Europe's banks, sitting on $1.19 trillion of debt to Spain,Portugal, Italy and Ireland, are facing a wave of losses if Greeceabandons the euro.

While lenders have increased capital buffers, written down Greekbonds and used central-bank loans to help refinance units insouthern Europe, they remain vulnerable to the contagion that mightfollow a withdrawal, investors say. Even with more than two yearsof preparation, banks still are at risk of deposit flight andrising defaults in other indebted euro nations.

“A Greek exit would be a Pandora's box,” said Jacques-PascalPorta, who helps manage $570 million at Ofi Gestion Privee inParis, including shares in Deutsche Bank AG and BNP Paribas SA.“It's a disaster that would leave the door open to other disasters.The euro's credibility will be weakened, and it would set aprecedent: Why couldn't an exit happen for Spain, for Italy, andeven for France?”

The prospect of Greece leaving the 17-nation euro regionincreased after parties opposed to the terms of the nation's secondbailout by the European Union and the International Monetary Fundwon most of the votes in May 6 elections. A fresh round of votingwill be held June 17 after politicians failed to form a government.For the first time since the crisis began in November 2009,European leaders and central bankers are speaking openly of Greeceabandoning the currency union.

The immediate risk for Europe's banks, and for the euro region,would be a deposit flight from indebted nations such as Portugal,Ireland, Spain and Italy on speculation those countries also mightquit the currency. Lenders in Germany, France and the U.K. had$1.19 trillion of claims on those four nations at the end of 2011,Bank for International Settlements data show.

Should Greece go, its new currency probably would suffer animmediate devaluation of as much as 75 percent against the euro,forcing individuals and companies to default on foreign loans,economists at UBS AG said. Unless European leaders could make acredible case that a Greek exit was an exceptional and isolatedincident, depositors in other nations might decide to withdraweuros from banks or shift them to countries seen as safer.

“The highest risk facing the banks at the moment is thepossibility of deposit runs,” said Andrew Stimpson, a bankinganalyst at Keefe, Bruyette & Woods Ltd. in London. “The morepolicy makers continue to openly discuss an exit, the more likelythat people in Spain, Ireland and Portugal pull money out of theirlocal banks.”

Greek Withdrawals

That already may be happening. Banks in Greece, Ireland, Italy,Portugal and Spain saw a decline of 80.6 billion euros ($103billion), or 3.2 percent, in household and corporate deposits fromthe end of 2010 through the end of March, European Central Bankdata show. Lenders in Germany and France saw an increase indeposits of 217.4 billion euros, or 6.3 percent, in the sameperiod.

Greek central bank head George Provopoulos told PresidentKarolos Papoulias last week that savers have withdrawn as much as700 million euros and the situation may worsen, according to thetranscript of the president's meeting with party leaders publishedMay 15. Greece had 160 billion euros of bank deposits on March 30,down almost 75 billion euros from the peak in 2009, according tothe latest data from the central bank.

UBS, the third-biggest manager of money for the wealthy, sees a20 percent chance of Greece leaving the euro within six months, thebank's chief investment office, led by Alexander Friedman, toldclient advisers in an internal note last week.

To prevent contagion, countries in the euro area would have toform a full-fledged political and fiscal union immediately andimplement uniform guarantees on bank deposits throughout theregion, Thomas Wacker and Juerg de Spindler, economists atZurich-based UBS, said in a separate note. They said such aresponse can be ruled out.

The odds of a Greek exit are seen rising over time. CitigroupInc. analysts this month raised the likelihood of such an event tobetween 50 percent and 75 percent over the next 18 months afterGreece's inconclusive elections.

“Banks' risk-management departments have probably taken intoaccount a Greek exit and most would likely have a plan on how toproceed,” said Robert Liljequist, a Helsinki-based fixed-incomestrategist at Swedbank AB. “The big problem is that nobody reallyknows what would happen in the markets if the country leaves thecurrency, so there is a significant amount of risk with thatscenario.”

ECB Lifelines

The ECB's unprecedented provision of 1.02 trillion euros inthree-year cash in December and February helped calm financialmarkets in the first quarter by removing concern that banksunwilling to lend to one another would run out of cash. Lenders inSpain and Italy also used the funds to buy sovereign debt, reducinggovernment borrowing costs.

The rebound was short-lived as doubts about the health ofSpain's banks and questions over Greece's future returned. On May9, the Euro Stoxx Banks index dropped beneath the lows of March2009. The 30-company index of euro-region banking stocks fell 2.8percent by noon Frankfurt time today. The Markit iTraxx FinancialIndex of credit-default swaps on the senior debt of 25 Europeanbanks and insurers reached 308.398 on May 18, the highest sinceDec. 19, two days before the ECB's first offering of long-termfunds. The euro fell today to a 21-month low against thedollar.

Lenders probably would need another 800 billion-euro liquiditylifeline from the ECB to help stem contagion from a Greek exit,Citigroup analysts estimated in a May 17 note.

ECB President Mario Draghi said last week that Greece couldleave the euro area and signaled policy makers won't compromise ontheir key principles to prevent an exit.

The fresh doubts about Greece coincide with struggles by Spain,the euro region's fourth-largest economy, to shore up its banksfollowing the bursting of a property bubble. The government ofMariano Rajoy announced this month a fourth effort in less thanthree years to rebuild confidence in the industry as bad loanssoar. The state took control of Bankia group, the lender with themost Spanish assets, and ordered banks to set aside an additional30 billion euros on property loans.

