31 May 2012

EURO THEMES Risks and repercussions of a Greek exit
A cost/benefit analysis. We think rationality will prevail and Greece will remain in the euro area in the near term. The costs of an immediate Greek exit are still too high for either Greece or the euro area. A disorderly exit would lead to a massive run on bank deposits, a meltdown of the Greek banking system, and further aggravation of Greece’s large economic downturn. For the euro area, the main cost would be contagion (see Will Greece abandon the euro?). A Greek exit can still be avoided. Our base case is that a Greek exit can be avoided even if the left-wing Syriza party wins the elections on 17 June and forms a new government. Its leader has indicated that he would prefer to stay in the eurozone, provided he can negotiate a radical overhaul of the EU-IMF programme. We believe a programme could be agreed with some concessions by troika (EU, IMF, ECB) on a smoother fiscal consolidation path and some delays to the speed of public sector reform (see Will Greece abandon the euro?). However, a disorderly exit cannot be ruled out. An "accident" after the June elections cannot be ruled out, leading to a disorderly exit for Greece and elevated stress for the euro area as a result of contagion. The direct costs of a Greek default and exit appear manageable (euro area government exposure to Greek public debt is estimated at EUR290bn), but contagion risk could complicate the already precarious financial positions of countries like Portugal and Ireland, and the systemically more significant economies of Spain and Italy. The overall costs of a Greek event would amount to multiples of direct costs (see If Greece exits, can contagion be contained?). The euro area policy reaction to a Greek exit would likely entail: (a) stepping up the Securities Markets Programme (SMP), potentially through a leveraged European Financial Stability Facility (EFSF) or through the European Stability Mechanism (ESM); (b) aggressive monetary policy action by the ECB; (c) moves towards a panEuropean deposit insurance scheme, although implementation would be lengthy; (d) if all else fails, acceleration of EU economic and financial integration, including support for the eventual adoption of Eurobonds. Implications for European banks. Greek banks have lost almost a quarter of their deposit base over the past two years, despite having a deposit guarantee scheme, suggesting that such schemes are not sufficient to deal with either systemic risks or redenomination risks. We argue that even a European-wide deposit guarantee scheme would not be sufficient to manage contagion risks (see Deposit risks). Implications for rates and FX markets. In the event of a Greek exit, money markets would suffer a renewed bout of stress, with Italy and Spain bonds likely selling off aggressively, despite any policy responses that would be introduced (see A Greece exit is not fully priced into rate markets). Global currencies would follow the pattern since the Greek election on 6 May, only it would be much more severe: the EUR would depreciate against the USD, JPY and GBP in particular (see EUR/USD likely to fall independent of the Greek election result).

Contents Macro View: Will Greece abandon the euro? Contagion Costs: If Greece exits, can contagion be contained? Implications for European Banks: Deposit risks Implications for Interest Rates Markets: A Greece exit is not fully priced into rate markets 3 11 18


Implications for FX Markets: EUR/USD likely to fall independent of the Greek election result 35 Economics Antonio Garcia Pascual +44 (0)20 3134 6225 Piero Ghezzi +44 (0)20 3134 2190 Thomas Harjes +49 69 716 11825 Fabrice Montagne +33 (0) 1 4458 3236 Asset Allocation Strategy Michael Gavin +1 212 412 5915 Credit Research Jonathan Glionna +44 (0)20 3555 1992 Equity Research Simon Samuels* +44 (0)20 3134 3364 Barclays, London Rates Strategy Laurent Fransolet +44 (0)20 7773 8385 Foreign Exchange Strategy Paul Robinson +44 (0)20 7773 0903 * This research report has been prepared in whole or in part by equity research analysts based outside the US who are not registered/qualified as research analysts with FINRA.

Barclays | Risks and repercussions of a Greek exit


Will Greece abandon the euro?
Antonio Garcia Pascual +44 (0)20 3134 6225 Michael Gavin +1 212 412 5915 Piero Ghezzi +44 (0)20 3134 2190 Thomas Harjes +49 69 716 11825 Fabrice Montagne +33 (0) 1 4458 3236

The costs of Greece exiting the euro are too high for either Greece or the euro area. A disorderly exit would lead to a massive run on bank deposits, a meltdown of the Greek banking system, and further aggravation of Greece’s large economic downturn. For the euro area, the main cost would be contagion.

Greece – New government may reject the EU-IMF programme
The national elections in Greece on 3 May marked a turning point in the European political landscape. For the first time, and in stark contrast to earlier national elections in Ireland and Portugal, Greek political parties committed to policies agreed under an EU-IMF programme failed to achieve a majority in Parliament. Support for the two main parties, New Democracy (centre right) and Pasok (centre left), which have governed Greece for decades and negotiated the recent EU-IMF programme, fell below even modest expectations. At the same time, the left-wing Syriza party and more radical (left and right) parties that reject the policies under the EU-IMF programme gained a significant share of the votes (see, Election round-up: A vote for policy change in Europe). After failed attempts by the leaders of New Democracy (18.9% of the vote), Syriza (16.8%), and Pasok (13.2%) to negotiate a coalition, and by the Greek President to form another technocrat government with broad parliamentary support, Greece is heading for another round of elections scheduled on 17 June. It is difficult to predict the outcome of these elections, but the latest opinion polls suggest that New Democracy is currently leading. However, Syriza, led by the young and charismatic Alexis Tsipras, is not far behind New Democracy and could become the largest party. If this were to happen, it would automatically get an extra 50 seats in the Greek Parliament, and may amass enough support to form a government. Mr Tsipras has been adamant that he would cancel austerity policies in Greece, reverse plans to reduce public employment, and cancel interest payments and debt redemptions. (He has also said that he would prefer that Greece remain in the eurozone, but only if the EU-IMF programme is radically overhauled.) Other parties, including ND and Pasok, have stepped up their rethoric and are seeking to cast the next elections as a vote on the future of Greece in the euro area. Polls still suggest broad support amongst the Greek population for remaining in the euro area. However, the elections on 3 May have shown that frustration and anger about past ND and Pasok policies prevailed when Greeks cast their votes: they delivered a protest vote that may also be interpreted as a popular rejection of the EU-IMF adjustment programme that is associated, rightly or wrongly, with the miserable economic and social conditions that now prevail. Developments within Greece are now in the hands of the Greek electorate; the country’s continued membership in the European Monetary System hinges upon decisions that will be taken in the 17 June elections, and the response of other European governments to that political outcome. But these political processes are being driven in large part by economic developments, as they have been interpreted by politicians and electorates. Without underplaying the importance of the elections, fundamentals suggest that Greece may remain a concern for financial markets, regardless of who wins. The main difference the election could make is whether Greece’s day of reckoning happens very soon or somewhat later.

31 May 2012


Barclays | Risks and repercussions of a Greek exit

A grim economic outlook within the euro zone
2011 marked the fourth year of Greece’s recession, in which real GDP has already fallen nearly 15%. Unfortunately, the wrenching external and fiscal adjustments that are putting intense pressure on the economy are only partly accomplished, and the end of the downturn does not appear to be imminent.

Public finances remain far from equilibrium
Greek debt is expected to reach nearly 164% of GDP by year-end

Greece ended 2011 with a primary (non-interest) deficit of 2.4% of GDP, and an overall budget deficit of 9.1%. Even after the 2011 restructuring of privately-held public debt, the debt is expected to reach nearly 164% of GDP by year-end, and is likely to continue rising in 2013 due to the shrinking economy and a primary deficit. (The still-high amount of debt is due, in part, to the high cost of recapitalizing the Greek banks, which will add over 25% of GDP to public debt in 2012 as a result of the large losses of Greek banks on their holdings of government debt.) Under the existing programme, Greece will need to engineer a large swing from deficit into a primary surplus of over 4% of GDP (a swing of roughly 6 percentage points of GDP), in order to stabilize its high level of public debt.

Adjustment of external payments is far from complete
Greece’s current account deficit has been shrinking since 2008, but remains untenably high at roughly 10% of GDP. With no capacity to promote ‘expenditure switching’ via devaluation, the current account adjustment has been associated with a painful compression of public and private spending. The adjustment would of course have been far more abrupt if eurozone governments had not stepped in to finance the external payments deficits that market participants are no longer willing to finance. The result has been intensified dependence on official financing of external payments deficits. By now, the lion’s share of the country’s international liabilities is “official” funding (c.EUR313bn), including the EU (EUR126bn), the IMF (EUR22bn), and the Eurosystem (EUR165bn).

Banks remain under severe stress
As a result of the sharp and sustained drop in economic activity, non-performing bank loans have risen to about 15%. More importantly, the large losses imposed by the February restructuring of their government bond holdings have left banks with a large capital deficiency. The new programme has set aside an additional EUR50bn for bank recapitalization, which will (as noted above) be added to the public debt. Figure 1: Current account adjustment – A work in progress
0 -5 -10 -15 -20 -25 -30 -35 -40 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Current account balance (12-mo total, bn euros)
Source: Haver Analytics

Figure 2: Deposit outflows have intensified funding squeeze
300 250 200 150 100 50 0 Jan-01






Domestic residents deposits and repos (bn euros)
Source: Haver Analytics

31 May 2012


Barclays | Risks and repercussions of a Greek exit

Moreover, the loss of capital markets access has left the central bank of Greece (through the Eurosystem) as practically the only funding channel for Greek credit institutions. Most of the outstanding funding is now provided through the Emergency Liquidity Assistance facility of the Eurosystem (c.EUR100bn of the total c.EUR130bn provided by the Eurosystem). The Greek banks’ funding squeeze has been intensified by a persistent outflow of bank deposits since the crisis started in late 2009. From the end of 2009 to March 2012, the banking system lost nearly a third of its domestic deposits. Anecdotal evidence indicates that the outflow accelerated in May, especially after the election results, and it may continue given the elevated uncertainty and downside risks that confront domestic depositors.

A grim outlook
With large fiscal and external imbalances that have yet to be fully unwound, the immediate outlook for the Greek economy remains grim. The economy is likely to shrink by more than 5% in 2012, the 5th consecutive year of contraction, while the rate of unemployment is approaching 20%. Because the fiscal and external adjustment will likely last into 2013, we (and the IMF) are forecasting yet another year of recession in 2013. Moreover, the public debt overhang is unlikely to be resolved in the immediate future. Under the February 2012 programme, public debt is projected to peak at 167% of GDP in 2013, but then rapidly decline to reach 116% of GDP by 2020 and 88% of GDP by 2030. However, this downward trajectory is explained by programme targets that include a primary surplus of 4.5% of GDP by 2014, real growth in the range of 2.5-3% over the medium term, and privatization revenues of EUR45bn, which are spread over several years. We consider these assumptions too optimistic. Under a more realistic baseline macroeconomic scenario, the Greek public debt would stabilize, but at an extremely high level (Figure 3). Figure 3: Debt sustainability not addressed by the February PSI (gross public debt/GDP)
200 180 160 140 120 100 80 60 40 20 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 Base
Source: Barclays Research

Debt relief (zero interest on all official debt for 20y)

Stabilization of the debt at such a high level satisfies one narrow and theoretical definition of ‘sustainability’, but it would leave the Greek government in a precarious position; highly exposed to fiscal shocks, and reliant upon official funding for decades to come. Figure 3 also illustrates how one form of debt relief, a forgiveness of all interest on public debt for 20 years, could create a more robustly sustainable trajectory for the public debt. But because the public debt remains very high for a long period of time (above 125% of GDP at least until 2020), even this form of debt relief may not be sufficient to restore confidence in public financial stability over a reasonable period of time.

