Banks should act now to get cleaned up

The Greek economy needs local banks to be strong and well-capitalized so that they can perform their role as intermediaries and support the recovery effort. Although the recapitalization and mergers that took place last summer have gone a long way to this end by addressing capital shortfalls, the time may have come for core banks to frontload the brunt of future provisioning losses and fully clean their balance sheets even if this leads to new share capital increases in the months ahead. This way, they can take advantage of favorable market conditions abroad and attract enough private capital in the process to remain under private control.

The banking system paid dearly for the biggest-ever restructuring of sovereign debt by suffering losses close to 38 billion euros from bonds and state loans subject to the terms of the PSI (Private Sector Initiative). The estimated losses amounted to 28.2 billion for the four pillar banks – Piraeus, Alpha, National and Eurobank. In addition, banks sustained losses from loan portfolios hit by the protracted recession and a loose credit policy in the past.

To fill the capital gap identified by the Bank of Greece, which in turn relied on the diagnostic tests of loan books conducted by BlackRock Solutions in 2011, more than 40 billion euros was provided for resolutions, restructuring and the recapitalization of local banks. This amount came out of nearly 50 billion euros allocated for the recapitalization of the banking system under the country’s bailout program.

The end result was an oligopoly with four core banks dominating the market and capital adequacy ratio (Core Tier I) close to or above 9 percent of their risk-weighted assets. Eurobank was the only exception among the four banks, featuring a Core Tier I ratio below 9 percent, which explains why it initiated the process for a new share capital increase.

Although progress has been made on some fronts, a lot of work remains to be done. Undoubtedly, the most important issue is the management of non-performing loans (NPLs). Banks continue to suffer losses as companies and individuals find it increasingly difficult to service their loans with the economy contracting for a sixth consecutive year. Moreover, they will have to face the so-called strategic defaulters, namely individuals who fail to pay even though they can afford to do so.

Analysts expect Greek banks to continue recording losses from bad loans in 2014 even if forecasts calling for real GDP growth of 0.3 to 0.6 percent prove correct. This is because there is a time lag between the formation of NPLs and economic activity but more importantly unemployment. Bad loans are continuing to rise, albeit at a declining rate, and market consensus wants Greek NPLs to peak next year, somewhere between 30 and 35 percent of total loans. Lending to the private sector stood at 219.2 billion euros in October from 227.1 billion at end-2012.

At this point, the market expects the results of the second round of diagnostic tests on loan portfolios conducted by BlackRock (BlackRock II) to be announced soon and the Greek central bank’s verdict on the capital needs of each core bank in early 2014. The outcome is unknown but past press reports suggest that total capital needs should range between 4.5 and 6 billion euros. Eurobank was supposed to be the only credit institution requiring a share capital increase of 2 billion euros or more to meet the capital adequacy ratio requirement. The other three core banks could rely on non-core asset disposals and liability management exercises, and Piraeus Bank along with Alpha Bank on their fat Core Tier I ratio to absorb some losses.

But their capital needs could turn out to be greater if banks are asked to clean their loan books sooner rather than count on expected profits in coming years to lighten the burden. This will likely lead to a new round of share capital increases. Kathimerini understands that talks are under way between the Greek side and the European Central Bank (ECB) on this issue so there may be some news relatively soon.

Although there are prose and cons for either option, it may be better for local banks to bite the bullet and take all the provisions for NPLs now even if it means going for new share capital increases in the first quarter of 2014.

The ECB has an incentive to support such a capital-enhancing exercise because it will not have to demand local banks to do so after it conducts its own stress tests at some point into 2014. In addition, investors always like clear solutions and tend to reward banks with clean portfolios. This means that there should be considerable demand for Greek bank shares if investors feel confident there are no more skeletons in their closets. This would contribute to the successful conclusion of the share capital increases and help keep banks in private hands. The favorable international market conditions and a strong appetite for risk, the prospects for a return to economic normalcy in Greece and banks’ attractive valuations also support this argument.

On the other hand, some of the existing shareholders will see their stakes diluted if they cannot participate in the new share capital increases. Also, local banks will not have the opportunity to prove that they can turn around their franchises without resorting to fresh share capital increases.

Undoubtedly, there are no easy choices. However, it is in the best interest of the Greek economy that banks frontload the brunt of future provisioning losses and completely clean their balance sheets by taking advantage of the best international market conditions since 2007.