With Spain's economy in a recession and unemployment at morethan 24 percent, more borrowers are defaulting. Bad loans as aproportion of total lending in Spain jumped to 8.37 percent inMarch, the highest since August 1994, data published last week bythe Bank of Spain show. As much as 8.21 billion euros of loanssoured in the first quarter, 90 percent more than in the sameperiod of last year.

Moody's Downgrades

Moody's Investors Service downgraded 16 Spanish banks last week,including the two largest, Banco Santander SA and Banco BilbaoVizcaya Argentaria SA, citing the nation's economy, reduced fundingaccess for lenders and a deterioration in loan quality. The ratingcompany also cut 26 Italian banks, including UniCredit SpA andIntesa Sanpaolo SpA.

In all, Moody's said in February it would review the ratings on114 banks in Europe, as well as eight non-European firms with largecapital-markets businesses, to assess the impact of the debtcrisis.

Spanish, Italian, French and U.K. banks were the biggestborrowers in the ECB's long-term refinancing operations, or LTROs,according to data compiled by analysts at Credit Suisse Group AG.While the cash injections temporarily soothed markets, they led toa retrenchment from countries on the periphery of the euro region,undermining the EU's “solidarity incentive,” said Christine Schmid,a Zurich-based analyst with the bank.

That may explain the recent wave of comments contemplating whatwas once unthinkable. While German Finance Minister WolfgangSchaeuble last week urged the Greek government to stay in themonetary union, he signaled that a departure would be manageable asEuropean authorities “react in such a way as to ensure that theconsequences are as contained as possible.” Bank of France GovernorChristian Noyer told journalists in Paris last week that “whateverhappens in Greece” won't place any French financial institution indifficulty.

A year ago Schaeuble said a Greek exit would create an“exceptionally difficult” situation that would be “hard tocontrol,” while Noyer called the possibility of a Greek default a“nightmare” and a “catastrophe.”

What's changed is that banks in the so-called core EU countriesof Germany, France and the U.K. used funds from the ECB in Decemberand February to insulate their southern European units againstlosses should one or more country exit the euro.

“If you're a U.K. lender and you've lent 10 billion euros toyour Spanish subsidiary and Spain exits, you're suddenly only goingto get paid back in 50 percent devalued pesetas and you're on thehook for 5 billion euros,” said Philippe Bodereau, London-basedhead of European credit research at Pacific Investment ManagementCo., the world's largest bond investor.

Insulating Units

One way multinational banking groups are mitigating that risk isby replacing their own funding lines to subsidiaries in the regionwith ECB loans. Deutsche Bank, Europe's biggest bank by assets,tapped “a small amount” of ECB cash to help fund corporate andretail business in continental Europe, where it has sizeableoperations in Italy and Spain. BNP Paribas, Europe's third-biggestbank, used the programs to help fund its Italian unit as it reducesintergroup backing.

Barclays Plc, the U.K.'s second-biggest bank by assets, took 8.2billion euros of three-year loans from the ECB to provide “fundingstability” for its units in Spain and Portugal. Lloyds BankingGroup Plc said it's using central bank money to “ring-fence” itsSpanish operation. Credit Agricole SA, which is using 1.6 billioneuros of ECB funding for Athens-based Emporiki, reduced refinancingexposure to its Greek unit by half in the nine months through Marchto 4.6 billion euros.

European banks also have cut their sovereign-debt holdings andexposures to Ireland, Italy, Spain and Portugal. Lenders inGermany, France and the U.K. reduced exposure to Greece by morethan half in the two years through the end of 2011 to $68.2billion, BIS data show. Their claims on the other four countriesare down 36 percent in the same period.

The average core Tier 1 capital ratio of the 10 biggest Europeanbanks by assets rose to 10.7 percent as of Sept. 30 under Basel 2rules from 9.3 percent at the end of 2009, according to datacompiled by Bloomberg. Most lenders changed at the end of last yearto stricter, so-called Basel 2.5 capital rules, making comparisonwith prior periods meaningless.

The cash and near-cash holdings of the 10 biggest banks jumped77 percent on average in the two years through the end of 2011,data compiled by Bloomberg show.

'Chain Reaction'

Christian Clausen, president of the European Banking Federationand CEO of Nordea Bank AB, the largest bank in Scandinavia, said aGreek exit from the euro zone is unlikely and won't be disastrousfor the region's banks if it does occur.

“We've come to a level in Europe where that can happen withoutany major repercussions for the rest of Europe,” Clausen said in aninterview in Copenhagen on May 11. “Every bank in Europe willprepare for this, but to think it will impact the European economyand banks in general, that will not happen.”

Still, the efforts may not shield banks from contagion. The 1.1trillion-euro liquidity buffers Europe's eight biggest banks haveto guard against deposit flight and funding-market dislocationswill be insufficient if there's a systemic loss of confidenceacross the region, Goldman Sachs Group Inc. analysts wrote in anote yesterday. The buffers include cash, deposits with centralbanks and unencumbered assets.

Loan and currency losses in the event of a euro breakup mayreach $1.1 trillion across German, French, U.K., U.S., Swedish,Swiss, Dutch, Austrian and Belgian banking systems, analysts atParis-based Societe Generale SA estimated in a note last week.

UBS economists Wacker and de Spindler see a “significant”likelihood of a Greek exit “triggering a chain reaction of bankruns and soaring risk premiums on government bonds of weakercountries, and that ultimately breaks up the entire euro zone.”

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