31 May 2012


the debt dynamics would look even more challenging.5% on average).5% of GDP by 2016. Figure 4: Holdings of Greek public debt Before PSI IMF loans EU loan package 1 EU loan package 2 ECB SMP + Investment portfolio T-bills Sub total 1 Banks (o/w Greek banks c.5% of GDP by 2014 and sustain it at around that level through 2020. etc) Greek Social Security fund Sub total 2 New exchange bonds from PSI Total Greek debt Source: Barclays Research Post PSI. it is likely than the pace of fiscal consolidation would be even less aggressive. Macroeconomic conditions have deteriorated. We expect economic activity to recover only very gradually over the next 5 years to reach a real GDP growth of 1. the new government is highly likely to renegotiate a less aggressive fiscal consolidation targets. Greece could achieve a fiscal consolidation of about 1% of GDP per year over the next five years.EUR40bn) Insurance Central banks/official institutions Other investors (real money.Barclays | Risks and repercussions of a Greek exit Box 1: Debt sustainability analysis: medium-term assumptions Our medium term baseline scenario includes a less aggressive fiscal consolidation path than the February 2012 programme. mainly as a result of the uncertainty about a potential exit. end 2012 28 74 88 46 15 251 22 (13) 3 12 22 6 0 65 316 20 53 0 55 15 143 70 (40) 10 38 70 18 206 0 349 31 May 2012 5 . if the radical left parties were to form a government after the 17 June election.8% in the programme. Our growth assumptions also differ from the EU-IMF programme. In that scenario.5% instead of 3% assumed under the programme. to achieve a primary surplus of about 2. Realistically. as well as exports. The debt dynamics would look very different if Greece were to restructure or default on the outstanding debt. And official creditors including the ECB have so far resisted a restructuring of the Greek obligations that they hold. consequently. as we expect real GDP to shrink by 6% instead of 4. but over half of that debt are official loans from the EU and IMF (see Figure 4). This is in stark contrast to the medium-term assumptions in the programme. Private consumption and investment will contract further than originally envisaged. the fiscal path assumed in the baseline would have to be revised downwards and. debt held by the domestic banking system cannot be written down without breaking the banks and requiring a government-financed bank recapitalization. which also assumes that real GDP will remain above 2% through 2020 (while we assume a growth of 1. which expects Greece to achieve a primary surplus of 4. Our fiscal baseline assumes that the moderate parties (New Democracy and PASOK) form a government and an agreement on the revised programme can be reached. As we have seen. In any event. and much of the remainder is held in the domestic banking system and by the ECB. Obviously.

which could lead to a government crisis. A Greek exit would be very costly for Greece The only possible justification for a policy framework that delivers a prognosis of this sort is that outcomes would be even worse under alternative policies. The EU and the IMF would then stop funding Greece. the government would also be forced to default on its euro-denominated liabilities. If history serves as any guidance for the Greek case. Likewise. costs of exit would likely be very high compared with benefits A Greek exit in the near term would be disorderly almost by definition. Households with local accounts and savings will suffer substantial losses while cash-rich agents with 31 May 2012 6 . not strength. given the serious implications. Even if it is accompanied by a cessation of public debt service. the pace of fiscal adjustment in such a scenario would need to be even larger than contemplated by the existing programme (though it might be facilitated by a burst of inflation over the medium term). Nevertheless. fiscal adjustment is far from complete. and this would (most likely) imply that the ECB could not continue the provision of emergency liquidity support to Greek banks. it will be essential to have the political backing of the European Council and the IMF. further aggravating the large economic downturn. Potentially even more disruptive for economic activity could be a massive run on bank deposits: depositors would run on the banks as they would fear a forced conversion in a reintroduced drachma. as this would likely be triggered by a failure of a Greek government to reach a compromise with the rest of the euro area on a programme. Many of the domestic contracts that are now denominated in euros would also become unviable and need to be restructured. exceeding the increase in local currency revenue. once Greece is locked out of the Eurosystem without an EU-IMF programme. few governments have survived traumatic exchange rate devaluations. quite possibly forcing massive government intervention in the banking system. No immediate end of the recession is in sight. Indeed. it would quickly run out of cash and be forced to exit the EMU. the exit would lead to a meltdown of the Greek banking system. Expulsion from the EU does not appear to be a legally viable option and Greece could decide to remain within the EU. and the unresolved debt overhang means that Greece may ultimately need to obtain official sector debt relief (in NPV terms) or leave the eurozone. Redenomination away from the euro will also cause massive transfers between agents. adding to the above-mentioned transfers between debtors and creditors. at least in the short run. In the short term. The sudden cut in government expenditure would likely aggravate social unrest. While this decision might be taken by the Governing Council of the Eurosystem (by at least a 2/3 majority). The curtailment of official financing of the government and the balance of payments would enforce a more abrupt adjustment of both imbalances.Barclays | Risks and repercussions of a Greek exit In short. The reintroduced drachma would likely depreciate significantly and hence many local companies (clearly those in the non-tradable sector) and households would need to default on their foreign currency debt. the economic outlook over the next two years is cloudy. In the absence of Eurosystem’s support and without bank and capital controls to limit the outflows. and 2) the local currency needed to pay euro debts would increase with the devaluation. a strong case can be made that the costs would be higher than the benefits. Non-performing loans would surge because of: 1) the negative balance sheet effects for firms and households. Greece would be going it alone from a position of economic and financial weakness. If the alternative policy is rejecting the EU-IMF programme and exiting the eurozone. now including euro-denominated liabilities.

to some extent at least. if higher inflation triggers higher wages. as well as costs. Politically difficult fiscal and structural reforms would still be required to make the country more competitive. and because other stressed European economies are also trying to engineer similar improvements in competitiveness. Most of the world’s financial exposure to Greece has been shifted to public balance sheets. Inflationary finance would likely be used. and would need to be rebuilt. losses would also be politically very sensitive. but even a total loss would be manageable from a fiscal policy and debt sustainability perspective. the positive effects of large devaluations on competitiveness are very limited. Assuming final recovery rates in the range of 20-50%. that is. By leaving the eurozone. there would of course be some long-term benefits. Greek exit would also be very costly for the euro area We consider the potential direct and indirect costs for Europe of a Greek exit in considerably more detail in subsequent sections. by the public debt overhang (which is aggravated by slow growth or even deflation in the nominal tax base). Greece would not only suffer enormous short-term dislocation. especially if an exit from EU would follow. Recovery rates on this exposure would probably be low. In the Greek case.Barclays | Risks and repercussions of a Greek exit accounts abroad will be the big winners and could take advantage of the chaos to seize capital and production capacities. and promote economic growth. Over the longer term.5% of euro area GDP (see Greece: Euro area official sector exposures in excess of EUR290bn). Given the weak state of the government. Direct links appear manageable The direct trade and financial links of Greece with the rest of the euro area are meaningful. are hard to achieve. these redistributions will likely benefit to the already oversized unofficial sector. Here we extract the elements of that discussion that are relevant for the eurozone’s decision whether or not to take actions that might precipitate a Greek departure from the monetary area. Devaluation would provide a faster route to international price competitiveness than the grinding ‘internal devaluation’ that will be required within the eurozone. most of the existing sovereign exposure is already included in gross debt figures. International evidence suggests that ‘internal devaluations’. but it would also forego the longer term ‘structural’ advantages of membership. The exposure of the euro area official sector is somewhat above EUR290bn. the loss. making it all the more difficult to achieve the required improvement with neighbours who are important trading partners. to replace the official finance that now supports Greece. Like other participating countries. or involuntary transfer to Greece from other member states and the ECB could roughly amount to EUR150-230bn. the existing contracting framework and financial infrastructure would be broken. and very sizable in absolute terms in France (about EUR60bn) and Germany (about EUR80bn). the difficulty is compounded by inflexible labor and product markets. in fact. In short. The IMF estimates the need for a 15% improvement in cost competitiveness on a unit-labor-cost basis. but the direct economic fallout from a Greek exit appears manageable given the size of the Greek economy (only about 2% of eurozone GDP). However. Greece entered the eurozone because it offered important long-term advantages created by integration into a continental monetary and financial system with commonly governed EU institutions. exit by Greece would have some offsetting benefits While the costs of exit seem likely to be very high in the short run. or 1-2. improvements in competitiveness that are achieved by reductions in domestic wages and prices rather than a devaluation of the nominal exchange rate. 31 May 2012 7 .

we suspect that there is more room for negotiation about the programme than some recent statements may suggest. Portugal and the systemically far more important economies of Italy and Spain. given the recent focus on the election. and have no mandate from their voters to extend a ‘blank check’ for financial support in unlimited amounts over an indefinite horizon. The French banking system’s exposure is the largest. We could explore these costs and benefits in more detail. and these have by now. we simply note that there are a number of channels through which a disorderly Greek exit could compound the difficulties that already face other stressed eurozone sovereigns such as Ireland. Given the economic duress under which the Greek population is labouring. The main concern is not the overall size of the potential loss. we think. One way to interpret these apparently conflicting opinions is that the Greek population is committed to membership in the eurozone. Other countries in the eurozone appear to be edging toward a similar perspective. Greek voters face a choice between a painful future within the eurozone. and the economic misery with which this is – rightly or wrongly – associated. but even in this case the system’s exposure to the Greek private sector is less than 20% of core tier one capital. This is obvious in Greece. and it is possible that an isolated institution may experience enough trouble to create some market reaction. However. and ultimately the entire continent. or a future outside the eurozone that is very likely much more painful in the short term. not all of which is owed to European creditors. and the potentially high cost for Europe of a Greek exit. For now. in which electorates (and their representatives) rather than technocrats will have the final word. but the possibility that it might be concentrated enough to destabilize a systemically significant financial institution. The larger risk for Europe is financial contagion We consider the risks and potential policy responses to contagion in much more detail below. but not under any conditions whatsoever. with an uncertain balance of costs and benefits down the road. the May elections seemed also to signal that the population is reaching some limits of its tolerance for ‘austerity’. Moreover. Greece’s official creditors have already put enormous quantities of their taxpayers’ wealth at risk. but it is increasingly true in the broader European context. Italy and Spain are already facing very shaky confidence and a withdrawal of private international capital. public opinion polls suggest that a large majority of the Greek population strongly supports continued membership in the eurozone. hardened into an essential political reality. that room is not unlimited.Barclays | Risks and repercussions of a Greek exit Liabilities of the Greek private sector to the rest of the world are considerably smaller. In the event of a Greek exit from the eurozone. This gives European policymakers a strong incentive to avoid a Greek abandonment of the EU-IMF programme and exit from the eurozone. because they depend in large part upon ‘psychological’ responses to the exit. the EU-IMF 31 May 2012 8 . but which the country’s partners in the EU insist is a necessary condition for continued membership in the monetary union. From economics to politics Greece’s future is now being determined by very public political processes. many of these liabilities would probably need to be written down dramatically. There are no easy or appealing alternatives for the main actors in this drama. but it would probably take us away from the underlying political dynamic. The costs for Europe of a Greek exit under these circumstances are quite literally incalculable. at about EUR130bn. However. Within Greece. But it seems unlikely that this exposure will create a large economic problem for Europe. What matters is the assessment reached by the political actors in Europe. Accidents do happen. But they are potentially enormous.

Any delays in the fiscal consolidation will. as financial turmoil takes its likely toll on the economy. We see three main potential outcomes: The first and in some ways the worst possibility is that. some active labour market policies (targeted at reducing youth unemployment). In this case. The subject of debt relief is likely to be a theme of discussion between the new government and the EU. Our best guess is that ‘pro-growth’ initiatives and social policies may provide a Greek government with political ammunition to defend a revised agreement that it finds otherwise acceptable. It would be impossible to alter the long-run fiscal targets without addressing the public debt problem that dictates the long-run fiscal effort that is arithmetically required to ensure eventual fiscal solvency. IMF. these reforms touch upon politically sensitive areas of Greek society. it will have to be related to the question of fiscal transfers within the EA. no party or coalition of parties manages to secure a mandate to govern. of course. In fact. they believe that Greece’s prospects inside the monetary union would be bleak.Barclays | Risks and repercussions of a Greek exit programme is organized around the view that the structural reforms and institutionbuilding elements of the reform agenda are necessary conditions to regain competitiveness and financial stability. we think it would be difficult for eurozone governments to interrupt the financial support for the Greek banking system that is required to keep Greece in the eurozone. 31 May 2012 9 . While the election process plays out. and seldom come without a price tag. Even without such concessions. Reforms are needed to regain competitiveness and thus lay a firm foundation for economic growth over the long term. but the escalation of contingent financial liabilities associated with this support would also be difficult for the ECB to countenance indefinitely. we think it would be the proposed structural reforms. but will not alone transform Greek attitudes toward the ‘memorandum’. and may depend upon political events in the coming weeks (such as the upcoming French parliamentary elections). and the potentially destabilizing flight from the Greek banking system could accelerate further. How far the EU and IMF might be willing to alter the existing economic programme is highly speculative. If there is anything “non-negotiable” for the EU and IMF. any delays in the pace of fiscal consolidation would only compound the already untenable overhang of public debt. The problem is that such initiatives are not easy to come up with (if they were. The EU and IMF may well be willing to offer some leeway in the pace of fiscal consolidation. Without them. and possibly some limited support for health services. and ECB. In a larger sense. as in the first election. we think there are reasons to doubt that solvency can be re-established without substantial debt relief. the political deadlock would have to be resolved by yet another round of elections. and to build a public sector that is efficient and sustainable without continued injections of foreign resources. create a yet larger financing gap that would need to be filled by taxpayers in other eurozone countries. and thus to thrive within the monetary union over the longer term. This could include investments in infrastructure. However. from the perspective of the EU. as explained above. Our thoughts at the moment are as follows: The EU has signalled that it is willing to introduce ‘pro-growth’ initiatives in the existing adjustment programmes. what government would tolerate slow growth?). the existing programme is likely to require additional EU financing given the likelihood of a worse-than-projected economic growth outlook since February. Can the minimum requirements for a programme be reconciled with the maximum policy effort that a new Greek government can sustain? We think that is heavily dependent upon the outcome of the 17 June election. Tolerating a slower adjustment would not be costless. Uncertainty would persist.

