How to fix Greece’s banks

August 10, 2015

Greece’s banks are the weakest point in its economic system. They need to be repaired in order to lift capital controls, restore depositor confidence and finance a future recovery. There are good and not-so-good ways of doing this.

The banks have been hit by a perfect storm since the radical-left government of Alexis Tsipras came to power in January. Deposit flight, which has been a periodic feature of the Greek crisis, took off again. The banks were then closed and capital controls imposed after Tsipras launched a referendum on whether to accept the demands of the country’s euro zone creditors and the International Monetary Fund.

What’s more, the long recession, briefly interrupted last year, has returned with a vengeance. Non-performing loans, which reached 35 percent of all loans at the end of last year, will increase to well over 40 percent in 2015-2016, Moody’s Investors Services predicts.

As a result, the banks, which have already been recapitalised several times during the Greek crisis, need another equity injection of 10-25 billion euros. Until that happens, the European Central Bank, which has been authorising emergency liquidity for the lenders, will not be willing to lift the capital controls. And so long as those last, more and more companies will go bust, landing the banks with yet more bad loans.

Fortunately, there are reasons to be mildly optimistic. Although the people voted in the referendum against the terms demanded by Greece’s creditors, Tsipras performed a U-turn and is now engaging in constructive talks. There’s a good chance that a deal, offering Athens up to 86 billion euros in exchange for deep reforms, will be agreed soon.

Meanwhile, the ECB, which supervises Greek banks, is moving fast to complete an assessment of how much capital they need. Supervisors are working through their summer holidays to get the job done by end-October.

The creditors also seem to have excluded the worst option for recapitalising the banks: bailing in their uninsured depositors. This would have involved forcibly converting a portion of their deposits into bank equity.

It is a good idea, in theory, to bail in a bust bank’s creditors rather than bail them out with taxpayers’ money. But this is only sensible in practice when there is enough equity and debt to take the hit without harming depositors. Greek banks do not have much of a cushion.

Although the worst idea for recapitalising the banks seems to have been rejected, the best option isn’t making much headway either. This is for the European Stability Mechanism, the euro zone’s bailout fund, to take direct stakes in the banks. Instead, it looks like the ESM will lend money to Athens which, in turn, will inject capital into the banks.

A direct recapitalisation would be preferable because it would cut the link between the government and the country’s lenders. Athens would no longer be able to meddle with their management. Nor would the state, which is already virtually bust, be loaded up with up to 25 billion euros in extra loans. A further advantage is that, if the euro zone directly owned the banks, depositor confidence would be immediately boosted and capital controls could be swiftly lifted.

One reason this option has not been favoured is because the ESM guidelines require a bail-in before it can inject equity. What’s more, Germany has never been keen on the idea of banks being directly recapitalised. However, if the euro zone wished, it could change these guidelines.

A further issue is whether Greece should create a “bad bank”. The idea would be for the banks to sell non-performing corporate loans to a new asset management company at a deep discount to their official value.

Experts in distressed debt would run the bad bank. In some cases, they would liquidate companies; in others, they would kick out the management; and in yet others, they would convert debt into equity. After shedding their dud loans to the bad bank, the “good” banks could then focus on lending to good companies.

Spain and Ireland have both had success creating bad banks after they were bailed out a few years ago. So far, though, the creditors have not favoured a similar arrangement for Greece. One reason is that they worry that Athens would pull the bad bank’s strings, favouring its cronies.

The government reinforced this fear by proposing a state-controlled bad bank. But there’s an obvious solution: ensure that the asset management company is controlled by private investors.

Yet another issue is whether the Greek banks should be allowed to count deferred tax assets as part of their capital. These are the right not to have to pay future taxes because past losses have been so big. They are a controversial form of capital because they cannot be used to absorb more losses in the present and so, arguably, aren’t really capital at all. They now account for over half Greek banks’ capital.

Even if deferred tax assets are not excluded completely, there should be limits on how much lenders can use them in calculating their equity. Although this would increase the overall bailout bill, bank balance sheets would emerge stronger.

Greece’s lenders are its Achilles heel. There is now a chance to clean them up properly. It would be a shame if this was wasted.

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How to fix Greece’s banks: Gasoline + matches.

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