A year after European officials bailed out Greece, investors saythe region's banks haven't raised sufficient capital or cut loansenough to withstand the contagion that may follow a default.

While European lenders reduced their risk tied to Greece by 30percent to $136.3 billion last year by not renewing loans, writingdown the value of debt and shifting it off their books, they stillhave almost $2 trillion linked to Portugal, Ireland, Spain andItaly, figures from the Bank for International Settlements show,leaving them vulnerable if the crisis spreads.

“The Greek debt situation certainly has the potential to createhavoc with the European banking system,” said Neil Phillips, a fundmanager at BlueBay Asset Management Plc in London, which overseesabout $45 billion. “A Greek default and the ramifications of thatwould be too ghastly for Europe and the European banking system tocontemplate right now.”

German Chancellor Angela Merkel retreated last week from aconfrontation with the European Central Bank that threatened toshove Greece into the euro zone's first sovereign default,softening demands that bondholders be forced to shoulder a big partof a rescue. Questions remain about how any such burden- sharingagreement would work without prompting ratings companies to declarea default and whether Greek Prime Minister George Papandreou canpersuade legislators to pass the austerity measures needed for abailout.

Forceful Reminder
“We forcefully remindedthe Greek government that by the end of this month they have to seeto it that we are all convinced that all the commitments they madeare fulfilled,” Luxembourg Prime Minister Jean-Claude Juncker toldreporters early today after chairing a euro-crisis meeting inLuxembourg.

European governments failed to agree on releasing a loan payoutto spare Greece from default, ramping up pressure on Papandreou tofirst deliver budget cuts in the face of domestic opposition andleaving open whether the country will get the full 12 billion euros($17.1 billion) promised for July.

Decisions on the next payout and a three-year follow-up packagewere put off until early next month.

A Greek sovereign default could lead to insolvency of thecountry's banks and a liquidity crisis as a result of a run ondeposits, Standard & Poor's said in a June 15 report.

Insolvency Fears
Concern that Greece islurching toward insolvency drove the 48-company Bloomberg EuropeBanks and Financial Services Index to a one-year low today andlifted the cost of insuring against default on the sovereign debtof Greece, Ireland and Portugal close to record levels lastweek.

The cost of insuring Greek debt saw the biggest weekly increaselast week, while
credit-default swaps on National Bank of Greece SA, the country'sbiggest bank, rose to a record, according to CMA, a data providerowned by CME Group Inc. that compiles prices quoted by dealers inthe privately negotiated market.

Banks led an increase in the cost of protecting Europeancorporate bonds from default, with the Markit iTraxx FinancialIndex of credit-default swaps on subordinated debt rising 7 basispoints to 296.5 as of 11 a.m. in London, according to JPMorganChase & Co.

Analysts say contagion following a Greek default could play outlike this: Refinancing costs for Ireland, Portugal, Spain andpossibly Italy and Belgium would soar, thwarting efforts to rein inpublic deficits and putting states under pressure to restructuretheir debt as well; banks in countries with weak finances couldface a run by depositors, while other lenders would see theircapital eroded by credit writedowns; investors would shun equitymarkets and the euro and seek the safest securities. In aworst-case scenario, panic could freeze credit markets, as happenedafter the bankruptcy of New York-based Lehman Brothers HoldingsInc. in September 2008.

Market 'Massacre'
“If, after a year ofdiscussion without conclusion, we conclude there will be a haircut,the next morning the market will massacre Ireland, Portugal andmaybe other countries,” Federico Ghizzoni, 55, chief executiveofficer of UniCredit SpA, told journalists in Vienna June 16,referring to a Greek default.

The concern is already having an impact on European banks. BNPParibas SA, France's biggest bank, and rivals Societe Generale SAand Credit Agricole SA may have their credit ratings cut by Moody'sInvestors Service because of their investments in Greece, theratings company said on June 15. German banks could also be at riskfrom contagion, Fitch Ratings said last month.

Infection Risk
Merkel, 56, said on June 17she would work with the ECB to get Greek creditors to participatein a rescue on a voluntary basis, seeking to appease ECB PresidentJean-Claude Trichet, 68, who contends that any compulsory move toinvolve bondholders would trigger a default. The ECB doesn't acceptdefaulted debt as collateral when providing the cash banks inGreece, Portugal and elsewhere depend on after being shut out ofcredit markets.

Merkel said June 18 in Berlin that policy makers must make surethe Greek crisis doesn't infect the rest of the euro region andspark a new global financial crisis.

“We all lived through Lehman Brothers,” she told a meeting ofactivists from her ruling Christian Democrat party. “I don't wantanother such threat to emanate from Europe. We wouldn't be able tocontrol an insolvency.”

The risk that euro-area banks holding Greek government bondswill be saddled with losses increased after S&P slapped Greecewith the world's lowest sovereign credit rating June 13.

