The fateof the Greek banking sector is closely linked to the country’s ability to deliver the fiscal targets set in the three-year program agreed with the European Union and International Monetary Fund totaling 110 billion euros. Still, developments in the banking sector could either help or derail the fiscal effort. Markets openly doubt Greece’s ability to bring its general government budget deficit down to 8.1 percent of gross domestic product in 2010 and 7.6 percent in 2011 from an estimated 13.6 percent in 2009 with the economy shrinking 4.0 percent this year and 2.6 percent next. Of course, they also doubt whether the country will cut its deficit below 3.0 percent in 2014 to signal the decline of its public debt-to-GDP ratio. To be more exact, markets see a relatively high probability that Greece will be forced to restructure its public debt in the next five years or so. This is particularly evident in the credit default swap (CDS) market, where investors buy contracts either for hedging risks or speculation. The spread on the 5-year CDS on Greek debt went up to 605 basis points in late afternoon trading last Friday from 537 points last Thursday, according to Markit. This discounts a significant probability of default depending on the recovery rate assumed holders of Greek bonds will get back in that case. Of course, markets are very volatile at this point and can change perceptions if they are convinced a country’s efforts will bear fruit but this will take some time. The state of the banking sector will play a key role in influencing market perceptions, judging from past instances of IMF involvement. That’s why the EU and the IMF made sure the three-year program for Greece includes a 10-billion-euro financial stability fund to ensure banks will have adequate liquidity during this period. At this point, the Greek banking sector seems to be well capitalized. This is also confirmed by Poul Thomsen, the deputy director of the IMF European Department, who has stated «the Greek banking system is actually quite well capitalized.» So, Greece may be lucky in this respect, because its banks may be able to withstand an expected sharp rise in non-performing loans (NPL) in the quarters ahead, driving the NPL ratio to 12 percent of total loans or even more in the next couple of years. Although well capitalized, it is not a secret that all local banks are not the same, in the sense that some are more vulnerable than others, even though the combination of higher deposit rates, higher sovereign bond yields and the rise of bad loans on the back of the recession will affect them all, ultimately hurting their earnings and equity. There is no question that international markets pay a lot of attention to the liquidity of banks, estimating that their deposits have been trimmed by 10 billion euros or more since the beginning of the year. However, the four large local banks have been able to more than offset this decline in deposits by taking advantage of mainly state guarantees on loans provided by the previous Greek state-sponsored program with the purpose of injecting 28 billion euros into the economy. Banks can quite simply issue bonds with the state guarantee and deposit them as collateral at the European Central Bank to get cheap funding. The state intends to extend the amount available by an additional 15 billion euros. Local banks also benefited from the ECB’s decision to suspend the minimum rating threshold for collateral eligibility for marketable debt issued or guaranteed by the Greek government. These developments reduce the liquidity risk of Greek banks. Still, the sharp rise in sovereign yields means banks will have to place more collateral with the ECB, while putting more pressure on their deposit rates. Although Greek banks appear to be showing an extraordinary degree of solidarity during this tumultuous period, it is clear that there is a need for mergers and acquisitions so that the stronger banks join forces with weaker ones to produce larger lenders. Size has always been an important factor but this is particularly true during periods of economic recession and market turbulence. Moreover, M&A deals are likely to lift market sentiment on the Athens bourse and the economy at a time when pessimism seems to have the upper hand. It will not be a cure for Greece’s fiscal illness but it will certainly help. Of course, these banking deals, although welcome, do not guarantee success. Banks cannot do much if the country fails to deliver on its new austerity plan targets. However, by merging, some banks may be able to avoid the fate of some banks in other countries that adopted an IMF-sponsored program in return for valuable low-cost funding. That is, to be sold at a very low price-to-book value to foreign interests. Greek banks have a chance to avoid the same fate and possibly even negotiate a better deal, while boosting market sentiment at a difficult juncture. Strength is in unity.