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

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

“The Greek debt situation certainly has the potential to create havoc with the European banking system,” said Neil Phillips, a fund manager at BlueBay Asset Management Plc in London, which oversees about $45 billion. “A Greek default and the ramifications of that would be too ghastly for Europe and the European banking system to contemplate right now.”

German Chancellor Angela Merkel retreated last week from a confrontation with the European Central Bank that threatened to shove Greece into the euro zone's first sovereign default, softening demands that bondholders be forced to shoulder a big part of a rescue. Questions remain about how any such burden- sharing agreement would work without prompting ratings companies to declare a default and whether Greek Prime Minister George Papandreou can persuade legislators to pass the austerity measures needed for a bailout.

Forceful Reminder
“We forcefully reminded the Greek government that by the end of this month they have to see to it that we are all convinced that all the commitments they made are fulfilled,” Luxembourg Prime Minister Jean-Claude Juncker told reporters early today after chairing a euro-crisis meeting in Luxembourg.

European governments failed to agree on releasing a loan payout to spare Greece from default, ramping up pressure on Papandreou to first deliver budget cuts in the face of domestic opposition and leaving 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 package were put off until early next month.

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

Insolvency Fears
Concern that Greece is lurching toward insolvency drove the 48-company Bloomberg Europe Banks and Financial Services Index to a one-year low today and lifted the cost of insuring against default on the sovereign debt of Greece, Ireland and Portugal close to record levels last week.

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

Banks led an increase in the cost of protecting European corporate bonds from default, with the Markit iTraxx Financial Index of credit-default swaps on subordinated debt rising 7 basis points to 296.5 as of 11 a.m. in London, according to JPMorgan Chase & Co.

Analysts say contagion following a Greek default could play out like this: Refinancing costs for Ireland, Portugal, Spain and possibly Italy and Belgium would soar, thwarting efforts to rein in public deficits and putting states under pressure to restructure their debt as well; banks in countries with weak finances could face a run by depositors, while other lenders would see their capital eroded by credit writedowns; investors would shun equity markets and the euro and seek the safest securities. In a worst-case scenario, panic could freeze credit markets, as happened after the bankruptcy of New York-based Lehman Brothers Holdings Inc. in September 2008.

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

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

Infection Risk
Merkel, 56, said on June 17 she would work with the ECB to get Greek creditors to participate in a rescue on a voluntary basis, seeking to appease ECB President Jean-Claude Trichet, 68, who contends that any compulsory move to involve bondholders would trigger a default. The ECB doesn't accept defaulted debt as collateral when providing the cash banks in Greece, Portugal and elsewhere depend on after being shut out of credit markets.

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

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

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

Lehman Legacy
Greece should “absolutely not default,” Josef Ackermann, CEO of Frankfurt-based Deutsche Bank AG, said in a June 17 interview in St. Petersburg, Russia. The EU needs to provide more aid to the country if required, he said.

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

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

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

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

European banks have raised 59 billion euros since stress tests last July, according to calculations by Huw van Steenis, an analyst at Morgan Stanley.

Independent Credit View, a Swiss ratings company that predicted Ireland's banks would need another bailout last year, said in a stress-test study earlier this month that 33 of Europe's biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent from 9.1 percent at the end of 2010. The group chose that threshold because it's about 30 percent above the average ratio for the past 10 years.

An S&P stress test published in March estimated European banks would need as much as 250 billion euros in fresh capital if faced with a “sharp” increase in yields and a “severe” economic decline.

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

German lenders were the biggest foreign owners of Greek government debt with $22.7 billion in holdings last year and had the second-most overall claims, the BIS said. Their claims on Ireland, Italy, Portugal and Spain amounted to $498.8 billion. The two countries hold more than 60 percent of all foreign claims on Greece, according to BIS data.

Banks in the two countries have lowered their risk tied to Greek public debt by 25 percent to $37.6 billion from the end of March 2010 through December. The main reason for the decline is companies letting bonds or loans expire without renewing them, according to Lutz Roehmeyer, who helps manage about $17 billion at Landesbank Berlin Investment in Berlin. Lenders also have been writing down the value of Greek holdings, setting aside provisions and moving assets into so-called bad banks, as well as selling shares to boost reserves, he said.

Too Big to Shoulder
“The direct hit from Greece 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 be too big for the banks to shoulder.”

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

The ECB is lending unlimited amounts of cash to support banking systems and has relaxed collateral requirements. In May 2010, it took the unprecedented decision to start buying the bonds of distressed nations in an effort to calm markets as Greece's fiscal woes began to infect other euro-area members.

Credit-Default Swaps
The impact of credit-default swaps, which led to the near- collapse of American International Group Inc. in 2008, may be limited in a Greek default. Credit-default swaps on Greek sovereign debt cover a net notional $5 billion, according to the Depository Trust & Clearing Corp., which runs a central registry that captures most trades. That's only 1 percent of the government's $482 billion of bonds and loans outstanding, according to data compiled by Bloomberg.

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

Most banks have already had to write down the value of their Greek bond holdings as they have fallen in the market, said Florian Esterer, who helps manage more than $60 billion at Swisscanto Asset Management AG in Zurich.

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

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Greek Default Spells &lsquo;Havoc&rsquo; for European Banks

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