Lehman Legacy
Greece should “absolutelynot default,” Josef Ackermann, CEO of Frankfurt-based Deutsche BankAG, said in a June 17 interview in St. Petersburg, Russia. The EUneeds to provide more aid to the country if required, he said.

Ackermann, 63, told CNBC the same day that the risk of a Greekdefault lies in “what is going to happen in other markets and whatis going to happen in other countries,” concluding that “no one hasa clear answer.”

Ackermann knows about contagion firsthand. He told an audiencein Frankfurt's Congress Center in September 2007 that risks fromthe U.S. subprime mortgage market were “manageable.” The crisisspread to other markets soon after, leading to more than $2trillion of losses and writedowns worldwide and the collapse ofLehman Brothers a year later.

“The worst consequence of any Greek sovereign default for Germanand other European banks would be a sharp increase in generalcapital market and creditor risk aversion at a time when many banksare still in rehabilitation mode,” Michael Dawson- Kropf, aFrankfurt-based Fitch analyst, said in a May 25 report.

Raising Capital
European banks are more atrisk from a “disorderly” market reaction to Greek debtrestructuring than any losses on their holdings of the country'sbonds, James Longsdon, a managing director at Fitch, said in aninterview in Seoul today. Greek government debt held by Europeanbanks isn't large enough to trigger an “insolvency event” at thelenders, he said.

European banks have raised 59 billion euros since stress testslast July, according to calculations by Huw van Steenis, an analystat Morgan Stanley.

Independent Credit View, a Swiss ratings company that predictedIreland's banks would need another bailout last year, said in astress-test study earlier this month that 33 of Europe's biggestbanks would need $347 billion of additional capital by the end of2012 to boost their tangible common equity to 10 percent from 9.1percent at the end of 2010. The group chose that threshold becauseit's about 30 percent above the average ratio for the past 10years.

An S&P stress test published in March estimated Europeanbanks would need as much as 250 billion euros in fresh capital iffaced with a “sharp” increase in yields and a “severe” economicdecline.

Germany Tops Lenders
French lenders hadthe highest overall foreign claims on Greek borrowers of $56.7billion, including $15 billion in public debt, at the end of 2010,data from the BIS showed. French banks had $589.8 billion of loanstied to Ireland, Italy, Portugal and Spain.

German lenders were the biggest foreign owners of Greekgovernment debt with $22.7 billion in holdings last year and hadthe second-most overall claims, the BIS said. Their claims onIreland, Italy, Portugal and Spain amounted to $498.8 billion. Thetwo countries hold more than 60 percent of all foreign claims onGreece, according to BIS data.

Banks in the two countries have lowered their risk tied to Greekpublic debt by 25 percent to $37.6 billion from the end of March2010 through December. The main reason for the decline is companiesletting bonds or loans expire without renewing them, according toLutz Roehmeyer, who helps manage about $17 billion at LandesbankBerlin Investment in Berlin. Lenders also have been writing downthe value of Greek holdings, setting aside provisions and movingassets into so-called bad banks, as well as selling shares to boostreserves, he said.

Too Big to Shoulder
“The direct hit fromGreece is manageable because investors have had time to prepare,but contagion to other countries is the big risk,” Roehmeyer said.“If the crisis spreads to Ireland, Portugal and Spain, it would betoo big for the banks to shoulder.”

The ECB's total exposure to Greece may be between 130 billioneuros and 140 billion euros, Dutch Finance Minister Jan Kees deJager said earlier this month. The ECB provided 90 billion euros ofliquidity to Greek banks, he said.

The ECB is lending unlimited amounts of cash to support bankingsystems and has relaxed collateral requirements. In May 2010, ittook the unprecedented decision to start buying the bonds ofdistressed nations in an effort to calm markets as Greece's fiscalwoes began to infect other euro-area members.

Credit-Default Swaps
The impact ofcredit-default swaps, which led to the near- collapse of AmericanInternational Group Inc. in 2008, may be limited in a Greekdefault. Credit-default swaps on Greek sovereign debt cover a netnotional $5 billion, according to the Depository Trust &Clearing Corp., which runs a central registry that captures mosttrades. That's only 1 percent of the government's $482 billion ofbonds and loans outstanding, according to data compiled byBloomberg.

Swaps on Italian sovereign debt cover a net notional $25billion, the most of any country or company in the world, accordingto DTCC. That compares with $2.3 trillion of debt.

Most banks have already had to write down the value of theirGreek bond holdings as they have fallen in the market, said FlorianEsterer, who helps manage more than $60 billion at Swisscanto AssetManagement AG in Zurich.

“The biggest problem that we have is less to do with the loss ofGreece as such and more to do with the question of what wouldhappen to other countries,” Esterer said. “The risk of contagion isprobably exactly the same as a year ago.”

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