size of the potential loss, but the possibility

that it might be concentrated enough to destabilize a systemically significant financial

institution. The French banking systems exposure is the largest, but even in this case the

systems exposure to the Greek private sector is less than 20% of core tier one capital.Accidents do happen, and it is possible that an isolated institution may experience enough

trouble to create some market reaction. But it seems unlikely that this exposure will create a

large economic problem for Europe.

The larger risk for Europe is financial contagion

We consider the risks and potential policy responses to contagion in much more detail

below. For now, we simply note that there are a number of channels through which a

disorderly Greek exit could compound the difficulties that already face other stressed

eurozone sovereigns such as Ireland, Portugal and the systemically far more important

economies of Italy and Spain, and ultimately the entire continent. Italy and Spain are already

facing very shaky confidence and a withdrawal of private international capital. The costs for

Europe of a Greek exit under these circumstances are quite literally incalculable, because

they depend in large part upon psychological responses to the exit. But they are potentially

enormous. This gives European policymakers a strong incentive to avoid a Greek

abandonment of the EU-IMF programme and exit from the eurozone.

From economics to politics

Greeces future is now being determined by very public political processes, in which

electorates (and their representatives) rather than technocrats will have the final word. This

is obvious in Greece, given the recent focus on the election, but it is increasingly true in the

broader European context. There are no easy or appealing alternatives for the main actors in

this drama. Greek voters face a choice between a painful future within the eurozone, or a

future outside the eurozone that is very likely much more painful in the short term, with anuncertain balance of costs and benefits down the road.

We could explore these costs and benefits in more detail, but it would probably take us

away from the underlying political dynamic. What matters is the assessment reached by the

political actors in Europe, and these have by now, we think, hardened into an essential

political reality. Within Greece, public opinion polls suggest that a large majority of the

Greek population strongly supports continued membership in the eurozone. However, the

May elections seemed also to signal that the population is reaching some limits of its

tolerance for austerity, and the economic misery with which this is rightly or wrongly

associated, but which the countrys partners in the EU insist is a necessary condition for

continued membership in the monetary union. One way to interpret these apparently

conflicting opinions is that the Greek population is committed to membership in theeurozone, but not under any conditions whatsoever.

Other countries in the eurozone appear to be edging toward a similar perspective. Given the

economic duress under which the Greek population is labouring, and the potentially high

cost for Europe of a Greek exit, we suspect that there is more room for negotiation about

the programme than some recent statements may suggest. However, that room is not

unlimited. Greeces official creditors have already put enormous quantities of their

taxpayers wealth at risk, and have no mandate from their voters to extend a blank check

for financial support in unlimited amounts over an indefinite horizon. Moreover, the EU-IMF


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programme is organized around the view that the structural reforms and institution-

building elements of the reform agenda are necessary conditions to regain competitiveness

and financial stability, and thus to thrive within the monetary union over the longer term.

How far the EU and IMF might be willing to alter the existing economic programme is highly

speculative, and may depend upon political events in the coming weeks (such as the

upcoming French parliamentary elections). Our thoughts at the moment are as follows:

The EU has signalled that it is willing to introduce pro-growth initiatives in the existingadjustment programmes. This could include investments in infrastructure, some active

labour market policies (targeted at reducing youth unemployment), and possibly some

limited support for health services. The problem is that such initiatives are not easy to

come up with (if they were, what government would tolerate slow growth?), and

seldom come without a price tag. Our best guess is that pro-growth initiatives and

social policies may provide a Greek government with political ammunition to defend a

revised agreement that it finds otherwise acceptable, but will not alone transform Greek

attitudes toward the memorandum.

The EU and IMF may well be willing to offer some leeway in the pace of fiscalconsolidation. Tolerating a slower adjustment would not be costless, from theperspective of the EU. Even without such concessions, the existing programme is likely

to require additional EU financing given the likelihood of a worse-than-projected

economic growth outlook since February, as financial turmoil takes its likely toll on the

economy. Any delays in the fiscal consolidation will, of course, create a yet larger

financing gap that would need to be filled by taxpayers in other eurozone countries.

It would be impossible to alter the long-run fiscal targets without addressing the publicdebt problem that dictates the long-run fiscal effort that is arithmetically required to

ensure eventual fiscal solvency. In fact, as explained above, we think there are reasons

to doubt that solvency can be re-established without substantial debt relief; any delays

in the pace of fiscal consolidation would only compound the already untenable

overhang of public debt. The subject of debt relief is likely to be a theme of discussionbetween the new government and the EU, IMF, and ECB. In a larger sense, it will have to

be related to the question of fiscal transfers within the EA.

If there is anything non-negotiable for the EU and IMF, we think it would be theproposed structural reforms. Without them, they believe that Greeces prospects inside

the monetary union would be bleak. Reforms are needed to regain competitiveness and

thus lay a firm foundation for economic growth over the long term, and to build a public

sector that is efficient and sustainable without continued injections of foreign resources.

However, these reforms touch upon politically sensitive areas of Greek society.

Can the minimum requirements for a programme be reconciled with the maximum policy

effort that a new Greek government can sustain? We think that is heavily dependent upon

the outcome of the 17 June election. We see three main potential outcomes:

The first and in some ways the worst possibility is that, as in the first election, no party orcoalition of parties manages to secure a mandate to govern. In this case, the political

deadlock would have to be resolved by yet another round of elections. Uncertainty would

persist, and the potentially destabilizing flight from the Greek banking system could

accelerate further. While the election process plays out, we think it would be difficult for

eurozone governments to interrupt the financial support for the Greek banking system that is

required to keep Greece in the eurozone, but the escalation of contingent financial liabilities

associated with this support would also be difficult for the ECB to countenance indefinitely.