likely surviving with a razor-thin parliamentary majority and enjoying weak support from the public. negotiations between the ‘troika’ and government could be lengthy (possibly several months). would be able to implement the agreed programme more effectively than it was able to implement similar programmes in the past. The question would then become whether the government. 31 May 2012 10 . we think it is entirely possible that discussions could end without agreement on a programme. including dismissals of public sector employees. Given the economic programme upon which Syriza has been campaigning. Given that these are the political parties who negotiated the existing programme. a programme could be agreed with some concessions by ‘troika’ on a smoother fiscal consolidation path and some delays to the speed of public sector reform. But our baseline scenario is that even then. The third of the most plausible scenarios is that the center-right New Democracy party wins the election and forms a government in coalition with other traditional and centrist parties. The most contentious themes would likely be the delay in fiscal consolidation targets and cuts to the size of the public sector. wins the election and forms a government.Barclays | Risks and repercussions of a Greek exit A second possibility is that a coalition of the radical left. it is reasonable to think that their election would facilitate negotiations over another revision of the programme. led by Syriza. In this case.

3 0.1 Nominal GDP (2011.0 0.8 4.8 0.4 2.9 21. it appears to be manageable even if Greece were to default and recovery rates were low. some credit losses from a restructuring of Greek liabilities to the rest of the eurozone will likely be realized even if Greece remains part of the monetary union.6 0.5 0.2 0.7 0. For SMP.8 0.0 0.montagne@barcap.1 0.2 6.7 5.6 16.7 10.3 37.9 291.harjes@barcap.0 Piero Ghezzi +44 (0)20 3134 2190 piero.7 52.4 15.3 73.0 Target 2 3.1 0.0 0.2 2. €. EFSF and Target 2. Bn) 301 368 18 16 192 2002 2571 215 156 1580 43 6 602 171 69 36 1073 9419 SMP 1. national exposure have been allocated according to capital keys.garciapascual@barcap.3 84.5 3.0 0.0 1.8 0. can contagion be contained? Antonio Garcia Pascual +44 (0)20 3134 6225 antonio. Exposures are reported in nominal amounts. the exposure does not seem large enough to pose a systemic threat.6 3.8 0.0 0. Barclays Research The eurozone’s exposure to the Greek private sector is substantially smaller than its exposure to the Greek government.3 0.0 Thomas Harjes +49 69 716 11825 thomas.0 1.Barclays | Risks and repercussions of a Greek exit CONTAGION COSTS If Greece exits.1 2.4 3. The exposure to the Greek public sector that eurozone governments have accumulated now amounts to roughly 3% of GDP.0 0.5 0.gavin@barcap.9 EFSF garantees 2.0 25. However.8 0.4 4.9 0.1 8. PT and GR stepped out.0 6.6 63.2 0.9 3.1 0.1 0.3 0.2 3. Figure 1: Official exposure to Greece in EMU by country and type Member States Bilateral loans Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain Total 1.2 0. But even in France. National central banks.4 15.7 7.5 28.9 4. In any event.0 0. the most heavily exposed of the larger European banking systems (EUR34bn).7 0.0 0.1 The direct costs of a Greek default and exit appear manageable.0 €. but contagion risk could complicate the already precarious financial positions of countries like Portugal and Ireland.1 Note: * IR.6 1.0 0.0 0.5 1.3 9.0 0.2 0.3 10. Much of this exposure is in the form of bank claims (EUR70bn).2 3.3 0.3 17.6 10. Source: European commission.5 2. Direct costs of a Greek exit are not big enough to destabilize the rest of the eurozone The direct exposure to Greece for euro area countries is non-negligible: about EUR290bn of exposure to the Greek government.4 35.1 0.5 130.9 0.0 14. EFSF.0 0.3 55. The overall costs of a Greek event could be orders of magnitude larger than the direct costs.0 2.6 1.2 1.ghezzi@barcap.8 3.1 3.0 Eurosystem Total % of GDP 2.1 0. with roughly one third of this amount in exposure to private-sector entities.2 4.4 0. Bn 8.9 3.3 36.8 1.9 2.1 4.7 Michael Gavin +1 212 412 5915 Fabrice Montagne +33 (0) 1 4458 3236 fabrice.2 0. 31 May 2012 11 .0 11.4 0. and the systemically more significant economies of Spain and Italy.0 0.2 1.

It is not inevitable that a Greek exit from the eurozone will trigger strong contagion to other stressed sovereigns. but the bigger concern is the potential for contagion.186 773 146 1. financial.473 21.831 493 Source: Bank of International Settlements. while markets rallied in Q1 2012. In particular. Argentina defaulted and suffered a historic economic and financial collapse. It is not only more complex but also more unpredictable in its consequences.032 6. abandoning the euro and re-denominating contracts into a currency that does not yet exist is much more complex than a public-sector debt restructuring.199 673 US 4. as well as public defaults.759 1. other emerging markets were. The question is contagion The direct costs of a Greek default and exit appear manageable.929 3. However. many of which will be indirect. and the corresponding losses may be very difficult to predict. even if they lead to widespread restructuring of claims on the Greek private sector. If developments in Greece create even deeper anxiety about the rest of the euro area.502 223 37. we would caution against complacency. the overall costs of a Greek event could be orders of magnitude larger than the direct costs.256 1. the losses may undermine political support for financial programmes in other eurozone economies. we think that the main reason markets did not react negatively to Greece’s restructuring in March was because the default was fully priced when it happened – the issue of Greek default contagion affected peripheral debt markets throughout the second half of 31 May 2012 12 .406 505 155 746 UK 10.455 725 672 3.953 8. Contagion is not inevitable It is possible that this contagion will be more limited than many now fear.548 15.940 168 476 1. The Greek debt restructuring and a potential exit from the eurozone are very different shocks to the economic.295 29. First.835 6. After all. and the systemically more significant economies of Spain and Italy.048 Spain 969 302 39 627 417 172 24 221 Switzerland 1. valuations at EUR prices at end-December 2011 In short.353 6. and political systems.167 65.649 France 44. It also has potentially greater negative value as a precedent.692 1. but even partial breakup of a monetary union is very rare. in the end.901 1. A Greek exit will likely result in private. If Greek becomes the first departure from the eurozone. ECB losses from its Greek exposure would further undermine support for the SMP within the ECB. for which precedents abound. but contrary to anxiety about contagion.537 1. Government debt restructurings happen all the time.231 907 44.779 470 2.Barclays | Risks and repercussions of a Greek exit Figure 2: Foreign Bank Claims on Greece End-December 2011 Foreign claims Public sector Banks Non-bank private sector Other potential exposures Derivatives contracts Guarantees extended Credit commitments European banks 90. That said.664 Germany 13.790 462 280 1. More than a decade ago. it will be hard to avoid the question ‘who’s next’? Second.847 3.825 2.266 1. Political backlash could complicate attempts to mount a determined effort to support other stressed sovereigns in the months following a Greek exit.058 46. Greece restructured its debt in March. little affected.545 3.772 11.818 491 Italy 2.749 759 5.628 6.005 7. the direct losses from a Greek exit seem unlikely to destabilize the rest of the eurozone. which could complicate the already precarious financial positions of countries like Portugal and Ireland.355 6.

As the situation in Europe has become more complicated. the Greek default occurred in a context in which the ECB had surprised markets by effectively launching the 3year LTROs.Barclays | Risks and repercussions of a Greek exit 2011 and hence had minimal residual effect in 2012. depositors in Spain view turmoil in Greece as a risk scenario for themselves that they had not adequately considered. with Banco de Espana ex BdE Figure 4: … and in Italy 200 150 100 50 0 -50 -100 -150 Jan-00 BOP. concentrated to some degree in foreign owners of public debt. The same cannot be said of a Greek exit from the eurozone: it is not priced in yet. international investors in European government bond (EGB) markets have either sold their exposures or failed to roll over investments as they come due. thanks to the ability of the banking systems in those countries to tap the liquidity assistance of the eurosystem. In recent months. 30 April 2012). The SMP has provided direct support for government bond markets. especially not in key markets. and to permit banks in Spain and Italy to act as government bond buyers of last resort. the capital outflows have been accommodated without crisis in Spain and Italy. ultimately. non-resident selling of Spanish and Italian assets has accelerated. foreigners still selling (but less). it would be dangerously complacent to rule this out. While there is no guarantee that a disorderly Greek exit would trigger a broader and more intense ‘run’ against vulnerable eurozone financial systems. we estimate that non-resident investors (other than the ECB) had by April of this year cut their exposure by 50% from early 2010 levels (Spain: Banks still buying. while the LTRO operations provided long-term funding to reduce liquidity pressures confronting banks. financial account. or as further evidence that the situation in Greece and in Spain are fundamentally different. whether. financial account. for example. with Banca d'Italia Ex-Banca d'Italia Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Source: Haver Analytics Source: Haver Analytics 31 May 2012 13 . Stressed eurozone sovereigns are already suffering a confidence crisis Whether financial instability that may result from a Greek exit is transmitted to other eurozone economies depends. Third. for example. Figure 3: Capital outflows have been replaced by eurosystem funding in Spain 200 150 100 50 0 -50 -100 -150 Jan-00 BOP. Thus far. and seems to have broadened somewhat (Figures 5 and 6). In Spain. the risk of an adverse market reaction is heightened by the fact that stressed sovereigns in Europe are already suffering a form of confidence crisis. upon market participants’ reaction to events. While it is not possible to predict shifts in sentiment of this nature. but which could certainly become more generalized and intense in the future.

a run against bank deposits could be triggered. The fact that there has so far been no run against bank deposits is not. In Spain. but one that lies within the plausible limits of the eurozone’s capacity. This is a big number. The numbers become much larger if the ‘run’ extends beyond government bond markets. Problems would be compounded dramatically if domestic investors also lose confidence and sell domestic assets. We have not seen evidence of any material depositors’ outflows in Portugal. the remaining exposure would be finite and. 31 May 2012 14 . In particular. Deposits left Ireland in the months leading up to the EU-IMF programme of November 2010. proof that it cannot happen in the future. other (presumably official) sources would need to be tapped in the amount of roughly EUR250bn. Portuguese and Spanish government debt. And in Italy there is no material evidence of deposits outflows other than large multinationals that had to diversify away from countries/banks with low ratings.Barclays | Risks and repercussions of a Greek exit Figure 5: EGB investor are leaving the periphery (holdings by non residents. Irish. of course. in %) 80% 70% 60% 50% Greece 40% 30% 20% 10% Sep-07 Source: Barclays Research Portugal Ireland Italy Spain Jul-08 Jun-09 May-10 Apr-11 Mar-12 If foreign selling were confined to government debt. somewhat manageable. In fact the evidence shows that deposits are rather sticky even in Greece. if foreign bondholders sold 25% of their remaining holdings of Italian. For example. We have not observed bank deposit ‘runs’ in the periphery thus far (other than Greece). but have stabilized since then. where nearly twothirds of the bank deposits have (astonishingly) not left despite the longstanding risk of a potential disorderly exit. if a Greek exit creates fears of loss among bank depositors in other eurozone economies. there is evidence of “flight to quality” away from weak cajas but they have moved into stronger domestic banks.

