The fate of Greek banks largely depends on the ability of the country to shore up its public finances and avoid the restructuring of its public debt. With the banks being under pressure from the government and regulators to consolidate, some think a tie-up with some large foreign credit institutions may be the best outcome for them and the national economy. Is it the case? As the Greek economy slides deeper into recession, local banks feel the pinch more and more. There is no doubt the pain would have been much sharper if they had not parked a great deal of their bonds into the so-called «held to maturity» portfolio, which largely insulates them from adverse market-price moves. Still, their second-quarter financial results to be announced by the end of this month will reflect the strains of the higher cost of funding and higher provisions as non-performing loans continue to rise on the back of a contracting home economy. With the European Central Bank (ECB) being the only source of funding, banks find it more difficult to avoid competing against each other in Greece to attract deposits by paying fat interest rates. This hurts their net interest margin and their net interest income, bruising their bottom line. However, few analysts expect the results to be the catalyst for the much anticipated M&A action in the banking sector. On the other hand, more market participants view the new stress tests Greek banks are going to undergo in September as more likely to serve as a catalyst for consolidation. This is so because the stress test will be based on International Monetary Fund (IMF) methodology and may reveal more weaknesses than those identified in the CEBS tests in July. It is noted that all large Greek banks but ATEbank passed the CEBS stress test, even under the most adverse scenario. The government is also expected to appoint some foreign advisers to value state-controlled banks and perhaps instruct them to come up with proposals on the future shape of the Greek banking sector. Many think this report, along with the results of the new IMF stress test, will turn out to be the main catalyst for the reconfiguration of the banking sector. Whatever the case, it is clear that merger talks between the top brass of the large local banks have been going on for a while. However, some in the market doubt whether the merger of two or more large local banks makes sense. First, they question whether such mergers can generate the size of synergies required to create substantial value to the banks’ shareholders. They point out cost cutting is more difficult to implement with the Greek economy being in recession in 2010 and likely next year although they admit it will be much easier in their franchises abroad. Second, they argue the new bigger entity will combine the bond portfolios and loans of the two or more merged banks, and this may create a systemic problem if things do not go well. Moreover, the new larger bank will not enjoy an advantage in international capital markets as long as the country cannot borrow and will not be able to borrow more money for longer tenors in the interbank market. In other words, the liquidity of the new bank will not get a boost because of the merger. According to this view, it makes more sense for a large Greek bank to tie up with a large foreign bank, which may want to expand its footprint in Southeastern Europe. Given the access of the large foreign bank to the interbank market and wholesale capital markets, the acquired Greek bank will not have to rely any longer on ECB borrowing to fund the local economy but it can take advantage of its parent’s credit line and high credit rating. The proponents argue it will be even better for the Greek economy if more than one foreign bank make an acquisition. Still, this view is not well supported by empirical evidence, since acquisitions made by large French banks last decade have yet to bear fruit to their shareholders and the Greek economy in particular. After all, if the demand for loans from consumers and businesses in good credit standing is soft, banks, whether Greek or foreign, can do little about it. At this point, according to bankers, the demand for loans is coming from cash-thirsty businesses in poor credit standing. So, any bank which lends to them should be prepared to take more provisions for bad loans in the future, hurting its profitability and capital base. No prudent foreign or local bank would do this. Nevertheless, there is a strong argument in favor of a marriage between a large international bank, such as HSBC, and a large Greek bank. Such an acquisition will be viewed as a confidence of vote in the future of the Greek economy, assuming it exceeds 1 billion euros in value, since it is a foreign direct investment. All in all, the latter is perhaps the only and most convincing argument for having an international bank acquire a large local one. Still, one should not forget a deal alone cannot do much to change the negative sentiment and market expectations about Greece’s ability to avoid the restructuring of its debt down the road.