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A second possibility is that a coalition of the radical left, led by Syriza, wins the electionand forms a government. In this case, negotiations between the troika and government

could be lengthy (possibly several months). Given the economic programme upon

which Syriza has been campaigning, we think it is entirely possible that discussions

could end without agreement on a programme. The most contentious themes would

likely be the delay in fiscal consolidation targets and cuts to the size of the public sector,

including dismissals of public sector employees. But our baseline scenario is that eventhen, a programme could be agreed with some concessions by troika on a smoother

fiscal consolidation path and some delays to the speed of public sector reform.

The third of the most plausible scenarios is that the center-right New Democracy partywins the election and forms a government in coalition with other traditional and centrist

parties. Given that these are the political parties who negotiated the existing

programme, it is reasonable to think that their election would facilitate negotiations over

another revision of the programme. The question would then become whether the

government, likely surviving with a razor-thin parliamentary majority and enjoying weak

support from the public, would be able to implement the agreed programme more

effectively than it was able to implement similar programmes in the past.


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31 May 2012 11

CONTAGION COSTS

If Greece exits, can contagion be contained?

The direct costs of a Greek default and exit appear manageable, but contagion risk

could complicate the already precarious financial positions of countries like Portugaland Ireland, and the systemically more significant economies of Spain and Italy. The

overall costs of a Greek event could be orders of magnitude larger than the direct

costs.

Direct costs of a Greek exit are not big enough to destabilize therest of the eurozone

The direct exposure to Greece for euro area countries is non-negligible: about EUR290bn

of exposure to the Greek government, with roughly one third of this amount in exposure to

private-sector entities. However, it appears to be manageable even if Greece were to

default and recovery rates were low. In any event, some credit losses from a restructuring

of Greek liabilities to the rest of the eurozone will likely be realized even if Greece remains

part of the monetary union. The exposure to the Greek public sector that eurozone

governments have accumulated now amounts to roughly 3% of GDP.

Figure 1: Official exposure to Greece in EMU by country and type

Member States Eurosystem Total

Bilateral

loans

EFSF

garantees SMP Target 2 , Bn

% of

GDP

Nominal

GDP (2011,

, Bn)

Austria 1.6 2.2 1.0 3.9 8.7 2.9 301

Belgium 1.9 2.7 1.3 4.9 10.8 2.9 368

Cyprus 0.1 0.2 0.1 0.3 0.6 3.4 18

Estonia 0.0 0.2 0.1 0.4 0.7 4.5 16

Finland 1.0 1.4 0.7 2.5 5.6 2.9 192

France 11.4 15.9 7.6 28.3 63.3 3.2 2002

Germany 15.2 21.2 10.2 37.8 84.5 3.3 2571

Greece 0.0 0.0 0.0 0.0 0.0 0.0 215

Ireland 0.3 0.0 0.0 0.0 0.3 0.2 156

Italy 10.0 14.0 6.7 25.0 55.8 3.5 1580

Luxembourg 0.1 0.2 0.1 0.3 0.8 1.8 43

Malta 0.1 0.1 0.0 0.1 0.3 4.5 6

Netherlands 3.2 4.5 2.1 8.0 17.8 3.0 602

Portugal 1.1 0.0 0.0 0.0 1.1 0.6 171

Slovakia 0.0 0.8 0.4 1.4 2.6 3.8 69

Slovenia 0.2 0.3 0.2 0.6 1.3 3.7 36

Spain 6.7 9.3 4.4 16.5 36.9 3.4 1073

Total 52.9 73.0 35.0 130.0 291.1 3.1 9419

Note: * IR, PT and GR stepped out.Exposures are reported in nominal amounts. For SMP, EFSF and Target 2, national exposure have been allocatedaccording to capital keys.Source: European commission, EFSF, National central banks, Barclays Research

The eurozones exposure to the Greek private sector is substantially smaller than its

exposure to the Greek government. Much of this exposure is in the form of bank claims

(EUR70bn). But even in France, the most heavily exposed of the larger European banking

systems (EUR34bn), the exposure does not seem large enough to pose a systemic threat.


+44 (0)20 3134 6225

[email protected]

Michael Gavin

+1 212 412 5915

[email protected]

Piero Ghezzi

+44 (0)20 3134 2190

[email protected]

Thomas Harjes

+49 69 716 11825

[email protected]

Fabrice Montagne

+33 (0) 1 4458 3236

[email protected]
mailto:[email protected]:[email protected]:[email protected]:[email protected]


12/43


31 May 2012 12

Figure 2: Foreign Bank Claims on Greece

End-December 2011 European banks France Germany Italy Spain Switzerland UK US

Foreign claims 90,473 44,353 13,355 2,186 969 1,940 10,537 4,455

Public sector 21,929 6,502 6,749 773 302 168 1,759 725

Banks 3,167 223 759 146 39 476 1,005 672

Non-bank private sector 65,295 37,628 5,847 1,266 627 1,256 7,772 3,058

Other potential exposures 29,032 6,901 3,779 1,790 417 1,406 11,825 46,231

Derivatives contracts 6,548 1,545 470 462 172 505 2,953 907

Guarantees extended 15,835 3,692 2,818 280 24 155 8,199 44,831

Credit commitments 6,649 1,664 491 1,048 221 746 673 493

Source: Bank of International Settlements, valuations at EUR prices at end-December 2011

In short, the direct losses from a Greek exit seem unlikely to destabilize the rest of the

eurozone, even if they lead to widespread restructuring of claims on the Greek private

sector. That said, the losses may undermine political support for financial programmes in

other eurozone economies. In particular, ECB losses from its Greek exposure would further

undermine support for the SMP within the ECB. Political backlash could complicateattempts to mount a determined effort to support other stressed sovereigns in the months

following a Greek exit.