375 180.906. the ECB could consider a further extension of full-allotment into 2013 and offer another round (or rounds) of very long-term refinancing operations.895 198.386.307 1.500 1.071.934 1.738 1.085 171.094. Eurobonds. The EFSF/ESM would then play a similar role to that of the ECB.389.665.965 3.679.381.078 232.237 233.737 3.411 1.639 205.413 Spain 1.805 229.870. The intervention by the ECB or the EFSF/ESM would have to be signalled as unlimited (in quantity and time) for it to be effective.686.069 189.656 201. Policy responses The most immediate policy response would in all likelihood make use of emergency liquidity tools by the ECB.875.923.396. which would buy EGBs across different maturities and countries. including Spain (and other countries).685. Alternatively (and perhaps politically more acceptable in Germany).414.716.972.733.701. Above that.210 Italy 1.330 1. 31 May 2012 15 . The ECB is expected to extend its full-allotment policy in the June meeting (currently expiring in July).379 1.590 1.655.792.018 Greece 244. there is much more at stake (even) than in the government bond markets.502 1. The funds should have attached an EC-ECB-IMF programme with conditionality exclusively focused on bank restructuring and recapitalization (ie to satisfy Germany request for conditionality on EU help).744 213.968.651. including: A modified SMP programme. A declaration of the European Council concerning a roadmap to fiscal union including the first steps (crisis related) as well as the longer-term issues (transfer of sovereignty.771 2.606.510 195.555 219.207 3.209.912 1.730.503 215. alternative financing in the amount of more than EUR750bn would need to be found.Barclays | Risks and repercussions of a Greek exit Figure 6: Deposit liabilities of Euro Area MFIs Germany 2009Dec 2010Mar 2010Jun 2010Sep 2010Dec 2011Mar 2011Jun 2011Sep 2011Dec 2012Mar Source: ECB 2. By resolving weak European banks and the potential downside that they put on some European sovereigns. Other near-term crisis management tools that could be deployed relatively quickly include and could complement ECB liquidity injection: Changes to the status of the EFSF/ESM to allow it to directly inject equity into undercapitalized European banks.424 1.727.695 1.448 2. bank deposits total more than EUR3trn.848. but if a crisis were to unfold in June/July.695 231.165 227.612.212.649 209. etc).741.149 230.127 1. In Italy and Spain alone.320 211.366 226.180 220.503 1.858 199. Access to EFSF/ESM could put a ceiling to the debt (and future losses) that the government would have to take.088 Ireland 219.766.266 217.558 1. the EFSF/ESM could be granted a banking license to have access to the ECB and hence leverage its resources.354 1. it would reduce an important source of uncertainty.874.933 196. the ESM could assume any further losses.386.613 1.338 3.951 1.532 France 1.298 195.424.924.938 1.762 1. The SMP could be modified to explicitly give up its seniority status. Cuts to the ECB’s main policy rate to near the zero bound and a clear indication that the policy rate will stay at (near) zero through 2013.549 1.604 1.401.507 2. If those banking systems were to lose a quarter of their deposits (for the sake of illustration).529 Portugal 209.056 2.653.054 If it does.883 1.599 1.710 2.067 195.023 1.187 1.301 1.395 223.

and a meltdown of the banking system and. euro area leaders would be forced to agree and credibly communicate to the markets what the end-game is for the European integration project. While the Greek government has achieved a substantial fiscal consolidation. In the event of a disorderly exit. very likely. In fact. but this does not change the fact that disillusionment with the EU-IMF strategy. all these measures may not be enough in the event of a real loss of confidence owing to impending euro break-up risk. it could possibly trigger a (systemic) bank run in some of the periphery countries. a disorderly euro area exit would follow. Poor implementation of the programme has undoubtedly played a role. Conclusion Greece. the public debt dynamics remain unsustainable and further debt relief will be required. and this perception would in all likelihood condition the near and long-term investment decisions of domestic and foreign investors. as the EGB markets attest. However. the EU-IMF programme is evidently not delivering results that the Greek population considers acceptable. but France and other EMU member states have so far resisted the latter. Even if an accident of this sort is avoided in the near term. However. Liquidity would dry up very quickly. 31 May 2012 16 . which is yet to be approved by most countries). and the euro area. even if there is no evidence of the latter thus far.Barclays | Risks and repercussions of a Greek exit Additional powers to the European Financial Stability Facility (EFSF)/European Stability Mechamism (ESM) as a precursor of a pan-European deposit insurance scheme. if the crisis intensifies to the point of becoming a real threat to the EMU itself. even after the February debt restructuring. At that point. Germany has repeatedly indicated that more joint-liability requires common European institutions with decision-making authority for fiscal policy in member states. this would in turn lock out their access to eurosystem’s liquidity. The outcome of the 17 June elections remain uncertain and the rhetoric by some of the left parties suggest that. This is technically complex and may have fiscal implications that would be resisted by several countries. they would aim for negotiations to secure a deep revision of the current EU-IMF programme. including an explicit and credible support by all EMU leaders of the future adoption of Eurobonds. are at a cross roads again. Yet any form of Eurobonds (joint liability) will also face an uphill legal and political battle and are unlikely to be approved in the near term. However. If no agreement is found. Contagion is already at work. It would require treaty changes and would need to be voted by all parliaments (just like the current ESM. Ideally. the only policy response that could aid ECB emergency measures to stem the crisis is accelerating EU economic and financial integration. combined with continued political resistance by those who stand to lose privileges under the structural reforms demanded by the 'memorandum'. In the extreme. the common deposit insurance scheme could also be endowed with common supervisory and bank resolution powers. this is far more complex and less likely in our view than the previous policy response. if elected. the costs for the euro area could be very large: in fact the interconnectedness of the euro area markets makes the potential costs literally incalculable. Greek banks would quickly become insolvent. the government would lose access to EU-IMF funds and without them. means that even if a new programme is agreed with the new government. A Greek exit could leave the door open for speculation that other EMU members may follow. there is a non-negligible chance that the programme would go off-track again. Greece's future in the EMU is not cast in stone.

may not be sufficient to address the core problem. Instead. There have been specific proposals even from core countries. could compress sovereign debt spreads significantly while keeping average debt yields at relatively low levels. a credible commitment with steps towards greater integration that end with the adoption of Eurobonds may be what is required. That would be the price that the core may need to pay if it wants to save the euro. 31 May 2012 17 . In particular. Those have been rejected by Germany but may get traction again if the crisis becomes more acute.Barclays | Risks and repercussions of a Greek exit We think that such a disorderly outcome can be avoided. while necessary. But solutions that only entail liquidity provision. The debt redemption fund. as proposed by the German Council of Economic Experts. a credible commitment to greater political and fiscal integration may also be needed.

CFA European Banks Credit Analyst +44 (0)20 7773 7241 miguel. the insurance is currently provided at a national level by risky local Barclays. As shown in Figures 1 and 2. then any impact from redenomination is simply transferred from depositors to the guarantee scheme. London Nimish Rajkotia* European Banks Equity Analyst +44 (0)20 3134 3719 nimish. Barclays.harrison@barclays.rajkotia@barclays. it is worth examining the situation in Greece itself. suggesting that such schemes are not sufficient to deal with either systemic risks or redenomination risks. All of this suggests that whilst a Euro DGS may initially sound appealing. Facing a similar challenge a decade ago. Greek deposits have declined approximately 24% to €171bn in the past two years. suffering from two drawbacks. deposits in Argentina fell 20%. the unintended consequences are likely substantial: raising the costs of providing the guarantee and potentially undermining a recovery upon euro exit. Ireland and Portugal. This outflow has been largely offset by the provision of exceptional liquidity from the European Central Bank and Bank of Greece. Whilst this may be affordable vis-à-vis redenomination fears in Barclays. 31 May 2012 18 . Portugal). and its potential for long-term inclusion in the European Monetary Union. London Mike Harrison* European Banks Equity Analyst +44(0)20 3134 3056 mike. but it has not stopped the outflow of funds from the banking system. What’s happened in Greece? Before considering the issue of wider contagion of a Greek exit to Europe’s deposit markets. talk of a possible exit of Greece from the European monetary union has sparked fears of contagion. We view Europe’s current deposit insurance system as inadequate. it would lack credibility in a worst case scenario of contagion spreading to Spain and Italy as well. These schemes allow depositors to place their funds at a bank with confidence that they will be returned when demanded. but Greek banks have been experiencing a steady deposit run that could accelerate as the June elections approach. first. This liquidity provision has allowed the banks to remain adequately funded. second. despite having a deposit guarantee scheme (DGS). eventually resulting in a freeze on withdrawals. regardless of the solvency of the bank. Greek banks have been losing deposits for two years as concerns escalate regarding Greece’s economic and fiscal prospects. Most developed banking systems have deposit insurance schemes to offset the inherent mismatch of making long-term loans funded with deposits that must be repaid on demand. it does not protect against currency redenomination.j. London Greek banks have lost almost a quarter of their deposit base over the past two years. the health of its banks. it is probably an inappropriate tool to be used in isolation to manage down the contagion risks from a Greek exit. If redenomination risk is fully removed via a “Euro” DGS. Whilst to date there is little evidence of deposit outflows in other periphery countries (Spain. * This research report has been prepared in whole or in part by equity research analysts based outside the US who are not registered/qualified as research analysts with FINRA.glionna@barclays.hernandez@barclays. Simon Samuels* European Banks Equity Analyst +44 (0)20 3134 3364 simon.samuels@barclays. Deposit insurance exists in Greece.Barclays | Risks and repercussions of a Greek exit IMPLICATIONS FOR EUROPEAN BANKS Deposit risks Jonathan Glionna European Banks Credit Analyst +44 (0)203 555 1992 Miguel Angel Hernandez. Italy.

However. and Ireland. Barclays Research Q1 10 Q3 10 Q1 11 Q3 11 Source: ECB. The bank funding pressures prevailing prior to the 3-year LTROs led investors to closely monitor customer deposit flows in peripheral countries in the second half of 2011. As shown in Figure 4.820 2. €bn 250 200 150 100 50 0 Jun-10 -24% Figure 2: Q/Q changes in Greek household deposits. Source: ECB.000 -8.860 2. Barclays Research 31 May 2012 19 . Customer deposit balances declined across most of the European periphery during this period.920 2.840 2. Italy.900 2. In the first three months of 2012. Barclays Research Contagion: Little evidence to date However. Source for both charts: classified as deposits.000 8. having declined more than 10% since mid-2010. excluding Greece.Barclays | Risks and repercussions of a Greek exit Figure 1: Greek customer deposits outstanding. We find little evidence of a trend of recent large-scale deposit outflows from peripheral European countries. €mn 20. Irish deposits fell just 1% in the last six months of 2011. these concerns are not new. as investor confidence recovered following the 3-year LTROs.880 2. Spanish and Italian deposits fell 3% and 2%.780 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Note for both charts: Excludes government deposits and securitization bonds.000 16.800 2. although the declines were moderate outside of Greece (Figure 3). €bn 2.000 0 -4. and Ireland have increased in 2012. customer deposits remained stable or even increased (Italy).000 12.940 2. respectively.960 2. Portugal.000 -12. perhaps the key area of focus for investors is that of contagion risk as talk of a possible exit of Greece from the European monetary union has sparked fears about deposit outflows from other peripheral countries. Figure 3: Change in customer deposits since June 2011 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% Jun-11 Spain Aug-11 Oct-11 Italy Dec-11 Ireland Feb-12 Portugal Figure 4: Total deposits in Spain. Italy. aggregate deposits in Spain. Portugal.000 Deposits in non-resident banks Cash and sight deposits in domestic banks Cash burn Total household deposits Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Q1 09 Q3 09 Source: ECB.000 4. while Portuguese deposits actually rose.

deposit insurance limits diverged across Europe to the point that during 2008 and 2009. we believe that looking solely at customer deposits does not provide the full picture. which is something deposit insurance does not protect against. retail bonds have historically been an important source of funding for banks because of the tax advantage they entail for the end customer relative to traditional deposit products. despite some volatility during the period. have focused their fund-gathering efforts on placing bonds. which creates doubts about its ability to pay insurance claims. most notably Spain and Italy. The European Commission used to maintain a “minimum harmonisation” approach through its original Deposit Guarantee Scheme Directive (94/19/EC). but the financial crisis of 2008 highlighted some significant differences between the treatments of depositors within the 27 member states. Figure 5 shows the change in customer funding since June 2011. The first is the local nature of the guarantee provider. has been relatively stable since June 2011. Figure 5: Change in the aggregate of customer deposits and short-term debt outstanding (<2y) since June 2011 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% Jun-11 Aug-11 Spain Source: ECB. In the case of Spain. where this phenomenon is relatively new. These data confirm that. we believe the existing deposit insurance system in Europe is not capable of easing the current crisis. There are two flaws that are preventing it from stabilising deposits in Greece and that could prevent it from stabilising deposits in other peripheral European countries if the crisis intensifies. usually short-dated instruments. the deposit insurance landscape in the European Union reflected the varying degrees of strength and diverging priorities of individual member countries. In Italy. with their retail customers.Barclays | Risks and repercussions of a Greek exit In addition. and the second is that this crisis is defined by emerging currency risk. excluding Greece. Specifically. customer funding of peripheral banking systems. Barclays Research Oct-11 Italy Dec-11 Portugal Ireland Feb-12 The deposit insurance system in Europe: two problems Despite the relative stability of deposits in peripheral countries exclusive of Greece. there was evidence that EU depositors were shifting their cash to member states that offered higher deposit protection and away from those offering less 31 May 2012 20 . Problem 1: Limited size Historically. This is because banks in some peripheral countries. which we proxy by the aggregate of customer deposits and debt outstanding with a maturity of less than two years. this is in response to the government’s decision to increase banks’ contributions to the country’s deposit guarantee scheme (the contribution is calculated as a percentage of deposits outstanding).

