Greece’s plight offers clue to future of EU banking system

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There was a brief while last year when Greece looked like a good news story. For the first time since the global downturn hit Europe, the country was reporting decent tourism statistics. Memories of Greece as the doomed coal-mine canary for the eurozone crisis were fading.

Now, though, the healthy chirruping is once again fading to an ominous quiet. There is mounting speculation that the country will need a substantial third package of aid from the so-called troika of bailout authorities (the International Monetary Fund, the European Commission and the European Central Bank). In particular, IMF officials are said to be convinced that the Greek banking system needs up to €20bn of fresh capital – far more than the sub-€6bn that the national authorities, on the advice of outside experts from fund manager BlackRock, believe to be the shortfall.

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Once again Greece – a geographically and economically peripheral member of the eurozone – is at the centre of things.

The precariousness of the country’s finances will, of course, be a political touchpaper, especially in Germany where the population continues to balk at the transfer of wealth from north to south.

But there is a second dimension of importance to Greece’s latest plight. Quite how the row over the health of Greek banks is resolved may well give important insights into the European authorities’ approach to this year’s vast exercise to health-check the whole of the EU’s banking system.

The ECB, the new single banking supervisor across the eurozone, is not due to complete its “asset quality review” – an in-depth look at the value of loans on the books of the big 130 banks – until the autumn. The same goes for the simultaneous stress test by the EU’s umbrella regulator, the European Banking Authority. Hence the focus on Greece as an early indicator of an exercise that many believe could make or break investors’ faith in the integrity of the European banking system.

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Establishing the reasons for the range of estimated capital shortfalls at Greek banks is key.

There will of course be a bit of game-playing. Greece itself is keen to avoid, or at least minimise, the size of a third bailout, and had even tried to divert the remaining €9bn or so of bank-allocated funds from its last bailout package for other purposes. Troika officials, by contrast, are likely to be far more conservative. The bearish argument is supported by the rise in non-performing loans which may not peak for another year.

The ECB finds itself in a tricky middle position that imperils its own reputation. As a result of its new bank supervision powers, it must reconcile the conservative instincts of the troika with its duties in administering the AQR. On this count, it may be reluctant to treat the Greek banks too harshly for fear that it could backfire, not just in Greece but, by extension, to the lenders of other bailed-out countries, too.

In some regions, the only practical option for recapitalising weak banks is a state bailout or bail-in of creditors. Fresh equity from commercial investors is likely to be in short supply. But that in turn risks entrenching the bank-sovereign spiral that has played such economic havoc in the eurozone crisis to date.

Given the delicacy of the situation, it is little wonder that European officials are desperately keen to dispel any idea that the decision on the capital needs of Greece’s banks is some kind of litmus test for the EU health check as a whole.

Straight extrapolation would indeed be misguided. Greece’s economic situation is pretty unique. There are also crucial methodology differences between the troika view of bank capital and the AQR/stress test approach. The first takes a macroeconomic “top-down” approach, incorporating a 30-year view of the likely “lifetime losses” on loans. The second is more micro, with a sharper focus on the next three years.

As troika meetings in Greece continue this week, the noise is already making investors and the general populace nervous about how short of money the banking system really is. A decision is needed – and soon.

For Greece, too harsh an approach would be punishing and could even hurt recovery prospects. But a soft-touch option risks killing the canary altogether – wrecking a fragile faith in Greece, the broader eurozone banking system and the ECB’s oversight of it.