The question is contagion

The direct costs of a Greek default and exit appear manageable, but the bigger concern is

the potential for contagion, which could complicate the already precarious financial

positions of countries like Portugal and Ireland, and the systemically more significant

economies of Spain and Italy. If developments in Greece create even deeper anxiety about

the rest of the euro area, the overall costs of a Greek event could be orders of magnitude

larger than the direct costs.

Contagion is not inevitableIt is possible that this contagion will be more limited than many now fear. After all,

Greece restructured its debt in March, while markets rallied in Q1 2012. More than a

decade ago, Argentina defaulted and suffered a historic economic and financial

collapse, but contrary to anxiety about contagion, other emerging markets were, in the

end, little affected. It is not inevitable that a Greek exit from the eurozone will trigger

strong contagion to other stressed sovereigns.

However, we would caution against complacency. The Greek debt restructuring and a

potential exit from the eurozone are very different shocks to the economic, financial, and

political systems. First, abandoning the euro and re-denominating contracts into a currency

that does not yet exist is much more complex than a public-sector debt restructuring, for

which precedents abound. It is not only more complex but also more unpredictable in itsconsequences, many of which will be indirect. A Greek exit will likely result in private, as well

as public defaults, and the corresponding losses may be very difficult to predict. It also has

potentially greater negative value as a precedent. Government debt restructurings happen

all the time, but even partial breakup of a monetary union is very rare. If Greek becomes the

first departure from the eurozone, it will be hard to avoid the question whos next?

Second, we think that the main reason markets did not react negatively to Greeces

restructuring in March was because the default was fully priced when it happened the issue

of Greek default contagion affected peripheral debt markets throughout the second half of


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31 May 2012 13

2011 and hence had minimal residual effect in 2012. The same cannot be said of a Greek exit

from the eurozone: it is not priced in yet, especially not in key markets. Third, the Greek default

occurred in a context in which the ECB had surprised markets by effectively launching the 3-

year LTROs.

Stressed eurozone sovereigns are already suffering a confidence crisis

Whether financial instability that may result from a Greek exit is transmitted to other eurozoneeconomies depends, ultimately, upon market participants reaction to events; whether, for

example, depositors in Spain view turmoil in Greece as a risk scenario for themselves that they

had not adequately considered, or as further evidence that the situation in Greece and in Spain

are fundamentally different. While it is not possible to predict shifts in sentiment of this nature,

the risk of an adverse market reaction is heightened by the fact that stressed sovereigns in

Europe are already suffering a form of confidence crisis, concentrated to some degree in

foreign owners of public debt, but which could certainly become more generalized and intense

in the future. While there is no guarantee that a disorderly Greek exit would trigger a broader

and more intense run against vulnerable eurozone financial systems, it would be dangerously

complacent to rule this out.

As the situation in Europe has become more complicated, international investors inEuropean government bond (EGB) markets have either sold their exposures or failed to roll

over investments as they come due. In Spain, for example, we estimate that non-resident

investors (other than the ECB) had by April of this year cut their exposure by 50% from early

2010 levels (Spain: Banks still buying, foreigners still selling (but less), 30 April 2012). In

recent months, non-resident selling of Spanish and Italian assets has accelerated, and

seems to have broadened somewhat (Figures 5 and 6).

Thus far, the capital outflows have been accommodated without crisis in Spain and Italy,

thanks to the ability of the banking systems in those countries to tap the liquidity assistance

of the eurosystem. The SMP has provided direct support for government bond markets,

while the LTRO operations provided long-term funding to reduce liquidity pressures

confronting banks, and to permit banks in Spain and Italy to act as government bond buyersof last resort.

Figure 3: Capital outflows have been replaced by eurosystemfunding in Spain

Figure 4: and in Italy

-150

-100

-50

0

50

100

150

200

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

BOP, financial account, with Banco de Espana

ex BdE

-150

-100

-50

0

50

100

150

200

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

BOP, financial account, with Banca d'Italia

Ex-Banca d'Italia

Source: Haver Analytics Source: Haver Analytics
https://live.barcap.com/go/publications/content?contentPubID=FC1816302https://live.barcap.com/go/publications/content?contentPubID=FC1816302


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31 May 2012 14

Figure 5: EGB investor are leaving the periphery (holdings by non residents, in %)

10%

20%

30%

40%

50%

60%

70%

80%

Sep-07 Jul-08 Jun-09 May-10 Apr-11 Mar-12

Greece

Portugal

Ireland

Italy

Spain


If foreign selling were confined to government debt, the remaining exposure would be finite

and, somewhat manageable. For example, if foreign bondholders sold 25% of their remaining

holdings of Italian, Irish, Portuguese and Spanish government debt, other (presumably official)

sources would need to be tapped in the amount of roughly EUR250bn.

This is a big number, but one that lies within the plausible limits of the eurozones capacity.

The numbers become much larger if the run extends beyond government bond markets.

Problems would be compounded dramatically if domestic investors also lose confidence

and sell domestic assets. In particular, if a Greek exit creates fears of loss among bank

depositors in other eurozone economies, a run against bank deposits could be triggered.

We have not observed bank deposit runs in the periphery thus far (other than Greece). In

fact the evidence shows that deposits are rather sticky even in Greece, where nearly two-thirds of the bank deposits have (astonishingly) not left despite the longstanding risk of a

potential disorderly exit. Deposits left Ireland in the months leading up to the EU-IMF

programme of November 2010, but have stabilized since then. We have not seen evidence

of any material depositors outflows in Portugal. In Spain, there is evidence of flight to

quality away from weak cajas but they have moved into stronger domestic banks. And in

Italy there is no material evidence of deposits outflows other than large multinationals that

had to diversify away from countries/banks with low ratings.

The fact that there has so far been no run against bank deposits is not, of course, proof that

it cannot happen in the future.


