The recent European Union summit may have surpassed expectations for the first time in a long time, warding off an immediate fissure in the eurozone and raising hopes of a crisis resolution in Spain, Italy and program countries in the medium-to-long term. Although Greece has reasons to rejoice, some local politicians and others may have jumped the gun in assuming a direct Greek bank recapitalization from European bailout funds, leading to a significant reduction in the public debt-to-GDP ratio.
Under the second economic adjustment program, Greece has been allocated 48 billion euros for the recapitalization and resolution of the local banking sector by its international creditors. The capital support will be provided by the Hellenic Financial Stability Facility (HFSF), which was established in the fall of 2010, to which the 48 billion euros will be directed. Another 2 billion euros or so is available from the first bailout program, bringing the total sum to 50 billion.
Following the completion of the biggest-ever sovereign debt restructuring (PSI+) last March, and continued delays in bank recap due to the political situation, the four major banks — namely National, Alpha, Eurobank EFG and Piraeus — received bridge capital of 18 billion euros in the form of EFSF (European Financial Stability Facility) bonds from the HFSF. The capital bridge aimed at covering bond losses related to PSI and boosting the banks? total capital adequacy ratio to the minimum 8 percent required for them to be able to resume borrowing from the European Central Bank (ECB).
According to the initial plan, the Greek banks will have to be recapitalized to cover bond writedowns and loan losses from BlackRock stress exercises, bringing their core Tier I capital adequacy ratio to a minimum 9 percent by sometime in September and to 10 percent by June 2013.
A number of analysts estimate that the capital shortfall from bond and loan losses under the distress scenario of the four large banks should not exceed 25 to 27 billion euros to raise core Tier I ratio to 10 percent. Even if one adds 10 billion euros in resolution and recapitalization needs for other banks, such as Hellenic Postbank and ATEbank, and rules out private shareholder participation, the sector?s total capital shortfall may not exceed 35-37 billion euros. Of course, the above calculations will become meaningless if Greece exits the euro or gets trapped in a prolonged depression, but let?s assume this will not be the case.
So, Greece may be able to count on some 15 billion euros or more unused funds from the bank recap scheme to finance other needs. One possibility is to fund the extension of the economic program for two years, meaning until end-2016, which is one of the goals of the new coalition government. Another possibility would be to use all or part of the residual amount to buy back the new Greek bonds at, hopefully, depressed price levels and subsequently cancel them to reduce the outstanding stock of public debt, and cut the debt-to-GDP ratio by 10 to 20 percentage points to render the Greek debt more sustainable.
Following the decisions taken at the EU summit last week, many Greek politicians and others think there is a great opportunity to have the bailout mechanisms EFSF/European Stability Mechanism (ESM) recapitalize the local banks directly and not through the HFSF. This means the public debt stock can be possibly cut by 48-50 billion euros or 23-25 percentage points of GDP. Their hopes are basically pinned on the following segment from the EU statement.
?The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment program. Similar cases will be treated equally.?
With no intention of second-guessing anybody, we think the EU, which is eager to show that a program country can successfully access the markets, would like to reward Ireland for conforming to the terms of bailout program and facilitating its exit into the markets in the next 12 months or so by finding a way to recapitalize its banks retroactively.
Even so, it will be interesting to see how the EU will handle the capital injection of 20.7 billion euros by the country?s national pension fund to the AIB and Bank of Ireland, and the 30.7 billion-plus in promissory notes in the 64.4 billion-euro Irish bank recap, as Nomura pointed out in a report. Assuming full assumption of bank recapitalization by the European bailout mechanisms, Ireland would see its public debt-to-GDP drop by about 40 percentage points, improving drastically the sustainability of its debt.
On the other hand, Greece has not received good grades from the troika on the implementation of its economic adjustment program and is not likely to get a positive assessment anytime soon. So, it is rather unlikely the EU will approve the direct recapitalization of Greek banks from the EFSF/ESM.
Moreover, such a direct recap of any bank — Spanish, Irish or Greek — cannot happen before an EU centralized supervisor is up and running, as explicitly outlined in the EU statement. Most economists seem to reckon that it will take months before bank supervision at the European level is in place. In addition, the permanent bailout mechanism, ESM, which was supposed to be operational in early July, may not be ready following some delays in the ratification process. This means direct bank recap, even if it is approved, will have to wait for months.
All-in-all, the Greeks have every right to rejoice about the decisions taken at last week?s EU summit but less than others, like the Spanish and the Irish. This is so because direct bank recap is more likely to be used by the EU as a reward for program countries sticking to agreed-upon reforms and fiscal targets, and Greece cannot compete in that category. In addition, direct bank recap may take longer than many think, weakening its punch.