FSCS Greece Ireland Italy Portugal Spain UK Source: European Commission and individual member state DGS websites 31 May 2012 21 . and the remaining balance over €100. the deposit guarantee is provided by Fondos de Garantia de Depositos and Fonda Interbancaria di Titela dei Depositi. for example. term and savings deposits. the remodelled directive (2009/14/EC) was published in 2009. the creditworthiness of these agencies is only as good as the creditworthiness of the aggregate banking system or sovereign. the date can be extended further until December 31. For example.000 of an individual’s deposit is guaranteed by the DGS. To offset this. The first €100.EdB) and additional Deposit Protection Fund for Private Commercial Banks. the statutory Deposit Guarantee Scheme (DGS) was supplemented by the Eligible Liabilities Guarantee (ELG) scheme initiated in October 2010. In Spain and Italy. a challenge exists in that the guarantees are still provided locally. Some/all of the schemes funded by member financial institutions through annual proportionate contributions €100.Barclays | Risks and repercussions of a Greek exit coverage. Despite the increased harmonization.FGD) Financial Services Compensation Scheme . A list of the deposit insurance provider in various countries is shown in Figure 7. Figure 7: Deposit guarantees are still provided locally Selected country Belgium France Germany Who is responsible for depositor insurance? Protection Fund for Deposits and Financial Instruments Deposit Guarantee Fund (Fonds de Garantie des Depots-FGD) Compensation Scheme of German Banks (Entschädigungseinrichtung deutscher Banken. However.FITD) Deposit Guarantee Fund (Fundo de Garantia de Depositos.000 (no limit) may be covered by the ELG Scheme or “Government Guarantee”. reducing the value of the insurance.000 by the end of 2010. Separate schemes exist for Savings and Cooperative Banks Hellenic Deposit Guarantee and Investment Guarantee Fund HDIGF Central Bank of Ireland Interbank Deposit Protection Fund (Fonda Interbancaria di Titela dei Depositi . partnerships All depositsmainly demand.FGD) Deposit Guarantee Fund for Banking Institutions (Fondos de Garantia de Depositos . individuals.000 Source: European Commission. respectively. Some of the additional features of the most recent directive are summarised in Figure 6. 2012. Figure 6: European deposit insurance directive harmonized basic terms Right to compensation Scope of claim All deposits held by non-banking institutions – ie. by governments and agencies that have credit risk. plus registered savings certificates How much? When? Payout no later than 21 days after funds are frozen Who funds the scheme? Various. The Irish ELG scheme is currently scheduled to expire on June 30. individual countries also took action to solidify deposit insurance schemes during the early stages of the crisis. in Greece deposit insurance is provided by the Hellenic Deposit Guarantee and Investment Guarantee Fund (HDIGF). This sought to increase harmonisation and required member states to ensure a level of coverage that was fixed at €100. In Ireland. In most cases. 2012 with EU state aid approval. Barclays Research In addition. small corporations.

6trn of deposits. Greece’s deposit insurance law states that if the funds in the Deposit Cover Scheme were not sufficient to meet depositor compensation payments. fund interventions covered by one-off contributions Credit institutions in the form of annual contributions Does it have preferred creditor status? No Country Spain Who provides for the Resources within the fund Can it borrow? shortfall? Total assets of €7. of which €5.Barclays | Risks and repercussions of a Greek exit Most deposit insurance schemes are funded independently by the banking system. the deposit insurance fund has total assets of just €7.3bn has already been committed to the resolution of Caja de Ahorros del Mediterraneo (CAM) banks. reimbursed within 3mths by Treasury. the available resources are moderate in relation to the size of each country’s deposit base. €5.414 Not contemplated Not contemplated No Portugal 229 Yes Credit institutions through one-off contributions. but it is less beneficial when the crisis involves the entire banking system. regular contributions cover operating expenses only.8bn (0. For example.1bn are liquid. borrowings in open market Italy 1. in Spain. Barclays Research 31 May 2012 22 . Also Fund can borrow required level from credit institutions Yes Ireland 196 Annual cash contribution of NA 0.1% of eligible deposits Yes Yes. the HDIGF may. a banking system with approximately €1.4bn (end 2010) form of annual contributions of 0.3% of eligible deposits Credit institutions. who then seeks fund replenishment from the credit institutions Supplementary contributions by credit institutions capped at 3x regular annual contribution. deposit insurance funds are prohibited from borrowing from national central banks or the ECB.4% of eligible deposits) €1. at its discretion.2-0. Figure 8: Funding status of selected deposit insurance schemes Customer Deposits How is deposit insurance €bn* funded? 1.4bn (of which €400mn are unfunded) Yes Credit institutions through one-off contributions.implied by new Bank Resolution plan * As at May 2012 Source: National regulators.3bn committed for resolution of CAM Unfunded. In Figure 8. Bank of Portugal can also cover immediate needs if systemic stability at risk Central Bank. In 2009.” after a bank has failed.9-1.655 Credit institutions in the form of annual contributions of 0.2% of deposit base Yes No Greece 171 Credit institutions in the €1.9bn. in Q4. maximum contributions in 2012 can be up to €1. this may have provided comfort that the fund could be replenished following a bank failure. Some of these schemes are financed by regular contributions from the member banks annually to build up the “ex ante” float in preparation for a future crisis.9bn as of October 2011. borrow from the credit institutions participating in the scheme for a determined period of time. we outline the funding status of selected European deposit insurance schemes. As shown. Others do not pre-finance at all and require the member banks to fund the required payout “ex post. although they often include a direct or implied guarantee from the government. Generally. of which €4.

Payments were initially allowed between banks in the system (though additional restrictions were subsequently applied). this could lead to widespread bank insolvencies.Barclays | Risks and repercussions of a Greek exit Problem 2: Redenomination risks The second challenge facing any European deposit guarantee system is dealing with redenomination risk and in particular the contagion risk that could follow a Greek exit from the eurozone. which manages the US DGS. the current arrangements for protecting depositors against potentially widespread currency redenomination concerns following a Greek exit are limited.0bn from ARS82. 2001 to help stem the overwhelming outflow of deposits. Argentina underwent a period of deposit flight prior to redenomination during the national economic crisis in the early 2000s. the Argentinean government instituted a deposit freeze. “Banks during the Argentine Crisis”. So they begin to withdraw their deposits. placing such an additional burden on the finances of already-troubled sovereigns would risk exacerbating the current crisis further.2bn per month in the first seven months of 1 IMF. in place at the time. once in the new currency. deposit withdrawals continued at an estimated rate of ARS0. The thinking here is that depositors in the periphery (ex Greece) come to view a Greek exit as a realistic template for how eurozone sovereign debt crises are resolved. Fearing a revaluation of the currency. In three of the worst days of November 2001. requiring national governments to step in and shore up the banking system. For example. Deposit insurance. As such. The conventional approach to prevent bank runs is a deposit guarantee scheme (DGS). Even in the US. the pace of this outflow and conversion increased. since the provider of the guarantee was in question. as noted. was uncertain given the increasingly apparent need for revaluation. the value of the currency. according to IMF data.1 Year-over-year.9-4. However. Indeed. did little to stem this flow. it was the Fed/Treasury and not the Federal Deposit Insurance Corporation (FDIC). We believe that the most likely transmission mechanism of contagion is that a Greek exit leads to bank runs in other peripheral banking systems. depreciate heavily versus the euro. as the crisis continued. often reposting these funds into dollar-denominated accounts. Argentina: 2001 Perhaps the most recent example of a country facing similar challenges around denomination risk was Argentina in the period leading up to the abandonment of its currency peg with the US dollar in 2001. or corralito. But clearly.9% in 2001. given the impending government default.5bn at the end of 2000. on December 3. Left unchecked. 31 May 2012 23 . As concerns escalated in late 2001. Argentineans began to pull deposits out of peso-denominated accounts. during which declining output and high inflation strained the country’s economic and political infrastructure. Moreover. the current European system of deposit insurance has important limitations. 2007. Nevertheless. deposits fell 19. depositors may become concerned that the end game for their own sovereign's debt crisis is that their deposits are redenominated and. with the government’s declaration of default in late December 2001 and conversion of dollar-denominated financial assets and liabilities into Argentinean pesos in February 2002. potentially sparking bank runs. As such. to ARS66. the extant DGSs have been designed to handle individual rather than systemic bank runs. who provided the backstop to the systemic crisis in 200809. but depositors were not permitted to withdraw the majority of funds from their accounts. 6% of bank deposits were pulled from the system. In response. not just the viability of the banks. Barajas et al. the Greek experience of deposit outflow is not dissimilar.

"once a bank run has started. Whilst a Greek exit clearly increases the proportion of depositors concerned about redenomination. it makes sense for the remaining depositors to participate if they think that everyone else will withdraw their deposits as well. there's no need to withdraw deposits in the first place. 2 World Bank.Barclays | Risks and repercussions of a Greek exit Figure 9: Argentinean total deposits (bn) 160 140 120 100 80 60 40 20 0 1993 1995 1997 1999 2001 2003 2005 Figure 10: Argentinean annualized deposit growth (%) 60% 40% 20% 0% -20% -40% -60% -80% y/y Growth (Native Currency) y/y Growth (SDRs) 1994 1996 1998 2000 2002 2004 Deposits (Native Currency) Deposits (SDRs) Source: IMF International Financial Statistics.2 A combination of monetary tightening. This holds true regardless of whether all depositors share the concerns that initially started the run. Barclays Research 2002. 31 May 2012 24 . Measures to reassure depositors about the size of liquidity buffers could potentially include further special measures from the ECB (although this may lead to uncomfortable questions about the credit risk they assume) or. The idea behind a DGS is to break this vicious circle. If a bank's liquidity buffer (including central bank reserves) is generally perceived to be greater than the proportion of depositors who are concerned about redenomination. it is rational to join in". given the shortcomings of existing national DGSs. the introduction of depositor preference regimes across Europe (although this would likely further undermine banks' wholesale funding models). government support for bank solvency. “Argentina’s Banking System. banks can cope with deposit withdrawals without becoming insolvent. 2004. bank runs will be prevented. If you know with confidence that you (and everyone else) can access your deposits in full. alternatively. Once aggressive deposit flight is underway and a bank’s solvency is threatened. any early-stage panic could – in theory – be addressed by national authorities in the periphery signalling to the rest of the depositor base that: (a) the group of 'concerned' depositors is too small to cause a run. Governor of the Bank of England. So the key barometer of a successful DGS lies in its credibility. and (b) banks' liquidity buffers are sufficiently large. Barclays Research Source: IMF International Financial Statistics. However.” Gutierrez and Montes-Negret. If a DSG can cope with depositors’ worst case scenarios. Deposit withdrawals slowed in 3Q02 and eventually started to grow again in late 2002 (Figures 9 and 10). In other words. As Mervyn King. it doesn't matter whether a bank run starts for valid reasons or not. are there other ways to reduce the risk of bank runs? One (limited) approach is as follows. Part of the problem with bank runs is that they quickly become self-fulfilling. and legal protection against deposit devaluation contributed to a reversal of these trends over the course of 2002. noted during the run on Northern Rock in 2007.