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31 May 2012 15

Figure 6: Deposit liabilities of Euro Area MFIs

Germany France Italy Spain Greece Ireland Portugal

2009Dec 2,875,710 1,606,738 1,209,695 1,686,023 244,237 219,180 209,649

2010Mar 2,874,507 1,612,590 1,212,938 1,651,301 233,395 220,266 209,149

2010Jun 2,923,056 1,653,307 1,401,379 1,665,951 223,555 217,320 206,744

2010Sep 2,924,448 1,685,502 1,381,604 1,701,127 219,503 211,656 213,366

2010Dec 2,972,771 1,733,500 1,424,330 1,730,187 215,639 201,067 226,165

2011Mar 2,968,338 1,766,883 1,386,424 1,727,934 205,510 195,858 227,349

2011Jun 3,023,207 1,792,549 1,389,411 1,741,354 195,069 199,895 230,695

2011Sep 3,071,737 1,848,503 1,396,599 1,716,762 189,375 198,933 231,078

2011Dec 3,090,965 1,870,912 1,386,613 1,679,558 180,085 196,298 232,805

2012Mar 3,094,532 1,906,210 1,414,413 1,655,018 171,088 195,529 229,054

Source: ECB

If it does, there is much more at stake (even) than in the government bond markets. In Italy

and Spain alone, bank deposits total more than EUR3trn. If those banking systems were to

lose a quarter of their deposits (for the sake of illustration), alternative financing in the

amount of more than EUR750bn would need to be found.Policy responses

The most immediate policy response would in all likelihood make use of emergency liquidity

tools by the ECB, including:

A modified SMP programme, which would buy EGBs across different maturities andcountries. The SMP could be modified to explicitly give up its seniority status. Alternatively

(and perhaps politically more acceptable in Germany), the EFSF/ESM could be granted a

banking license to have access to the ECB and hence leverage its resources. The EFSF/ESM

would then play a similar role to that of the ECB. The intervention by the ECB or the

EFSF/ESM would have to be signalled as unlimited (in quantity and time) for it to be effective.

The ECB is expected to extend its full-allotment policy in the June meeting (currentlyexpiring in July), but if a crisis were to unfold in June/July, the ECB could consider a

further extension of full-allotment into 2013 and offer another round (or rounds) of very

long-term refinancing operations.

Cuts to the ECBs main policy rate to near the zero bound and a clear indication that thepolicy rate will stay at (near) zero through 2013.

A declaration of the European Council concerning a roadmap to fiscal union includingthe first steps (crisis related) as well as the longer-term issues (transfer of sovereignty,

Eurobonds, etc).

Other near-term crisis management tools that could be deployed relatively quickly include

and could complement ECB liquidity injection:

Changes to the status of the EFSF/ESM to allow it to directly inject equity intoundercapitalized European banks. Access to EFSF/ESM could put a ceiling to the debt

(and future losses) that the government would have to take. Above that, the ESM could

assume any further losses. The funds should have attached an EC-ECB-IMF programme

with conditionality exclusively focused on bank restructuring and recapitalization (ie to

satisfy Germany request for conditionality on EU help). By resolving weak European

banks and the potential downside that they put on some European sovereigns, including

Spain (and other countries), it would reduce an important source of uncertainty.


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31 May 2012 16

Additional powers to the European Financial Stability Facility (EFSF)/European StabilityMechamism (ESM) as a precursor of a pan-European deposit insurance scheme.

However, this is far more complex and less likely in our view than the previous policy

response. Ideally, the common deposit insurance scheme could also be endowed with

common supervisory and bank resolution powers. This is technically complex and may

have fiscal implications that would be resisted by several countries. It would require

treaty changes and would need to be voted by all parliaments (just like the current ESM,which is yet to be approved by most countries).

However, all these measures may not be enough in the event of a real loss of confidence

owing to impending euro break-up risk. At that point, the only policy response that could

aid ECB emergency measures to stem the crisis is accelerating EU economic and financial

integration, including an explicit and credible support by all EMU leaders of the future

adoption of Eurobonds.

Yet any form of Eurobonds (joint liability) will also face an uphill legal and political battle

and are unlikely to be approved in the near term. Germany has repeatedly indicated that

more joint-liability requires common European institutions with decision-making authority

for fiscal policy in member states, but France and other EMU member states have so far

resisted the latter. However, if the crisis intensifies to the point of becoming a real threat to

the EMU itself, euro area leaders would be forced to agree and credibly communicate to the

markets what the end-game is for the European integration project.

Conclusion

Greece, and the euro area, are at a cross roads again. The outcome of the 17 June elections

remain uncertain and the rhetoric by some of the left parties suggest that, if elected, they

would aim for negotiations to secure a deep revision of the current EU-IMF programme. If

no agreement is found, the government would lose access to EU-IMF funds and without

them, Greek banks would quickly become insolvent; this would in turn lock out their access

to eurosystems liquidity. Liquidity would dry up very quickly, and a meltdown of the

banking system and, very likely, a disorderly euro area exit would follow.

Even if an accident of this sort is avoided in the near term, Greece's future in the EMU is not

cast in stone. While the Greek government has achieved a substantial fiscal consolidation,

the EU-IMF programme is evidently not delivering results that the Greek population

considers acceptable. In fact, even after the February debt restructuring, the public debt

dynamics remain unsustainable and further debt relief will be required. Poor

implementation of the programme has undoubtedly played a role, but this does not change

the fact that disillusionment with the EU-IMF strategy, combined with continued political

resistance by those who stand to lose privileges under the structural reforms demanded by

the 'memorandum', means that even if a new programme is agreed with the new

government, there is a non-negligible chance that the programme would go off-track again.

In the event of a disorderly exit, the costs for the euro area could be very large: in fact the

interconnectedness of the euro area markets makes the potential costs literally incalculable.

Contagion is already at work, as the EGB markets attest. A Greek exit could leave the door

open for speculation that other EMU members may follow, and this perception would in all

likelihood condition the near and long-term investment decisions of domestic and foreign

investors. In the extreme, it could possibly trigger a (systemic) bank run in some of the

periphery countries, even if there is no evidence of the latter thus far.


