As the Greek government reportedly prepares to downgrade its gross domestic product (GDP) growth projection for next year and the global financial crisis begins to knock on the door of neighboring countries, local banks have no option but to take measures to boost their capital bases. Greek banks have long advertised their strong capital bases and ample liquidity to keep the headwinds from the global financial crisis from gradually turning into a local economic disaster. But the events of the last few weeks have showed that any bank, especially the smaller ones and those with more loans than deposits, may be vulnerable to rumors. Moreover, the deterioration in economic conditions in Greece and in neighboring countries points to a future significant rise in non-performing loans, even if one assumes there is no crash from the writedowns of investments in financial products. Undoubtedly, Greek banks were relatively well-capitalized at the end of June, based on official data, and certainly much better off than many of their peers in the eurozone and the USA. Banks hold on to capital should they incur unexpected losses in addition to those covered by the provisions for loans in arrears and current profits. A good measure of their capital strength is so-called Tier I capital ratio, defined by the bank’s equity capital plus some types of preferred shares and hybrid products, divided by its total risk-weighted assets. The Tier I capital ratio of Greek banks was on average above 8 percent at the end of June, compared to less than 6 percent at large European banks, such as UniCredit and others. The National Bank of Greece showed a Tier I ratio of 9.9 percent at the end of the first half; Hellenic Postbank’s was close to 9.5 percent, Alpha Bank’s was around 8.9 percent and ATEbank’s around 8.6 percent. The Tier I ratio of Piraeus Bank stood at 8.5 percent and Eurobank’s at 8.2 percent. Even the Cypriot banks whose shares trade on the Athens bourse showed a strong capital position, with Marfin Popular Bank (MPB) at 9.2 percent and Bank of Cyprus’s ratio at around 9.5 percent, although it is estimated that the latter’s Tier I capital ratio has fallen to around 8 percent following the recent acquisition of a Russian bank. Although this capital ratio tends to fall as banks make more loans, this can be more than compensated for by profitable banks. The banks can retain a greater portion of their earnings rather than pay them out to shareholders in the form of cash dividends. Some Greek banks, such as National Bank, had resorted to paying stock instead of cash dividends to boost its capital base and, less so, liquidity. So, Bank of Greece Governor Giorgos Provopoulos caught many by surprise last week when he said the local banks’ capital adequacy ratio will be reduced at the end of this year or early next based on some negative assumptions made by the central bank. A number of observers and, obviously, market participants thought that was an indirect warning of things to come, pointing to a possible sharp rise in non-performing loans in Greece and neighboring countries, such as Romania, Bulgaria and Turkey, as the global crisis spreads. This is because local banks have repeatedly said they do not have toxic assets in their portfolios and any writedowns on some of their other portfolio investments need not take place following a favorable change in the IAS 39 rule. The latter allows them not to market them at the current beaten up prices and therefore hurt their earnings or eat up their capital base. Of course, Greek banks can take advantage of the recent offer by the state to buy preferred shares for up to 5 billion euros in total for the sector. There is already speculation that some state-owned banks, such as ATEbank and Hellenic Postbank, will take the offer as will perhaps one or two large private banks, forcing others to do so as well in order to avoid being at a competitive disadvantage. So, it is quite likely that Greek banks will have to put up with unfavorable credit conditions they have not seen since the liberalization of the Greek banking system. This means they may have to cut their dividends, not distribute any at all or pay them in the form of stock next year in order to boost their capital base and/or take the state offer for a capital injection and apply stricter criteria in lending out money here and abroad. That may not be good news for their shareholders in the short term but may be better for the long run for their financial strength.