this offers little relief if redenomination occurs 'tomorrow'. To give a sense of scale to this contingent liability from a sovereign issuance 31 May 2012 25 . bank runs can occur even if no depositors have redenomination as their base case. Similarly. it would be extremely challenging to quickly and effectively communicate a complex idea like depositor preference. In a world where the levels of financial sophistication vary significantly across the population. and even more problematic: how could authorities credibly assert that the proportion of depositors concerned about redenomination is too small to precipitate a bank run? How could they tell? Quite aside from the challenges presented in gathering such data. Would a more top-down. further ECB liquidity provisions may soothe financial markets and financially sophisticated corporates. it's a complicated solution. This suggests that any response that is either too complicated for retail depositors to understand or requires authorities to have 'private knowledge' that they can't realistically access will meet with limited success. Provided that the switching costs of moving deposits out of 'at risk' banks/geographies are lower than the perceived probability-weighted impact of redenomination. Barclays Research Depositor Preference Law? Yes No (proposed) Yes (indirect) Yes (indirect) No No No No Yes No Yes Yes No But the short-term efficacy of such an approach faces at least two significant hurdles. This is because even if deposits are guaranteed in euros 'today'. but they run the risk of bewildering many retail depositors. The only way such a DGS could work is if deposits were guaranteed in euros even after countries have left the euro – with the risks of devaluation being transferred from depositors to the DGS provider.Barclays | Risks and repercussions of a Greek exit Figure 11: Depositor preference laws by country Country United States United Kingdom Switzerland Germany Holland France Spain Italy China Japan Australia Argentina Brazil Source: FSB. First. then deposit withdrawals can reach the critical mass needed for a bank run. significant deposit outflows in the periphery would have to be met either from the ECB or from non-periphery sovereign debt issuance. Would they understand at what point 'enough' liquidity had been pumped into the systems? Second. Would such a scheme be credible? Given the limited pre-funding of DGSs across Europe. EU-wide approach to a DGS work any better? An EU-wide DGS would be helpful in the sense of enhancing the credit-worthiness of the guarantor but would be unlikely to offer adequate protection against currency redenomination. Another way of putting this is to say that any policy measure which is applied on a 'doing just enough' basis may well prove ineffective. Moody’s. This could result in the bizarre situation of having (newly) non-eurozone countries having all their domestic deposits denominated in euros.

Bloomberg. We calibrate the size of the contingent liability of an EU-wide DGS by comparing the size of the European periphery deposit base (Spain.665 10.575 222 157 241 194 40 401 36 70 16 355 96 21 32 165 12. Greece.754 31 May 2012 26 .777 1.Barclays | Risks and repercussions of a Greek exit perspective Figure 12 shows the deposits/GDP across the 27 countries in the EU.095 322 1.655 860 229 480 196 3. Figure 12: Customer deposits / GDP Customer Deposits Luxembourg Cyprus Malta UK Spain Netherlands Portugal Belgium Ireland Germany Austria France Italy Greece Czech Denmark Finland Bulgaria Sweden Slovenia Slovakia Estonia Poland Hungary Latvia Lithuania Romania Total Total SGIIP Total Non-SGIIP SGIIP Deposits % Non SGIIP GDP SGIIP Deposits % AAA GDP SGIIP Deposits % German GDP Source: ECB.190 9.069 599 169 371 155 2.775 1. Barclays Research GDP 44 18 6 1. subsequently referred to as SGIIP) relative to the GDP of various constituents of the DGS provider.755 3.606 305 2. Ireland.565 Deposits / GDP 503% 275% 167% 156% 155% 143% 136% 129% 126% 119% 106% 94% 90% 77% 71% 66% 66% 65% 61% 60% 56% 55% 53% 48% 38% 38% 26% 113% 115% 112% 38% 63% 141% 220 49 11 2.018 1. Portugal. Italy.906 1.419 3.414 171 111 160 128 26 246 22 39 9 187 46 8 12 44 14.

Any DGS is intended to improve financial stability. their sovereigns will come under further pressure. Waiting until large swathes of the banking system were insolvent before lending the monies would massively undermine the credibility of the scheme. but on a par with the UK and Netherlands. Moreover. this would be less of a guarantee scheme and more of a direct bail-out.Barclays | Risks and repercussions of a Greek exit SGIIP deposits are 38% of non-SGIIP GDP. replacing deposits immediately). it's unlikely that extending these mechanics to an entire banking system facing redenomination risk would be desirable. as well as the additional losses created by the increased macro distress. In the current political climate that may be seen as too generous. Determining the ultimate cost to the providers of the DGS on this basis is driven by three factors: the amount of deposits protected (depending on whether the DGS offers currency protection to all deposits upon a euro exit or just those that are withdrawn). For instance. If banks’ solvency is threatened by redenomination concerns (even though they are now irrational. Fire-selling these would increase sovereign bond yields – and significantly raise the execution risks of forthcoming primary debt issues. Furthermore. Could a DGS instead be used pre-emptively? Designing such a system is tricky. Or would a DGS have to operate on a drawdown basis. 31 May 2012 27 . with the DGS coming into play thereafter. At what point would an EU-wide DGS pay out? Ordinarily. the magnitude of the devaluation if/when euro exits occur and whether or not a peripheral banking system would subsequently default on their DGS liabilities. This is relatively high relative to the EU. widespread bank insolvencies would result in the need for additional capital injections to deal with 'ordinary' credit losses facing the banks. replacing domestic deposit accounts with currency-protected ones as funds are withdrawn? If an EU-wide DGS lends the funds straight away (ie. So a DGS that only kicks in upon insolvency would be an ineffective tool to deal with a systemic bank run. so in Figure 13 we provide a range of scenarios. would such a DGS operate purely on a contingency basis to guarantee the euro status of all deposits only in the event of a country leaving the euro? Time inconsistency problems here may still lead to self-fulfilling bank runs. However. the sudden stop in credit provision as banks try to meet deposit outflows would result in a swift 'credit crunch'. given the DGS) some time in advance of a euro exit. If taxpayer monies are used to bail out depositors. further hampering peripheral recovery prospects. If peripheral banks sell their unencumbered liquid assets to facilitate deposit withdrawals. the remaining depositors may still choose to withdraw funds rather than wait for the DGS. Depositors would be protected but the system would be crippled. a DGS only makes payments once a bank has exhausted its reserves and sold down its liquid assets to the point of insolvency. there may need to be some form of burden sharing between national banking systems and the DGS – for instance with domestic banking systems absorbing some initial proportion of deposit flight. Estimating these with any precision ex ante is clearly problematic. this immediately gets us into murky waters. these would usually be in the form of a loan (rather than a gift) with repayment occurring after the banks has been restructured or sold on. But the real credibility of such a scheme ultimately comes down to how much the contingent liability would potentially cost the DGS providers – and whether this is affordable. Instead. This implies that the deposit/GDP of the EU-wide DGS providers would rise to 151%. Many of these liquid assets would be domestic sovereign bonds. However.

Furthermore. Barclays Research 25% 916 10% 50% 1. But if. The costs to the DGS providers in this instance may become prohibitive: 6-19% of GDP (depending on the level of currency depreciation) if the monies are re-paid – and over one third of GDP in the case of default.374 550 916 1. it is likely that the ability of the DGS providers to raise the necessary funds and absorb the potential losses would be far lower than we have modelled. which represents the impact of redenomination/devaluation. If the SGIIP systems repay the DGS monies. 3 This would occur immediately if the DGS operates on a contingency basis and more slowly if it operates on a drawdown basis as depositors move their money into protected accounts. this appears uncomfortable but potentially manageable: EU sovereign debt/GDP excluding SGIIP is c75%. Furthermore. If SGIIP economies were to default on their DGS liabilities. being located in Spain and Italy. as an illustration. Bloomberg. then the final cost to the DGS would be somewhere in the region of 1-5% of GDP.749 29% 100% 3. But there’s a wrinkle in this analysis. then substantially all their deposits would be subject to the DSG3. If we are dealing with a situation of redenomination fear.833 19% 75% 2.655 45% 3. If fears become reality and SGIIP economies actually were to leave the eurozone en masse. excluding SGIIP. the rest of the EU would need to absorb the full €916bn cost. our analysis here is entirely static. after burden share 1. unsurprisingly.665 Italy 1. Pushing this figure up to around 80-85% may well be tolerable. the DGS may potentially have to replace €916bn – around 10% of EU GDP. evidently not all deposits would be withdrawn even if such fears were widespread. 25% of deposits are withdrawn. At first glance. Facing a situation of multiple SGIIP bank runs coupled with the imminent euro exit of several countries.665 38% 550 6% 82 137 275 137 229 458 275 458 916 412 687 1. 31 May 2012 28 .Barclays | Risks and repercussions of a Greek exit Figure 13: Potential cost of an EU-wide DGS (including redenomination impact).5trn SGIIP deposits that would need to be covered (and potentially currency-protected) by an EU-wide DGS – with the vast majority. Some deposits will be sticky as a function of the payments systems and because most salaries get paid directly into deposit accounts on a monthly basis. €bn Spain Customer deposits % SGIIP total Total SGIIP deposits.414 39% Portugal Ireland 229 6% 196 5% Greece 171 5% Deposit outflows 15% Deposit outflows met by EU-wide DGS % EU GDP (ex SGIIP) Impact of redenomination post Euro exit with… …15% devaluation …25% devaluation …50% devaluation Impact of redenomination % EU GDP (ex SGIIP) with… …15% devaluation …25% devaluation …50% devaluation Source: ECB.833 1% 1% 3% 1% 2% 5% 3% 5% 10% 4% 7% 14% 6% 10% 19% Figure 13 indicates that there are c€3. The credibility of the DGS in this instance comes down to whether such a cost could be borne by the DGS providers.

drawing comparisons with the FDIC scheme in the United States. encourage peripheral countries to soften their stance on austerity. Furthermore. But without protecting against redenomination. If redenomination risk is transferred from depositors to the DGS. This would essentially represent a direct transfer of wealth from the rest of the EU to the periphery. 2012. potentially increasing the risks of euro exits. Ireland and Portugal but would lack credibility in a worst case scenario of contagion spreading to Spain and Italy as well. Furthermore. encourage them to rapidly increase their domestic borrowings and redeposit the monies under the protection of the DGS. we would face a situation where domestic deposits are still in euros. An EU-wide DGS that does not protect depositors from redenomination may be helpful from the point of view establishing a credible guarantor/improving depositor psychology. perversely. by reducing the pain of euro exit for depositors. Moreover. 31 May 2012 29 . upon euro exit. then it’s plausible for deposit runs to spread to other economies that could also face redenomination/devaluation risk. and allowing deposit guarantee schemes to lend to each other on a voluntary basis under certain conditions. including the consideration of a “pan-EU Deposit Guarantee Scheme” as an economically effective solution to overcome the still-fragmented nature of the deposit guarantees in Europe. So an EU-wide DGS that protects depositors from currency redenomination may be able to withstand redenomination fears in Greece. Conclusion Recent press reports (Financial Times and Wall Street Journal) have suggested that an EUwide deposit guarantee scheme could be on the agenda in upcoming EU summit meetings. holding the EU presidency. these speculative borrowers would then reap a substantial currency gain. it may be possible for the DGS to be granted by the ECB rather than the EU. its effectiveness is limited. this could stoke inflation and make it harder for the freshly redenominated economies to improve their balance of payments. On February 10. So where does this leave us? Any DGS that is designed to handle individual bank runs but not widespread failures will do little to improve systemic risk if it only kicks in upon bank non-viability. the European Commission proposed a number of further amendments to the Directive 2009/14/EC. proposed some relevant changes for negotiation to the deposit guarantee schemes in Europe. All of this suggests that whilst a DGS may initially sound appealing. this is potentially manageable. These include enhancing prefunding mechanisms to ensure a common minimum target fund level. but may prove unaffordable – and thus lack credibility – in a worst case scenario. In the longer term. this may. Upon redenomination. but local prices are now in local currency. it is probably an inappropriate tool to be used in isolation to manage down the contagion risks from a Greek exit. Alternatively. Back in 2010. Denmark. the unintended consequences are likely substantial: raising the costs of providing the DGS and potentially undermining a recovery upon euro exit.Barclays | Risks and repercussions of a Greek exit once contagion has spread to the rest of SGIIP. But this would likely re-awaken ‘money-printing’ debates – not least because the ECB would then face the contingent costs of redenomination. What about the unintended consequences? Offering depositors shelter from devaluation would. shortening the time that depositors need to wait to be reimbursed. in the short term.