17/43


31 May 2012 17

We think that such a disorderly outcome can be avoided. But solutions that only entail

liquidity provision, while necessary, may not be sufficient to address the core problem.

Instead, a credible commitment to greater political and fiscal integration may also be

needed. In particular, a credible commitment with steps towards greater integration that

end with the adoption of Eurobonds may be what is required. There have been specific

proposals even from core countries. Those have been rejected by Germany but may get

traction again if the crisis becomes more acute. The debt redemption fund, as proposed bythe German Council of Economic Experts, could compress sovereign debt spreads

significantly while keeping average debt yields at relatively low levels. That would be the

price that the core may need to pay if it wants to save the euro.


18/43


31 May 2012 18

IMPLICATIONS FOR EUROPEAN BANKS

Deposit risks

Greek banks have lost almost a quarter of their deposit base over the past two years,despite having a deposit guarantee scheme (DGS), suggesting that such schemes arenot sufficient to deal with either systemic risks or redenomination risks.

Facing a similar challenge a decade ago, deposits in Argentina fell 20%, eventuallyresulting in a freeze on withdrawals. Whilst to date there is little evidence of deposit

outflows in other periphery countries (Spain, Italy, Ireland, Portugal), talk of a possible

exit of Greece from the European monetary union has sparked fears of contagion.

We view Europes current deposit insurance system as inadequate, suffering fromtwo drawbacks; first, the insurance is currently provided at a national level by risky

local entities; second, it does not protect against currency redenomination. If

redenomination risk is fully removed via a Euro DGS, then any impact from

redenomination is simply transferred from depositors to the guarantee scheme.

Whilst this may be affordable vis--vis redenomination fears in Greece, Ireland and

Portugal, it would lack credibility in a worst case scenario of contagion spreading to

Spain and Italy as well. Furthermore, the unintended consequences are likely

substantial: raising the costs of providing the guarantee and potentially

undermining a recovery upon euro exit.

All of this suggests that whilst a Euro DGS may initially sound appealing, it isprobably an inappropriate tool to be used in isolation to manage down the contagion

risks from a Greek exit.

Whats happened in Greece?

Before considering the issue of wider contagion of a Greek exit to Europes deposit markets,it is worth examining the situation in Greece itself. Greek banks have been losing deposits

for two years as concerns escalate regarding Greeces economic and fiscal prospects, the

health of its banks, and its potential for long-term inclusion in the European Monetary

Union. As shown in Figures 1 and 2, Greek deposits have declined approximately 24% to

171bn in the past two years. This outflow has been largely offset by the provision of

exceptional liquidity from the European Central Bank and Bank of Greece. This liquidity

provision has allowed the banks to remain adequately funded, but Greek banks have been

experiencing a steady deposit run that could accelerate as the June elections approach.

Most developed banking systems have deposit insurance schemes to offset the inherent

mismatch of making long-term loans funded with deposits that must be repaid on demand.

These schemes allow depositors to place their funds at a bank with confidence that they will

be returned when demanded, regardless of the solvency of the bank. Deposit insurance

exists in Greece, but it has not stopped the outflow of funds from the banking system.

Jonathan Glionna

European Banks Credit Analyst+44 (0)203 555 1992

[email protected]

Miguel Angel Hernandez, CFA

European Banks Credit Analyst

+44 (0)20 7773 7241

[email protected]

Simon Samuels*

European Banks Equity Analyst

+44 (0)20 3134 3364

[email protected], London

Mike Harrison*


+44(0)20 3134 3056

[email protected]

Barclays, London

Nimish Rajkotia*


+44 (0)20 3134 3719

[email protected]

Barclays, London

* This research report has been

prepared in whole or in part by

equity research analysts based

outside the US who are not

registered/qualified as research

analysts with FINRA.
mailto:[email protected]:[email protected]:[email protected]:[email protected]


19/43


31 May 2012 19

Figure 1: Greek customer deposits outstanding, bn Figure 2: Q/Q changes in Greek household deposits, mn

0

50

100

150

200

250

Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12

-24%

-12,000

-8,000

-4,000

0

4,000

8,000

12,000

16,000

20,000

Q1 09 Q3 09 Q1 10 Q3 10 Q1 11 Q3 11

Deposits in non-resident banks

Cash and sight deposits in domestic banks

Cash burn

Total household deposits

Source: ECB, Barclays Research Source: ECB, Barclays Research

Contagion: Little evidence to dateHowever, perhaps the key area of focus for investors is that of contagion risk as talk of a

possible exit of Greece from the European monetary union has sparked fears about deposit

outflows from other peripheral countries. However, these concerns are not new. The bank

funding pressures prevailing prior to the 3-year LTROs led investors to closely monitor

customer deposit flows in peripheral countries in the second half of 2011.

Customer deposit balances declined across most of the European periphery during this

period, although the declines were moderate outside of Greece (Figure 3). Irish deposits fell

just 1% in the last six months of 2011, having declined more than 10% since mid-2010.

Spanish and Italian deposits fell 3% and 2%, respectively, while Portuguese deposits

actually rose. In the first three months of 2012, customer deposits remained stable or even

increased (Italy), as investor confidence recovered following the 3-year LTROs. As shown inFigure 4, aggregate deposits in Spain, Italy, Portugal, and Ireland have increased in 2012. We

find little evidence of a trend of recent large-scale deposit outflows from peripheral

European countries, excluding Greece.

