Greek financial institutions have been counting on strong loan volume in retail banking and resilient spreads to boost their profits and satisfy their shareholders during the last few years but a few of them have paid less attention to the asset quality of their loan portfolios. This combined with a weak credit culture may spell trouble ahead if euro interest rates rise further and Greece’s blue sky economic scenario unravels. Greek banks have been the darlings of investors since 2003, a critical year because the combination of strong growth in retail banking revenues and cost containment overtook the slack from declining capital market-sensitive revenues to produce spectacular earnings growth and capital gains. This would not have happened if the Greek economy had not posted an annual average growth rate of more than 3.5 percent over the last four years on the heels of healthy consumption expenditure, strong investment spending barring 2005 and a pick up in exports in the last couple of years. Fast economic growth translated into higher disposable income and in turn consumption spending and sales for companies. To some extent, consumption expenditure and to a lesser degree investment spending were positively influenced by the lowest interest rates in generations as the ECB (European Central Bank) drove its key intervention rate as low as 2.0 percent in a bid to help major eurozone economies, such as Germany’s, recover. Greece’s relatively high inflation rate averaging more than 3.3 percent over this period along with ECB’s low nominal interest rate produced either a negative real interest rate or a small positive one during this period. This made it easier for the average household to take out a loan to buy a house, a car or other durable goods. The fact that the typical household had not borrowed before also helped. During this period, banks took advantage of their hefty profits, good capitalization and the favorable macroeconomic environment to clean up their loan portfolios and improve their asset quality indicators, namely the ratio of nonperforming loans-to-total loans (NPL ratio). According to the most commonly used definition, a loan is nonperforming when payments of interest and principal are past due by 90 days or more. Falling trend According to S&P, the gross NPL ratio of the Greek banking sector stood at 15.9 percent at the end of 1999 but continued to decline in the next few years apart from 2004 when the credit quality of construction, hotel and information technology companies deteriorated. The ratio resumed its downward course in the following year, with nonperforming loans falling to 6.3 percent of total loans at the end of 2005. The coverage of nonperforming loans was 62 percent at the end of 2005. The NPL ratio fell further to 5.4 percent at the end of 2006 based on Bank of Greece figures. Even so, the NPL ratio of the Greek banking system compares unfavorably with the European Union-15 which is estimated around 3.3 percent. Moreover, whereas some Greek banks have managed to lower their NPL close to or below the EU-15 average, some others, thought to be more than 5, have an NPL ratio greater than 5.0 percent. Undoubtedly, all banks have taken steps, some greater than others, to improve the credit quality of their loan portfolios by buying and putting in place risk management systems and upgrading their credit risk approval procedures and monitoring processes in recent years. In addition, the strong growth in retail banking, namely loans to households and small- and medium-size enterprises, has reduced the level of risk concentration in the banks’ loan portfolios because they are better diversified. This means the possible default of one or more corporations will not have the same impact on the banks’ credit quality as it would have had a few years ago. Does this mean everything is OK and there is no need to worry? Apparently not. Even the Bank of Greece, the country’s central bank, which is being accused by some of being soft, does not think so. Last month, it notified the banks that they would have to bring down their NPL ratio to 5.0 percent at the end of this month and submit a plan to the central bank, showing how they will take it down to 3.5 percent by the end of 2008. The central bank also asked them to bring down the ratio of nonperforming loans minus cumulative provisions to Tier I and II capital below 10 percent by the end of next year. Analysts and others say this may prove to be a Herculean task for a number of Greek banks even if monitoring improves and credit approvals become stricter. According to them, this may entail share capital increases and even mergers if penalties for non-abiding banks turn out to be sizeable. The new rules come at a time when euro interest rates are rising and spread compression on new mortgage loans, the most promising category, approaches average EU levels. Moreover, domestic loan volume growth shows signs of fatigue whereas loan growth from Southeast European operations is strong and expected to remain so for many years to come. There is not doubt that the weak credit culture in Greece and the other countries to which local banks have expanded over the last few years is a source of concern. This is especially true if one takes into account the high NPL ratio, albeit decreasing, of some Greek banks. The fact that most domestic mortgage loans are based on the ECB interest rate or the 3-month Euribor makes one even more cautious given the projections for further hikes by the European Central bank. What is still holding relatively well is the Greek economy which is seen growing at a rate of 3.7 percent or better this year and next. But counting on Greece’s blue sky economic scenario may not be the best thing for prudent banks to do, even if the odds are in their favor.