ANALYSIS

This has got to be the last bank recap

this-has-got-to-be-the-last-bank-recap

Increasing bank credit to the private sector is essential in facilitating economic activity, especially in countries with capital controls in place and small FDI (Foreign Direct Investment) like Greece.

In this regard, the recapitalization of the Greek banking system is a step in the right direction at a time when fiscal policy is becoming tighter, state arrears to the private sector are on the rise and capital controls are having an increasingly negative effect.

However, past mistakes have to be avoided for the recapitalization to be effective this time around.

There is no doubt that local banks face acute challenges as economic conditions deteriorate, eroding their ability to generate earnings and increasing bad loans. Most analysts expect non-performing loans (NPLs) to exceed 40 percent of gross loans at the end of this year, from about 36 percent in March. All agree the NPL rate could rise further unless action is taken as soon as possible.

In addition, banks have seen the deposits of households and businesses fall to about 121 billion euros from more than 160 billion at the end of last year, while their reliance on Eurosystem funding (ECB and ELA) has increased to more than 120 billion euros. The increase in private sector deposits by 330 million euros in August – the first in the last 10 months – is encouraging and is generally attributed to capital controls.

Therefore, it is not surprising that credit to individuals and households continues to shrink, recording a negative 1.6 percent year-on-year reading last August. As a matter of fact, banks provided 710 million euros less to the private sector than they received that month, compared to 610 million in July. It is clear the deleveraging is continuing. This is expected as both demand for credit is subdued and supply constraints have become more binding after the imposition of capital controls in late June. Nevertheless, it is definitely not good news for the economy.

To mitigate the negative effects, the government and the international lenders have made the recapitalization of the core banks a priority in the third bailout program. They hope this will boost confidence in the country’s banking system, speed up the relaxation of capital controls and pave the way for credit expansion later on. They may be right.

However, the recapitalization is a necessary but not a sufficient condition for resolving credit supply constraints and getting credit to flowing back into the private sector. Moreover, it has to be done in the right way to maximize its effectiveness. This requires two things, as we have argued again the past. First, the banks have to be restructured first and recapitalized later to attract as much private capital as possible. Second, the banks will have to be overcapitalized to be able to absorb shocks and play their role. This was not the case in the two previous rounds of recapitalizations and the same mistake should not be repeated again.

Since there is not much time left since the Asset Quality Review (AQR) and stress test exercises are expected to be completed in the second half of October, the focus will be on the banks’ capital needs. At this point, market estimates differ from 12 to more than 20 billion euros under the adverse macroeconomic scenario. Some observers have already pointed out the ECB and others have a credibility issue as far as the investment community is concerned. This is because they told private investors the banks will need no more capital after the initial share capital increases two years ago but changed that in the spring of 2014 and are about to do the same again now.

Even a few months ago, while the negotiations between the Greek government and the European Commission were ongoing, high-level ECB officials were openly saying that Greek banks were solvent to justify their access to liquidity from the ECB’s funding facility and the Bank of Greece’s ELA mechanism. Since local banks will seek fresh capital after the results of the AQR and the stress tests are out, critics argue nobody can preclude investors being asked to do the same a year or two down the road.

It is reminded up to 50 billion euros had been set aside for bank recapitalization in the second bailout program. In the first round of bank recaps in 2013, the Hellenic Financial Stability Fund (HFSF) provided a good deal of the necessary funds and took up the unsubscribed shares in the rights issues. However, Alpha Bank, National Bank of Greece and Piraeus Bank managed to convince private investors to put enough money to achieve the minimum 10 percent equity participation and remain in private hands. Private investors were granted warrants for the entire HFSF stake.

All four banks, including Eurobank this time, managed to further boost their capital base by raising several billion euros from private, mostly non-resident, investors in the first few months of 2014. The money raised helped them pass the AQR and the stress tests of the EBA and the ECB concluded almost a year earlier.

True, the Greek credit institutions along with some banks from other countries facing economic problems were treated with greater leniency. This helped them pass the stress tests without having to raise even more money.

The only way Greek banks will be able to withstand severe economic shocks, emanating from political or other factors in the future, and silence the critics is to make sure this will be the last recapitalization round in a long time. This requires the banks to be overcapitalized this time so that they can cleanse their balance sheets and private investors to be offered incentives to join in. If not, Japanization will inevitably take hold.