Figure 3: Change in customer deposits since June 2011 Figure 4: Total deposits in Spain, Italy, Portugal, and Ireland, bn

-5%

-4%

-3%

-2%

-1%0%

1%

2%

3%

4%

Jun-11 Aug-11 Oct-11 Dec-11 Feb-12

Spain Italy Ireland Portugal

2,780

2,800

2,820

2,840

2,860

2,880

2,900

2,920

2,940

2,960

Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12

Note for both charts: Excludes government deposits and securitization bonds. Source for both charts: classified as deposits. Source: ECB, Barclays Research


20/43


31 May 2012 20

In addition, we believe that looking solely at customer deposits does not provide the full

picture. This is because banks in some peripheral countries, most notably Spain and Italy,

have focused their fund-gathering efforts on placing bonds, usually short-dated

instruments, with their retail customers. In the case of Spain, where this phenomenon is

relatively new, this is in response to the governments decision to increase banks

contributions to the countrys deposit guarantee scheme (the contribution is calculated as a

percentage of deposits outstanding). In Italy, retail bonds have historically been animportant source of funding for banks because of the tax advantage they entail for the end

customer relative to traditional deposit products. Figure 5 shows the change in customer

funding since June 2011, which we proxy by the aggregate of customer deposits and debt

outstanding with a maturity of less than two years. These data confirm that, despite some

volatility during the period, customer funding of peripheral banking systems, excluding

Greece, has been relatively stable since June 2011.

Figure 5: Change in the aggregate of customer deposits and short-term debt outstanding(


21/43


31 May 2012 21

coverage. To offset this, the remodelled directive (2009/14/EC) was published in 2009. This

sought to increase harmonisation and required member states to ensure a level of coverage

that was fixed at 100,000 by the end of 2010. Some of the additional features of the most

recent directive are summarised in Figure 6.

Figure 6: European deposit insurance directive harmonized basic terms

Right to compensation Scope of claim How much? When? Who funds the scheme?

All deposits held bynon-bankinginstitutions ie, individuals, smallcorporations,partnerships

All deposits-mainly demand,term and savingsdeposits, plusregistered savingscertificates

100,000

Payout no laterthan 21 daysafter funds arefrozen

Various. Some/all ofthe schemes funded bymember financialinstitutions throughannual proportionatecontributions

Source: European Commission, Barclays Research

In addition, individual countries also took action to solidify deposit insurance schemes

during the early stages of the crisis. In Ireland, for example, the statutory Deposit Guarantee

Scheme (DGS) was supplemented by the Eligible Liabilities Guarantee (ELG) scheme

initiated in October 2010. The first 100,000 of an individuals deposit is guaranteed by the

DGS, and the remaining balance over 100,000 (no limit) may be covered by the ELGScheme or Government Guarantee. The Irish ELG scheme is currently scheduled to expire

on June 30, 2012. However, the date can be extended further until December 31, 2012 with

EU state aid approval.

Despite the increased harmonization, a challenge exists in that the guarantees are still

provided locally, by governments and agencies that have credit risk, reducing the value of

the insurance. For example, in Greece deposit insurance is provided by the Hellenic Deposit

Guarantee and Investment Guarantee Fund (HDIGF). In Spain and Italy, the deposit

guarantee is provided by Fondos de Garantia de Depositos and Fonda Interbancaria di Titela

dei Depositi, respectively. A list of the deposit insurance provider in various countries is

shown in Figure 7. In most cases, the creditworthiness of these agencies is only as good as

the creditworthiness of the aggregate banking system or sovereign.

Figure 7: Deposit guarantees are still provided locally

Selected country Who is responsible for depositor insurance?

Belgium Protection Fund for Deposits and Financial Instruments

France Deposit Guarantee Fund (Fonds de Garantie des Depots-FGD)

Germany Compensation Scheme of German Banks(Entschdigungseinrichtung deutscher Banken- EdB) andadditional Deposit Protection Fund for Private Commercial Banks.Separate schemes exist for Savings and Cooperative Banks

Greece Hellenic Deposit Guarantee and Investment Guarantee Fund -HDIGF

Ireland Central Bank of Ireland

Italy Interbank Deposit Protection Fund (Fonda Interbancaria di Titeladei Depositi - FITD)

Portugal Deposit Guarantee Fund (Fundo de Garantia de Depositos- FGD)

Spain Deposit Guarantee Fund for Banking Institutions (Fondos deGarantia de Depositos - FGD)

UK Financial Services Compensation Scheme - FSCS

Source: European Commission and individual member state DGS websites


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31 May 2012 22

Most deposit insurance schemes are funded independently by the banking system,

although they often include a direct or implied guarantee from the government. Some of

these schemes are financed by regular contributions from the member banks annually to

build up the ex ante float in preparation for a future crisis. Others do not pre-finance at all

and require the member banks to fund the required payout ex post, after a bank has

failed. Greeces deposit insurance law states that if the funds in the Deposit Cover Scheme

were not sufficient to meet depositor compensation payments, the HDIGF may, at itsdiscretion, borrow from the credit institutions participating in the scheme for a determined

period of time. In 2009, this may have provided comfort that the fund could be replenished

following a bank failure, but it is less beneficial when the crisis involves the entire banking

system. Generally, deposit insurance funds are prohibited from borrowing from national

central banks or the ECB. In Figure 8, we outline the funding status of selected European

deposit insurance schemes. As shown, the available resources are moderate in relation to

the size of each countrys deposit base. For example, in Spain, a banking system with

approximately 1.6trn of deposits, the deposit insurance fund has total assets of just

7.9bn, of which 5.3bn has already been committed to the resolution of Caja de Ahorros

del Mediterraneo (CAM) banks.

Figure 8: Funding status of selected deposit insurance schemes

Country

Customer

Deposits

bn*

How is deposit insurance

funded? Resources within the fund Can it borrow?

Who provides for the

shortfall?

Does it have

preferred

creditor

status?