fransolet@barcap.(bp) 3m FRA/OIS (bp) 1m Italy GC vs eonia (bp) The ECB would have to be the main wholesale liquidity provider to the banking systems in peripheral markets… Figure 1: The ECB has been intermediating money markets (gross ECB borrowing by banking system. At this stage. despite any policy responses that would be introduced. an increased focus on credit and counterparty risks. it is clear that a Greece exit is currently not fully priced into rate markets. Others Germany Ireland France Spain Italy Greece Portugal 50 0 -50 Jan-08 Nov-08 Oct-09 Aug-10 Jul-11 May-12 Source: Barclays Research. Two factors have helped keep some money markets from disappearing completely: the move towards repos. This would be exacerbated further should deposits decline at an increased rate on the back of redenomination risk: these would have to be compensated by increased ECB reliance as well. We would expect money markets to suffer a renewed bout of stress. EUR bn) 600 500 400 300 200 100 0 Jan-08 Oct-08 Jun-09 Mar-10 Nov-10 Jul-11 Apr-12 AT. we would expect large knee-jerk reactions in money markets and EGB markets. with a sharp reversal of cross-border flows. A Greece exit. The breadth and forcefulness of policy reaction would define how much and how fast these reactions last. Figure 2: Money markets have been less subject to volatility recently 300 250 200 150 100 3m EUR/USD basis. in particular those settled at central clearing counterparties (CCPs). BE. and probably in much larger The impact on interest rate markets of Greece exiting the EMU is likely to be significant. €90bn for Italy as at end April). given the current size of deposit bases in peripheral markets (around €4trn). In our view. FI. with Italy and Spain bonds likely selling off aggressively. lower volumes and a very large domestic re-segmentation of these markets. NE. if not all. LUX. triggering rating downgrades for other peripheral countries (and thus their banking systems). with only the top-tier banks retaining access to small amounts of market-based CCP repo funding (€60bn at most for Spain. and the massive re-intermediation provided by the ECB. of these banks. Money markets: ECB to increase intermediation role further Money markets would resegment even more than now Since 2007. against an ever broader set of collateral and for ever longer maturities. euro money markets have experienced sea changes in their functioning. inverted. €270bn for Italy).Barclays | Risks and repercussions of a Greek exit IMPLICATIONS FOR RATES MARKETS A Greece exit is not fully priced into rate markets Laurent Fransolet +44 (0)20 7773 8385 laurent. on demand. national central banks Source: Barclays Research 31 May 2012 30 . would likely make the remaining short and long wholesale funding for peripheral banks disappear. Should it become clearer that this is going to happen. it is fair to say that the vast majority of peripheral banks’ money market funding comes from the ECB (€315bn for Spain. and leave the ECB as the single funding source for the vast majority. at typical maturities of up to one month.

even if the actual cross currency funding needs of a lot of European banks have been dramatically reduced in recent years (as evidenced by the limited take-up in USD ECB operations). although the profile of such a trade is less asymmetric than for the others. As a hedge. French banks via their CD programmes) would also likely be significantly affected by rating downgrades. across the board. these rates would at least initially shoot up). we believe receiving short-term rates (say 2 or even 3-4y OIS) may also be profitable. We would also recommend being short GC repos in Italy and Spain (currently round 35bp). etc). but with the same drawbacks likely. as it is fairly asymmetric (it will likely not rally much.Barclays | Risks and repercussions of a Greek exit … but even in non-peripheral markets In our view. we would expect the ECB to cut all rates and inject a lot more liquidity. or complete 31 31 May 2012 . GC repo spreads would likely widen for peripherals (1 month GC for Italy and Spain currently trade around 35bp). addicted banks. This process of ECB intermediation will. In terms of market variables. The ECB would have to provide policy responses We would expect the following moves in money markets In a Greek exit scenario. The widening might be limited because it would be on the back of less active markets. While money markets have stabilised (their reaction to the most recent volatility has been muted). of course. Our expectation would be for further large declines in wholesale money market liquidity and availability. FRA-OIS (and other bases) spreads would likely widen back to around 60bp in 1y1y fwd maturities (their previous highs in 2008 and 2011). even if spot FRA-OIS might be kept tight by the absence of any kind of market. EGB markets: Greece exit likely to trigger additional liquidation flows Peripheral markets The re-domestication trend would likely pick up pace The European government bonds markets (EGBs) have already experienced massive changes in the past few years. also have the side effect of raising concerns about the ECB balance sheet (collateral. as have occurred in peripheral markets in recent years. and are not representative of a broader wholesale market. higher cost and haircuts). Target 2 exposures. since a lot of the ‘risky’ repo funding would now be done at the ECB. banks that currently retain some access to euro area money markets (eg. Cross currency bases would likely widen by a further 20bp or so. The ECB would. with declines of foreign ownership of between 10-20pp in all peripheral countries over the past two years) and in terms of liquidity (a clear deterioration. Trade recommendations to manage risks of a Greece exit Our current preferred trade recommendations in the short end are still to keep FRA-OIS wideners (in Europe and the US) in 1y1y fwd. and reduced funding availability. but if a Greece exit materialises. of course. in terms of ownership (a clear re-domestication. as they typically do when credit risk rises. rather than be market based. it is essentially because the ECB has injected a lot of surplus liquidity and is providing a central intermediation role: the current market levels are representative of marginal trades with ‘good’ counterparties. which in fact no longer exists. given the easing that is already priced in (1 year 3y fwd OIS is at 1%). increased counterparty defiance (reduced volumes. while the core GC will likely continue to trade well below Eonia (Germany is at 10-15bp). stand ready to compensate this lost funding via additional LTROs at full allotment. maybe five years). we would expect the following: Eonia should move further down (and the Eonia curve flatten out for a longer period of time.

… and Spain and Italy would suffer The recent widening has not really been driven by liquidations. any such liquidations would push yields much higher Core countries Core markets are unlikely to hold up if Spain and Italy sell off… As has been the case over the past few quarters. Over the past few months. While the liquidation flows might be smaller than in H2 11 (positions are less overweight in Italy. despite having fewer implementation risks on the banking/fiscal side. and the foreign ownership has already declined significantly). but it has been sufficiently Figure 4: Liquidations have been more limited recently: any selling is likely to push yields much higher Figure 3: Foreign ownership (ex ECB) of EGB markets has declined heavily recently. Smaller EGB markets will remain virtually non existent It seems highly probable that in the case of a Greece exit.5%). At worst. with around 40% of bonds still held by non residents. markets will start to discount more fully restructuring of these debts in the near term. France and Austria would also suffer to a certain extent: the relationship between spreads in these markets and peripheral spreads has not been constant over time. It is also worth noting that Italy. a Greece exit would only push these trends to more extreme levels. it is likely that any kind of liquidations post a Greece exit announcement would have very large price effects (the whole BTPs/SPGB curve moving way above 6. the moves in peripheral debt have occurred amid low liquidity and are no longer on the back of large liquidations by foreign investors in these markets. with only around 20% of non resident ownership. EGB markets in Portugal and Ireland will remain virtually non existent. those at the short end have stayed at much lower levels. Given the poor liquidity and risk absorption of the markets currently. might be as much at risk as Spain.Barclays | Risks and repercussions of a Greek exit shutdown in the case of the three smaller peripherals). countries such as Belgium. or start to price the possibility of redenomination. a Greek exit would raise the probability of Spain and Italy needing to get some official help. but liquidations have been limited recently 90% 80% 70% 60% 50% 40% 30% 20% Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Greece Portugal Ireland Italy Spain 250 200 150 100 50 0 -50 -100 -150 -200 -250 Yields higher (bp) Spain 5y (5 days chg. during which new financing will have to come from official sources. Spain and Italy would be the two main casualties: while yields in long maturities have already moved back up towards or above the 6% level. In our view. and that market access by these treasuries at longer maturities will be at best pushed back a few years. While further LTROs and SMP would be likely. especially if current firewalls are not raised in the meantime. which would have a very large further impact on prices/yields. even if the ECB intervenes. helped by the ECB LTROs. they are unlikely to be keep yields down on a longer-term basis. In our view. bp) Net selling Flows+supply (RHS) Yields lower (bp) 3y LTRO (ann+all) Net buying May-11 Jul-11 Aug-11 Oct-11 Dec-11 Mar-12 May-12 Source: Barclays Research Source: Barclays Research 31 May 2012 32 . the ECB interventions will also be less effective due to the implicit seniority of the ECB on these purchases since the Greek PSI.

Rather than being outright long. Rates: already very low. But this would likely be fairly short lived. In contrast. especially if Greece leaves the EMU. 1y fwd 31 May 2012 33 . Indeed. Positioning for a cheapening of Germany in CDS allows one to be less exposed to the flight– to-quality risks. Currently. Eurobonds/Euro T-bills: a move towards debt redemptions plans likely Some progress towards mutualisation of debt would be likely Talks about a Eurobond/euro T-bills are likely to accelerate in the coming quarters. Post 10y rates are already well below that (15y15y fwd at below 2%). and underperform versus Germany. Hence. or higher term premium) from 2014 onwards. we estimate that the 5y5y fwd rates is already about 65bp below the low end of the range we would expect based on: 1) the level of short end rates (which are broadly fair versus our base-case monetary policy expectation or the next two years). a knee-jerk reaction would likely push all yields lower. At the longer end. and still high foreign ownership. especially in bonds (ie. yields would rally further). without probably necessitating a lot of the legal changes that fully fledged Eurobonds would require. in our view We believe CDS markets are likely to move broadly in line with bond markets. we believe a more limited scheme like the German-proposed debt redemption fund. as substantial firewalls. we prefer being long 5s vs 2s and 10s. France). these markets would likely be impacted strongly as well by noneuro area resident selling. while benefiting from the latter concerns. we like buying protection on Germany in CDS. as the investor base is more oriented towards ‘fast money’ Germany would initially outperform. which may have a negative impact on post-five year rates once the initial flight-toquality rally has taken place. holders. but… Rates would likely rally. maybe by up to 50bp. Eurobonds still face important (political) challenges before being introduced. Without direct ECB SMP support. 1% real growth). or an alternative to it in the form of the T-bill redemption fund could be developed relatively quickly (the initial ERF proposal envisioned a a set-up period of less than six months). despite their different supply/demand dynamics. as we would expect it be followed by subsequent moves towards mutualisation of the debt (or expectations thereof).Barclays | Risks and repercussions of a Greek exit present to likely have an effect going forward. and 2) medium-term nominal growth expectations of 3% (a fairly unchallenging 2% inflation. less-active. in our view. we believe the recent retightening to the past nine months’ tights provides attractive entry points for hedging against a Greece exit. being long rates is far from being an asymmetric trade. There would also likely be some expectations that inflation will be allowed to run slightly higher than hitherto. But given the current levels of yields (around 50-90bp above Japanese swap rates). maybe by up to 50bp There is no doubt that a Greek exit would have a very significant knock-on effect on the euro area economy and thus drive a very accommodative policy from the ECB for a very long period of time. the market is pricing in roughly a 50% chance of an ECB rate cut in H2 12. while the bond market has a higher proportion of long-term. in our view. as we would expect large medium-term GDP losses (5y5y fwd should move about one–for-one with moves in medium-term nominal growth expectations according to our models). but not for long. banks CVA desks). CDS markets will move more quickly. and then rates on hold until end 2013. A Greek exit would initially likely trigger a big flight to quality. But in outright and RV terms. In our view. On a Greece exit. with the curve starting to steepen (and reflect chances of rate hikes. the 5y sector is likely to benefit the most. asset swap spreads would widen. probably by 100bp or more across maturities. the CDS market shows a much higher proportion of ‘fast money’ and ‘price takers’ (eg. While some of these markets have been popular shorts (eg. and thus lead to an outperformance of Germany. or mechanisms to help Italy and Spain in particular would be needed. All OIS/swap rates would likely rally further in such an environment.

