Bailouts or Bankruptcies? Europe Begins Working on Plan B for the Euro

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How should the euro zone solve its currency crisis? European capitals are currently preparing to inject fresh capital into their banks with some economists arguing that saving financial institutions would be cheaper than propping up entire countries.

World Bank President Robert Zoellick, International Monetary Fund President Christine Lagarde and German Chancellor Angela Merkel: Would it be better to rescue banks or states? Zoom
AP

World Bank President Robert Zoellick, International Monetary Fund President Christine Lagarde and German Chancellor Angela Merkel: Would it be better to rescue banks or states?

How much longer will the euro zone be patient with Greece? A growing number of politicians and economic experts are criticizing the rescue packages for the overly indebted nation and are instead demanding that Greece be allowed to slide into insolvency. Paris and Berlin continue to hold back. But, to be on the safe side, they are already preparing their domestic banks for a possible Greek default.

On Tuesday, European Union finance ministers discussed plans to provide state capital to shore up Europe's major banks. And during its regularly scheduled interest rate meeting on Thursday, the European Central Bank (ECB) committed significant sums of money to come to the aid of financial institutions. ECB President Jean-Claude Trichet warned European governments to ensure that their banks were sufficiently capitalized.

In Germany, Chancellor Angela Merkel of the conservative Christian Democratic Union (CDU) has been clear in her support of this position. On Wednesday, together with European Commission President Jose Manuel Barroso, she announced her preparedness to support a bank bailout. Following a meeting of the heads of the most important international economics and financial institutions, the chancellor reiterated her position on Thursday, saying that if banks urgently need money, the European states should "not delay" in providing financial aid. That, she said, would be "intelligently invested money."

Crisis Returns to Banks

Behind this week's string of announcements are growing concerns that the European debt crisis is spreading and could soon threaten to engulf major banks, many of which still hold a good deal of Greek government bonds and even more Spanish and Italian securities on their books. Many banks would likely be unable to withstand a national insolvency inside the euro zone. They would be forced to write off billions, and some could face bankruptcy themselves as a result. Trust has diminished to such a degree in recent weeks that interbank lending has dried up, creating a credit crunch not seen in Europe since the 2008 collapse of Lehman Brothers.

More than anything, though, the threat of a Greek bankruptcy has risen significantly. The Greek economy has collapsed, and the country has once again failed to meet its austerity targets. Patience is now dwindling among the other euro-zone member states that have been stepping up to rescue the country.

Voices calling for an orderly insolvency in Greece are growing. Within the euro zone, this position is most pronounced in Slovakia. But there are also critics within the German government, a group led by Philipp Rösler, the head of the business-friendly Free Democratic Party (FDP), the junior partner in Merkel's coalition. The faction of supporters of insolvency is also growing among economists. Thomas Straubhaar, director of the influential Hamburg Institute of International Economics, for example, has stated that a system needs to be created that would permit a euro-zone country to go through bankruptcy proceedings. The problem, however, is that so far no one has been able to say how, exactly, an orderly insolvency would proceed.

The consequences could be disastrous for banks. Private financial institutions only recently agreed to write off 21 percent of the value of the Greek government bonds they possess. In the event of an actual insolvency, the losses would be significantly higher -- with many experts predicting banks would have to write off half of their entire Greek bond holdings.

German financial institutions would likely survive a Greek collapse. Data from the recently published stress test indicated that the country's biggest banks -- Deutsche Bank and Commerzbank -- still held Greek securities valuing a total of €1.7 billion and €3 billion, respectively, at the end of 2010. But the banks have already written off a large share of those holdings as losses. Deutsche Bank has stated that the current volume of its Greece portfolio is around €900 million and that all of its Greek securities have already been written down to their current market value.

Saving Banks Cheaper than Rescuing States

"A debt haircut for Greece might be uncomfortable for German banks, but they could cope with it," said Dieter Hein, a banking analyst at independent research institute Fairesearch. The outstanding volume, he said, is no longer high enough to endanger the two banks.

Unfortunately, the problems stretch well beyond two German banks. A Greek insolvency would hit French banks harder and would be catastrophic for financial institutions in Greece. The largest Greek bank, the National Bank of Greece, held close to €19 billion in Greek government bonds on its books at the end of 2010. If forced to write off 50 percent of those securities, the bank's equity capital would vanish in its entirety.

The second problem is potentially even graver. What happens if the pressure created by a Greek insolvency further increases the pressure on other highly indebted nations -- such as Portugal, Spain or Italy -- and drives them to bankruptcy? Under that scenario, there's a good possibility the contagion would become unsustainable for German banks, too. The state would have to infuse them with fresh money in order to rescue the financial institutions from ruin, just as the German government did with Commerzbank following the Lehman Brothers collapse. Only this time around, even more banks would have to be rescued using state funds -- in almost every country in Europe.

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Graphic: Greek bond yields over the years. Zoom
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Graphic: Greek bond yields over the years.

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