Spain 1,655 Credit institutions in theform of annualcontributions of 0.2-0.3% ofeligible deposits

Total assets of 7.9bn as ofOctober 2011, of which4.1bn are liquid; in Q4,5.3bn committed forresolution of CAM

Yes Credit institutions throughone-off contributions,borrowings in open market

No

Italy 1,414 Credit institutions, regularcontributions coveroperating expenses only;

fund interventions coveredby one-off contributions

Unfunded; maximumcontributions in 2012 canbe up to 1.8bn (0.4% of

eligible deposits)

Notcontemplated

Not contemplated No

Portugal 229 Credit institutions in theform of annualcontributions

1.4bn (of which 400mnare unfunded)

Yes Credit institutions throughone-off contributions; Bankof Portugal can also coverimmediate needs ifsystemic stability at risk

Yes

Ireland 196 Annual cash contribution of0.2% of deposit base

NA Yes Central Bank, reimbursedwithin 3mths by Treasury,who then seeks fundreplenishment from thecredit institutions

No

Greece 171 Credit institutions in theform of annual

contributions of 0.9-1.1% ofeligible deposits

1.4bn (end 2010) Yes Supplementarycontributions by credit

institutions capped at 3xregular annualcontribution. Also Fundcan borrow required levelfrom credit institutions

Yes- impliedby new Bank

Resolution plan

* As at May 2012Source: National regulators, Barclays Research


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Problem 2: Redenomination risks

The second challenge facing any European deposit guarantee system is dealing with

redenomination risk and in particular the contagion risk that could follow a Greek exit from

the eurozone. We believe that the most likely transmission mechanism of contagion is that a

Greek exit leads to bank runs in other peripheral banking systems. The thinking here is that

depositors in the periphery (ex Greece) come to view a Greek exit as a realistic template forhow eurozone sovereign debt crises are resolved. As such, depositors may become

concerned that the end game for their own sovereign's debt crisis is that their deposits are

redenominated and, once in the new currency, depreciate heavily versus the euro. So they

begin to withdraw their deposits, potentially sparking bank runs.

Left unchecked, this could lead to widespread bank insolvencies, requiring national governments

to step in and shore up the banking system. But clearly, placing such an additional burden on

the finances of already-troubled sovereigns would risk exacerbating the current crisis further.

The conventional approach to prevent bank runs is a deposit guarantee scheme (DGS).

However, as noted, the current European system of deposit insurance has important limitations.

Moreover, the extant DGSs have been designed to handle individual rather than systemic bank

runs. Even in the US, it was the Fed/Treasury and not the Federal Deposit Insurance Corporation

(FDIC), which manages the US DGS, who provided the backstop to the systemic crisis in 2008-

09. As such, the current arrangements for protecting depositors against potentially widespread

currency redenomination concerns following a Greek exit are limited.

Argentina: 2001

Perhaps the most recent example of a country facing similar challenges around

denomination risk was Argentina in the period leading up to the abandonment of its

currency peg with the US dollar in 2001. Indeed, the Greek experience of deposit outflow is

not dissimilar. For example, Argentina underwent a period of deposit flight prior to

redenomination during the national economic crisis in the early 2000s, during which declining

output and high inflation strained the countrys economic and political infrastructure. Fearing arevaluation of the currency, Argentineans began to pull deposits out of peso-denominated

accounts, often reposting these funds into dollar-denominated accounts.

Deposit insurance, in place at the time, did little to stem this flow, since the provider of the

guarantee was in question, given the impending government default; the value of the

currency, not just the viability of the banks, was uncertain given the increasingly apparent

need for revaluation. As concerns escalated in late 2001, the pace of this outflow and

conversion increased. In three of the worst days of November 2001, 6% of bank deposits

were pulled from the system.1 Year-over-year, deposits fell 19.9% in 2001, to ARS66.0bn

from ARS82.5bn at the end of 2000, according to IMF data.

In response, the Argentinean government instituted a deposit freeze, or corralito, onDecember 3, 2001 to help stem the overwhelming outflow of deposits. Payments were

initially allowed between banks in the system (though additional restrictions were

subsequently applied), but depositors were not permitted to withdraw the majority of funds

from their accounts. Nevertheless, as the crisis continued, with the governments

declaration of default in late December 2001 and conversion of dollar-denominated

financial assets and liabilities into Argentinean pesos in February 2002, deposit withdrawals

continued at an estimated rate of ARS0.9-4.2bn per month in the first seven months of

1 IMF, Banks during the Argentine Crisis, Barajas et al, 2007.


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2002.2 A combination of monetary tightening, government support for bank solvency, and

legal protection against deposit devaluation contributed to a reversal of these trends overthe course of 2002. Deposit withdrawals slowed in 3Q02 and eventually started to grow

again in late 2002 (Figures 9 and 10).

Part of the problem with bank runs is that they quickly become self-fulfilling. As Mervyn

King, Governor of the Bank of England, noted during the run on Northern Rock in 2007,

"once a bank run has started, it is rational to join in". In other words, it doesn't matter

whether a bank run starts for valid reasons or not. Once aggressive deposit flight is

underway and a banks solvency is threatened, it makes sense for the remaining depositors

to participate if they think that everyone else will withdraw their deposits as well. This holds

true regardless of whether all depositors share the concerns that initially started the run.

The idea behind a DGS is to break this vicious circle. If you know with confidence that you

(and everyone else) can access your deposits in full, there's no need to withdraw deposits inthe first place. So the key barometer of a successful DGS lies in its credibility. If a DSG can

cope with depositors worst case scenarios, bank runs will be prevented.

However, given the shortcomings of existing national DGSs, are there other ways to reduce

the risk of bank runs? One (limited) approach is as follows. If a bank's liquidity buffer

(including central bank reserves) is generally perceived to be greater than the proportion of

depositors who are concerned about redenomination, banks can cope with deposit

withdrawals without becoming insolvent. Whilst a Greek exit clearly increases the

proportion of depositors concerned about redenomination, any early-stage panic could in

theory be addressed by national authorities in the periphery signalling to the rest of the

depositor base that: (a) the group of 'concerned' depositors is too small to cause a run; and

(b) banks' liquidity buffers are sufficiently large. Measures to reassure depositors about the

size of liquidity buffers could potentially include further special measures from the ECB

(although this may lead to uncomfortable questions about the credit risk they assume) or,

alternatively, the introduction of depositor preference regimes across Europe (although this

would likely further undermine banks' wholesale funding models).