85% FV for 2. Figure 5: Medium-term EUR swap forward rates are already at very low levels 11 10 9 8 7 6 5 4 3 2 91 93 95 97 99 01 03 05 07 09 11 4. in the case of a Greece exit. On an outright or asset swap basis.70% growth Source: Barclays Research 31 May 2012 34 . as the policy response from the Bank of England or from the Federal Reserve are likely to involve some renewed quantitative easing/bond buying. but is not too exposed to the 10y sector rates.20% growth Current fair value and range based on LT nominal growth EUR 5yr5yr Model for OIS 5y5y (1999 to Apr11) 2.04% FV for 3. we believe that UK or US rates would perform better than German ones.Barclays | Risks and repercussions of a Greek exit We like receiving the 5y sector versus 2 and 10s 1y fwd: this should benefit from low rates for long.

robinson@barclays. The CHF and INR are excluded due to recent idiosyncratic factors. The specific pattern of moves will depend on how serious the threat to global markets becomes and what measures the European authorities take as a result of the crisis. European EM currencies have been particularly weak since the Greek election on 6 May. Source: Barclays Research 31 May 2012 . What if Greece leaves? A Greek exit would be a major risk event. and ZAR in the European time zone. other “high beta” currencies such as the AUD have depreciated relative to the EUR. The period around the Lehman Brothers bankruptcy is probably the most natural to use. major EM currencies including the CE3.Barclays | Risks and repercussions of a Greek exit IMPLICATIONS FOR FX MARKETS EUR/USD likely to fall independent of the Greek election result Paul Robinson +44 (0)20 7773 0903 paul. There has been no comparator with such complicated economic. economic developments also matter despite being overshadowed recently. That is consistent with the stronger performance of Figure 1: Recent currency moves have been similar to those Figure 2: … and the ordering of G10 currencies has been in the financial crisis – though many European currencies approximately the same as in the financial crisis have underperformed… 2 Move relative to the USD since 1 Greek election (%) 0 -1 -2 -3 -4 EUR -5 -6 -7 EMEA currencies -8 -9 -45 -35 -25 -15 -5 12 10 8 6 R = 0. there has been a “European” side to recent currency moves. especially for medium-term moves. the relative currency performance since the Greek election has many similarities to the period from the Lehman bankruptcy to the trough of equity markets in March 2009 (Figures 1 and 2).equity mkt trough (%) Note: The currencies included are the G10. at times.s. In addition to the risk element. financial. at least in the short run. Even if Greece stays in the euro. and. However. JPY and GBP. JPY and GBP in particular. only it would be much more severe: the EUR would depreciate against the USD.7335 2 Rank 4 2 0 JPY NOK CAD GBP NZD AUD USD CHF EUR SEK 35 5 15 Performance in the 2008/9 sell off Performance since the Greek election Source: Barclays Research Move against USD Lehman bankruptcy . and the EUR/CHF floor has come under increased pressure. Nonetheless. Indeed. it is natural to look for past events which might give guidance on the likely outcomes. economic weakness is likely to lead to further EUR downside. The deepening euro area crisis has led to two broad patterns in currency markets so far: the EUR has depreciated against the USD. The effect of a Greek exit on global currencies would follow the pattern since the Greek election on 6 May. the EUR has not depreciated across the board. In anything beyond the very short run. The combination of European-specific currency moves and more widespread risk-on/risk-off moves at a global level appears likely to continue in response to European developments. political and legal issues.

and it would be very surprising if measures were not taken if Greece were to leave. Figure 3: Possible outcomes for currencies in light of a disorderly Greek exit from the euro area JPY Spot Half 2008-09 sell-off Full 2008-09 sell-off Source: Barclays Research EUR 1.19 NOK 6.46 NZD 0.03 6.400 1.22 8.4 The above calculations use the recent past as the template for relative currency moves.82 GBP 1.89 BRL 2.1 19.40 AUD 0. This is not necessarily going to remain the case ahead of the Greek election.00 2.67 28. No one can say with any confidence how much more severe it would be.81 11.90 0.28 9. are significantly less than they were at the time of the Lehman bankruptcy.44 1. Barclays Research 31 May 2012 Swi Nor US . but so far the authorities have made few policy changes in the face of the heightened risks. which matter a lot for FX.4 78.200 1. deposit insurance is effective at reducing the acute risks of bank runs.10 1. partly because important variables such as interest rate differentials. As a starting basis for analysis.60 SEK 7.98 CAD 1.42 23. for all the discussion about a Greek exit.1 HUF 238.35 9.1 PLN 3. only that it would be much more severe. We therefore consider several different scenarios in which the euro area takes steps to limit problems ahead of the Greek election.25 1.68 0.76 0.9 389. current spot values suggest that EUR/USD would fall to between 0. Scenario 1: Measures are taken to limit banking sector contagion Two possible measures are the introduction of some form of euro area-wide deposit insurance or further capital injections into vulnerable banks. the most likely outcome would be closer to the smaller moves.32 ZAR 8.11 0. In our view.7 295. If credible.98 and 1.000 800 600 Jan-08 500 450 400 350 300 250 200 150 Nov-08 Sep-09 Jul-10 May-11 Mar-12 CRB (RHS) Figure 5: European banking systems generally larger than those outside Europe (total banking system assets/GDP) 600% 500% 400% 300% 200% 100% 0% Swe UK Japan Can 36 Aus S&P500 (LHS) Source: Bloomberg Source: IMF. If this were to happen.56 1.4 77.3 5. partly because it is much easier for retail Figure 4: The sell-off of risky assets has been relatively muted so far 1.Barclays | Risks and repercussions of a Greek exit currencies such as GBP that have benefitted from safe-haven flows out of the euro area over recent months.65 7.16 79.7 CZK 20. it is far from fully reflected in market prices.20 2. we assume the effect on global currencies would follow the pattern since the Greek election.72 KRW 1176 1293 1436 RUB 32 40 51 MXN 13. but a reasonable range seems to be that it would lead to currency moves between half as large and the same size on average as those in the post-Lehman period.5 4.03 1. This is even more apparent in the underperformance of the EUR and EMEA currencies in the period since the Greek election (Figure 1).98 0.11 In our view.600 1.9 16.

we view banking sector fragility as the most likely way that euro area problems become truly global. in which monetary policy has less scope to loosen and the economies would benefit less from a stronger euro area economy. They would also be the most directly affected by a Greece exit and would probably loosen monetary policy. So the currency winners would likely initially be the USD and JPY. the SMP purchases and the LTROs. Independent of whether it is introduced. weaker confidence and yet lower growth. lessen the risk element and therefore the size of moves following a Greek exit. along with the ECB. it would be positive for risk appetite generally. partly via a weaker EUR. The economies that would likely benefit most from looser ECB policy would be those with the closest trading links with the euro area – largely other European economies (Figure 5).man Germany . a stronger capital basis for European banks is needed and would help restore general financial market confidence. threatening a vicious circle of austerity plans falling behind schedule. However. Figure 6: European economies are much more exposed to euro area demand 60% 50% 40% 30% 20% 10% 0% Swi Nor Swe UK NZ US Jpn Can Aus % of GDP Source: IMF Figure 7: Even core European economies are slowing (PMIs) 65 60 55 50 45 40 35 30 Mar-06 Feb-07 Jan-08 Dec-08 Nov-09 Oct-10 Sep-11 Germany . Second. In both France . a more resilient euro area banking system would have three effects. Third. While the ECB would be unlikely to achieve much lower short-term money market rates. in general. these tend to be European currencies. In our view.Barclays | Risks and repercussions of a Greek exit investors to understand insurance schemes than to judge the solvency of banks. But our banks analysts are concerned that the threat of “redenomination” arising from leaving the euro area means that even an EA-wide deposit scheme might prove ineffective in gaining credibility and thus stopping potential runs. Scenario 2: The ECB takes a more proactive role The ECB has already taken significant measures: eg.serv Source: Bloomberg France . We therefore think that proactive moves to stabilise European banks would primarily support European currencies relative to the baseline above and.serv % of total exports 31 May 2012 37 . if it were to happen. Reducing banking sector weakness would thus likely lead to a lower risk premium on the EUR because it reduces the correlation between euro area and global risk. signalling a change of focus towards medium-term growth prospects would likely boost confidence. growth remains very weak. something that has happened only to a limited extent thus far (Figure 3). it would benefit currencies of economies with large banking systems relative to the size of their economies (Figure 4) and relatively close banking ties to the euro area. It is important to distinguish between the effect of looser ECB monetary policy on economies and their associated currencies. First.

If Greece left.15. the euro area problems are so dominant at present and it is such a binary situation that the immediate response is likely to be “risk on” or “risk off”. it is our core view and therefore deserves some discussion. Prior to the recent increase in concerns.Barclays | Risks and repercussions of a Greek exit Eventually. Political risk has increased – not only in Greece but also in “core” countries such as the Netherlands. If Greece were to leave the euro area in the next couple of months. for the EUR at least. the easiest and quickest response by the authorities would be aggressive policy loosening by the ECB. Trading the Greek crisis using currencies Ideally. as discussed above. we now think the EUR is likely to depreciate more quickly and further than we previously expected. but it would still be profitable in that case and it cheapens the trade.19. However. that bounce would likely prove short-lived. Positioning via options is more attractive in our view than in spot because the possibility of a risk rally following a euro-friendly outcome in the Greek election would make it very easy to be stopped out of a spot position. but in the immediate aftermath of a Greek exit. prospects for the EUR are poor beyond a potential short-lived bounce. Even if Syriza were to win the Greek election. What if Greece stays? Though this is not our main focus here. it is very controversial politically and would need a major policy reversal by the German government if it were to take place quickly. Recent developments have generally been negative for the EUR.2441). However. the initial move would be much more aggressive. However. both of which are conditional on Greece remaining in the euro area. Nonetheless. 31 May 2012 38 . which costs 1.21 and 1. The problems in the Spanish banking system have highlighted the issues facing both banks and sovereigns in the euro area. Trades we find attractive are: Buy a 6m EUR/USD put spread with strikes of 1. both face huge problems. and risk-reward strongly favours positioning for further downside in European currencies. and therefore on global risk appetite. we would expect a looser monetary policy stance to be the major influence on currencies. whether or not Greece leaves. the initial response would be a rally of risky currencies. If this were to happen. Whether Greece stays or leaves the euro area. risk would likely dominate. And economic prospects have taken another turn for the worse (Figure 6).36% EUR (spot ref 1. adding to EUR weakness even as it supported the euro area economy. in particular the EUR. we think it would have a major positive effect on confidence.24 and 1.20 one-year forecast. If no significant measures have been taken prior to a Greek exit. Scenario 3: The euro area moves towards collectivisation of debt Many observers consider this essential in the long run if the euro area is to avoid repeat periods of instability. non-European EM currencies should also be supported to some extent. reducing the multipliers used in the baseline case above. we had expected EUR/USD to gently depreciate towards our 1. it is by no means clear that a Greek exit would take place. we think there is little likelihood of it happening in the near term. Buying a put spread limits the potential profit if Greece does leave. We have lowered our 3m and 1y forecasts to 1. In our view. there would be trades that would perform well whether or not Greece leaves. including EUR/USD. In light of these issues and recent economic data. as discussed in the “What if Greece stays” section. However. respectively.

the expected moves of EUR/CHF and EUR/USD would become more closely correlated. And if global risk appetite does stabilise. our commodities team views oil prices as likely to start to rise again. We recommend buying 3m straddles in GBP/USD and USD/CHF (spot refs. 1.9660) and delta hedging them.768% USD up front.5583 and 0.Barclays | Risks and repercussions of a Greek exit Short an equally-weighted basket of EUR/GBP and EUR/NOK. GBP/USD volatility should move sharply higher. But USD/CHF volatility would likely increase less because we think that many investors would position for a possible abandonment of the EUR/CHF floor. Barclays Research 1/1/10 = 100 Jul-11 Sep-11 Dec-11 Mar-12 eurgbp and eurnok Buy USD/GBP volatility and sell USD/CHF vol. that would likely increase further. If Greece were to leave. This would have done well for much of the period since the beginning of 2010 when the euro area crisis problems really started. 31 May 2012 39 . In the short run. The spread is significantly lower than its average and volatility spreads tend to mean revert. albeit only temporarily. Figure 8: A basket of short EUR/GBP and EUR/NOK should continue to fall in the medium run 102 100 98 96 94 92 90 88 86 Jan-10 Apr-10 Jul-10 Oct-10 Dec-10 Apr-11 eurgbp and eursek Source: Bloomberg. In the event of a Greek exit. which we would expect to be temporary. The investor receives 1. We think both the GBP and NOK are likely to appreciate against the EUR in the medium run whether or not Greece leaves. We stress that we expect the floor to hold but recognise that there is an increasing amount of scepticism in the market. EUR/GBP would likely fall significantly in light of a Greek crisis offsetting in liquidity-driven squeeze higher in EUR/NOK. supporting the NOK. If so.

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