Euro zone bank safety net leaves holes unplugged

By Paul Carrel and John O'Donnell

FRANKFURT/BRUSSELS | Tue May 29, 2012 9:44am BST

(Reuters) - As the euro zone ponders a possible Greek exit, policymakers have not yet built a shield robust enough to prevent a bank run in one country sending others in the bloc deeper into crisis.

A push by the European Central Bank for the euro zone to stand behind struggling lenders is slowly gaining traction with government leaders but the bloc has yet to build backstops to prevent, or cope with, a sudden collapse of confidence in banks.

Last week, European leaders discussed pan-European means of supporting banks, measures the ECB hopes will include a bank resolution fund to deal with the fallout from the wind-up or restructuring of a failing lender.

Such a body would complement the 1 trillion euros of 3-year credit the ECB has lent in recent months to banks across the 17-country euro zone, which has helped oil the wheels of Europe's banking system where confidence is so low that most remain reluctant to lend to one another.

But a wave of withdrawals by depositors - either for fear that their government is too weak to stand behind its banks or that their country will exit the euro and switch their savings into a vastly devalued national currency - would represent a whole different scale of crisis.

Such pressure on Ireland's banking system prompted a national bailout by the International Monetary Fund and European Union.

Now investors are worried about the contagion effect a Greek exit from the euro zone could have on savers in other countries.

"Preventing bank runs in Italy, Spain and Portugal should be the top priority," said Berenberg Bank economist Holger Schmieding. "Policymakers need to make sure that the potential Greek precedent of a forced conversion of domestic euro deposits into a weak new currency would not spark a run on banks ... elsewhere."

The ECB is pressing the euro zone to set up a fund that would prevent this dangerous ripple effect, a message reinforced by ECB policymaker Joerg Asmussen last week.

"The recapitalisation of a troubled bank by its government may lead to a deterioration of the government's fiscal position," Asmussen said. "The deteriorating fiscal position in turn further weakens banks' balance sheets, through their holdings of sovereign bonds.

"This feedback loop has to be stopped ... A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks."

Any pan-euro zone deposit guarantee scheme would need to be large in order to stem ebbing confidence.

The typical national guarantee in Europe now covers the first 100,000 euros on deposit, something that would do little to reassure corporate investors with millions.

It was the decision by companies in Ireland to withdraw deposits that accelerated its banking crisis.

The question of how to shut down or restructure teetering banks has risen to the top of European policymakers' agenda as concerns grow about the impact if Greece were to leave the euro zone, and as problems deepen in Spain's large banking sector, which is laden with bad property debts.

But policymakers are far from setting up a backup fund, not least because European paymasterGermany, who does not want to support laggard banks in Spain, is reluctant to finance it.

WAITING FOR DRAGHI

In the absence of a resolution fund or insurance scheme to deal with a bank collapsing, many investors expect the ECB would act to head off a bank run or a similar systemic threat.

ECB President Mario Draghi has said the 1 trillion euros the bank released into the financial system with twin 3-year, ultra-cheap lending operations - or LTROs - in December and February avoided a major credit crunch.

In the case of Greece, the belief is that the ECB would act again to contain a bank run, said Clemens Fuest, a professor at Oxford University and a member of the academic advisory board of the German Federal Ministry of Finance.

"The expectation seems to be that the ECB will prevent it by providing whatever liquidity is needed," he said, adding that this could either be from the ECB directly or as emergency funding from the Bank of Greece with the ECB's backing.

Greece's four largest banks received some help this week, with the country's bank stability fund approving an 18 billion euro injection of bailout money to rescue them.

If this proves insufficient and contagion spreads to other countries' banking sectors, policymakers may rapidly have to dust off plans to provide guarantees to weaker banks or inject further capital - scenarios discussed in the past but on which there has been no agreement.

CAPITAL FLIGHT

The banking environment has steadily deteriorated, according to statistics from the Bank for International Settlements, which chart the flight of capital from the euro zone's weakest members.

Figures from December last year show a sharp decline in deposits from abroad held in banks in Greece from $160 billion in late 2009 to less than $80 billion.

Ireland's bank deposits from abroad fell from $905 billion to $471 billion over that time and a similarly sharp fall was seen in Portugal.

Households and companies have almost 11 trillion euros on deposit with banks in the euro zone, with over 3 trillion in Germany alone, according to ECB statistics.

One way to reinforce banks would be to allow the euro zone's rescue scheme, the European Stability Mechanism (ESM), to inject capital directly into lenders - an idea which Spanish Prime Minister Mariano Rajoy is pressing but which Berlin opposes.

Under Europe's existing arrangements, countries like Spain - should they require assistance with their banks - must apply for a sovereign bailout programme, a humiliation too far.

"Taking on the risk of a bank failure at a European level through the ESM is far preferable to the much greater risk of a sovereign default," said John Fitzgerald, of the Economic and Social Research Institute, a Dublin-based think-tank.

In the absence of that, Berenberg's Schmieding said were Greece to leave the euro zone, Spain should apply to Europe's bailout funds for aid to recapitalise its banks.

The ECB could cut interest rates and - together with national central banks - supply banks with liquidity, he said, possibly with new long-term loans.

"COURAGEOUS LEAP"

Some ECB policymakers are open to considering a further LTRO, sources close to the bank say, but they face resistance from orthodox policymakers already worried by the balance sheet risks the ECB has taken on with the first two operations.

Germany's Bundesbank has already said the ECB should not significantly increase the risks associated with providing liquidity to Greece, and believes the impact of a Greek exit from the euro zone would be substantial but "manageable".

Easing the requirements on the collateral banks need to put up to access ECB funds is another way the central bank could help lenders short of liquidity - but such a technical step will not help if they become insolvent and a systemic risk.

Draghi is pressing governments rather than the ECB to take the decisive action and delivered a stark message last Thursday, saying: "We have reached a point in which the process of European integration needs a courageous leap of political imagination in order to survive."

(Additional reporting by Eva Kuehnen, editing by Mike Peacock)