2 World Bank, Argentinas Banking System, Gutierrez and Montes-Negret, 2004.

Figure 9: Argentinean total deposits (bn) Figure 10: Argentinean annualized deposit growth (%)

0

20

40

60

80

100

120

140

160

1993 1995 1997 1999 2001 2003 2005

Deposits (Native Currency) Deposits (SDRs)

-80%

-60%

-40%

-20%

0%

20%

40%

60%

1994 1996 1998 2000 2002 2004

y/y Growth (Native Currency) y/y Growth (SDRs)

Source: IMF International Financial Statistics, Barclays Research Source: IMF International Financial Statistics, Barclays Research


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Figure 11: Depositor preference laws by country

Country Depositor Preference Law?

United States Yes

United Kingdom No (proposed)

Switzerland Yes (indirect)

Germany Yes (indirect)Holland No

France No

Spain No

Italy No

China Yes

Japan No

Australia Yes

Argentina Yes

Brazil No

Source: FSB, Moodys, Barclays Research

But the short-term efficacy of such an approach faces at least two significant hurdles. First,

it's a complicated solution. In a world where the levels of financial sophistication vary

significantly across the population, it would be extremely challenging to quickly and

effectively communicate a complex idea like depositor preference. Similarly, further ECB

liquidity provisions may soothe financial markets and financially sophisticated corporates,

but they run the risk of bewildering many retail depositors. Would they understand at what

point 'enough' liquidity had been pumped into the systems?

Second, and even more problematic: how could authorities credibly assert that the

proportion of depositors concerned about redenomination is too small to precipitate a bank

run? How could they tell? Quite aside from the challenges presented in gathering such data,

bank runs can occur even if no depositors have redenomination as their base case. Provided

that the switching costs of moving deposits out of 'at risk' banks/geographies are lower

than the perceived probability-weighted impact of redenomination, then deposit

withdrawals can reach the critical mass needed for a bank run.

This suggests that any response that is either too complicated for retail depositors to

understand or requires authorities to have 'private knowledge' that they can't realistically

access will meet with limited success. Another way of putting this is to say that any policy

measure which is applied on a 'doing just enough' basis may well prove ineffective. Would a

more top-down, EU-wide approach to a DGS work any better?

An EU-wide DGS would be helpful in the sense of enhancing the credit-worthiness of the

guarantor but would be unlikely to offer adequate protection against currency

redenomination. This is because even if deposits are guaranteed in euros 'today', this offerslittle relief if redenomination occurs 'tomorrow'. The only way such a DGS could work is if

deposits were guaranteed in euros even after countries have left the euro with the risks of

devaluation being transferred from depositors to the DGS provider. This could result in the

bizarre situation of having (newly) non-eurozone countries having all their domestic

deposits denominated in euros. Would such a scheme be credible?

Given the limited pre-funding of DGSs across Europe, significant deposit outflows in the

periphery would have to be met either from the ECB or from non-periphery sovereign debt

issuance. To give a sense of scale to this contingent liability from a sovereign issuance


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perspective Figure 12 shows the deposits/GDP across the 27 countries in the EU. We

calibrate the size of the contingent liability of an EU-wide DGS by comparing the size of the

European periphery deposit base (Spain, Greece, Italy, Ireland, Portugal, subsequently

referred to as SGIIP) relative to the GDP of various constituents of the DGS provider.

Figure 12: Customer deposits / GDP

Customer Deposits GDP Deposits / GDP

Luxembourg 220 44 503%

Cyprus 49 18 275%

Malta 11 6 167%

UK 2,777 1,775 156%

Spain 1,655 1,069 155%

Netherlands 860 599 143%

Portugal 229 169 136%

Belgium 480 371 129%

Ireland 196 155 126%

Germany 3,095 2,606 119%

Austria 322 305 106%

France 1,906 2,018 94%

Italy 1,414 1,575 90%

Greece 171 222 77%

Czech 111 157 71%

Denmark 160 241 66%

Finland 128 194 66%

Bulgaria 26 40 65%

Sweden 246 401 61%

Slovenia 22 36 60%

Slovakia 39 70 56%

Estonia 9 16 55%

Poland 187 355 53%

Hungary 46 96 48%

Latvia 8 21 38%

Lithuania 12 32 38%

Romania 44 165 26%

Total 14,419 12,755 113%

Total SGIIP 3,665 3,190 115%

Total Non-SGIIP 10,754 9,565 112%

SGIIP Deposits % Non SGIIP GDP 38%

SGIIP Deposits % AAA GDP 63%

SGIIP Deposits % German GDP 141%

Source: ECB, Bloomberg, Barclays Research


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SGIIP deposits are 38% of non-SGIIP GDP. This implies that the deposit/GDP of the EU-wide

DGS providers would rise to 151%. This is relatively high relative to the EU, but on a par with

the UK and Netherlands.

But the real credibility of such a scheme ultimately comes down to how much the

contingent liability would potentially cost the DGS providers and whether this is

affordable. However, this immediately gets us into murky waters. At what point would anEU-wide DGS pay out? Ordinarily, a DGS only makes payments once a bank has exhausted

its reserves and sold down its liquid assets to the point of insolvency. If taxpayer monies are

used to bail out depositors, these would usually be in the form of a loan (rather than a gift) -

with repayment occurring after the banks has been restructured or sold on.

However, it's unlikely that extending these mechanics to an entir

95418609 Risks and Repercussions of a Greek Exit

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