Greek banks may be right in arguing they are not exposed to derivatives and other complex financial instruments and loans linked to the US mortgage market and the subprime mess in particular. However, this is only part of the story. There are other links to the credit crisis which should not be downplayed. With the exception of the Postal Savings Bank, which has invested some -40 million in a financial product tied to subprime loans and an additional portfolio of alternative investments, the other major Greek banks have admitted having no direct exposure to CDOs or other financial instruments tied to the US mortgage market. Still, this did not stop foreign investors from proceeding with aggressive selling, sending their shares to multi-month or multi-year lows. The shares of state-controlled Postal Savings Bank, which made its debut on the Athens bourse in early June 2006, fell below its IPO (initial public offering) price of -12.50 per share last Thursday. Just a few months ago, in July, the government had privately placed some 20 percent of the bank with mostly non-resident institutional investors at more than -18 per share. If hammering the shares of the Postal Savings Bank was considered by some normal given its exposure to risky securities and uncertainties about its future strategy, following a change at the helm of the bank, the battering of other Greek bank shares caught many by surprise. Even National Bank of Greece, the flagship of the local banking sector, was hit hard with its share dropping to -41 last Thursday before rebounding on Friday. Other fast growing banks with a good record of delivering the financial results they promised to the investment community, such as Piraeus Bank, were also hit hard. It was a sudden awakening to those who long thought Greek banks were largely immune to the developments on developed financial markets. It was the first link at work and it was long overdue. This is so because many foreign funds comparing the Greek banks they have in their holdings to other Western European banks realized they had become much more expensive than their European peers. The shares of major Greek banks were trading at some 12 times or more their expected 2008 earnings per share versus nine times or less for the large European banks. Even if Greek banks deserve a premium over their European peers in terms of P/E (price per earnings) or other valuation metrics because they promise higher earnings growth in the next two to three years and have no material investments in the US mortgage market, derivatives and other financial products hurt by the ongoing crisis, they apparently thought the premium was excessive. The premium had widened in the last few weeks while European banks shares were badly hurt, registering a loss of about 17 percent year-to-date on average compared to gains of about 8 percent for the Greek sector during the same time. Apparently, they thought the valuations of local banks had become excessive, so a steep correction of their prices was about to happen. Fortunately, the valuations of Greek banks, the most important and heavily weighted sector on the Athens bourse, have been broadly aligned with those of medium and small European banks following the dive of their shares last week. Unfortunately, another form of link between the credit crisis and the financial results of Greek banks has yet to show up. Even if one puts aside any doubts about the effect of a likely economic slowdown in Greece and other neighboring countries and higher Euribor rates on their loan volume growth, one cannot do the same with the impact on their spreads. Given the fact that interbank interest rates in the eurozone and the US have gone up due to the credit crisis, despite efforts by the European Central Bank (ECB) to stem it by injecting extra liquidity and keeping its intervention rate unchanged at 4 percent, a number of Greek banks will feel the pinch. This will mainly be the banks which rely more on interbank borrowing to finance their strong loan growth because they do not have a big deposit base. However, it is not just the higher cost of funding which will affect their financial results. After all, they can choose to pass it on to borrowers. It should be noted that more than 90 percent of Greek mortgage borrowers have taken out floating rate loans based on the three-month Euribor or the ECB’s official rate. What may hurt the most is the likelihood that the ECB will keep its intervention rate unchanged at 4 percent or even lower it in the foreseeable future, compressing the component of the spread they earn on deposits. Greek banks took advantage of the ECB’s campaign to raise rates by widening their deposit spreads to compensate for the squeeze on their asset spreads. The asset spread is defined as the difference between the average interest rate banks charge in their loan book and the three-month Euribor or the ECB official rate during a specific time span. The deposit spread is defined as the difference between the three-month Euribor, the reference interest rate in the eurozone, or the ECB’s intervention rate and the average interest rate it charges on its deposit base during a specified time period. The case of National Bank speaks by itself. The deposit spread at National Bank of Greece burgeoned to 298 basis points in the second quarter of 2007 from 183 points in the second quarter of 2006. It is noted that one percentage point is equal to 100 basis points. This means National Bank earned 116 basis points more on its deposits at the same time its asset spread narrowed by some 60 basis points. Of course, other banks saw their deposit spread widening less than National Bank’s. Nevertheless, it helped them offset the pressure on the spread they earn on loans, the so-called asset spread. In other words, banks are likely to face the prospect of narrower deposit spreads in the next few months. Since competition and a slowdown in loan volume growth limits their ability to increase their asset spread and cost of funding in the interbank market has risen a lot, they have no option but to offer higher deposit rates which will close the gap between the ECB or the three-month Euribor rate and their average deposit rate. All in all, the Greek banks are tied to the ongoing credit crisis via the comparative valuation and deposit spread links. The impact will be different from one to another but it should normally start in their fourth-quarter financial results to be published by the end of February 2008.