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

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

“A Greek exit would be a Pandora's box,” said Jacques-Pascal Porta, who helps manage $570 million at Ofi Gestion Privee in Paris, 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 a precedent: Why couldn't an exit happen for Spain, for Italy, and even for France?”

The prospect of Greece leaving the 17-nation euro region increased after parties opposed to the terms of the nation's second bailout by the European Union and the International Monetary Fund won most of the votes in May 6 elections. A fresh round of voting will 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 Greece abandoning 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 might quit 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 an immediate 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 a credible case that a Greek exit was an exceptional and isolated incident, depositors in other nations might decide to withdraw euros from banks or shift them to countries seen as safer.

“The highest risk facing the banks at the moment is the possibility of deposit runs,” said Andrew Stimpson, a banking analyst at Keefe, Bruyette & Woods Ltd. in London. “The more policy makers continue to openly discuss an exit, the more likely that people in Spain, Ireland and Portugal pull money out of their local banks.”

Greek Withdrawals

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

Greek central bank head George Provopoulos told President Karolos Papoulias last week that savers have withdrawn as much as 700 million euros and the situation may worsen, according to the transcript of the president's meeting with party leaders published May 15. Greece had 160 billion euros of bank deposits on March 30, down almost 75 billion euros from the peak in 2009, according to the latest data from the central bank.

UBS, the third-biggest manager of money for the wealthy, sees a 20 percent chance of Greece leaving the euro within six months, the bank's chief investment office, led by Alexander Friedman, told client advisers in an internal note last week.

To prevent contagion, countries in the euro area would have to form a full-fledged political and fiscal union immediately and implement uniform guarantees on bank deposits throughout the region, Thomas Wacker and Juerg de Spindler, economists at Zurich-based UBS, said in a separate note. They said such a response can be ruled out.

The odds of a Greek exit are seen rising over time. Citigroup Inc. analysts this month raised the likelihood of such an event to between 50 percent and 75 percent over the next 18 months after Greece's inconclusive elections.

“Banks' risk-management departments have probably taken into account a Greek exit and most would likely have a plan on how to proceed,” said Robert Liljequist, a Helsinki-based fixed-income strategist at Swedbank AB. “The big problem is that nobody really knows what would happen in the markets if the country leaves the currency, so there is a significant amount of risk with that scenario.”

ECB Lifelines

The ECB's unprecedented provision of 1.02 trillion euros in three-year cash in December and February helped calm financial markets in the first quarter by removing concern that banks unwilling to lend to one another would run out of cash. Lenders in Spain and Italy also used the funds to buy sovereign debt, reducing government borrowing costs.

The rebound was short-lived as doubts about the health of Spain's banks and questions over Greece's future returned. On May 9, the Euro Stoxx Banks index dropped beneath the lows of March 2009. The 30-company index of euro-region banking stocks fell 2.8 percent by noon Frankfurt time today. The Markit iTraxx Financial Index of credit-default swaps on the senior debt of 25 European banks and insurers reached 308.398 on May 18, the highest since Dec. 19, two days before the ECB's first offering of long-term funds. The euro fell today to a 21-month low against the dollar.

Lenders probably would need another 800 billion-euro liquidity lifeline 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 could leave the euro area and signaled policy makers won't compromise on their 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 banks following the bursting of a property bubble. The government of Mariano Rajoy announced this month a fourth effort in less than three years to rebuild confidence in the industry as bad loans soar. The state took control of Bankia group, the lender with the most Spanish assets, and ordered banks to set aside an additional 30 billion euros on property loans.

With Spain's economy in a recession and unemployment at more than 24 percent, more borrowers are defaulting. Bad loans as a proportion of total lending in Spain jumped to 8.37 percent in March, the highest since August 1994, data published last week by the Bank of Spain show. As much as 8.21 billion euros of loans soured in the first quarter, 90 percent more than in the same period 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 Bilbao Vizcaya Argentaria SA, citing the nation's economy, reduced funding access for lenders and a deterioration in loan quality. The rating company also cut 26 Italian banks, including UniCredit SpA and Intesa Sanpaolo SpA.

In all, Moody's said in February it would review the ratings on 114 banks in Europe, as well as eight non-European firms with large capital-markets businesses, to assess the impact of the debt crisis.

Spanish, Italian, French and U.K. banks were the biggest borrowers 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 to a 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 what was once unthinkable. While German Finance Minister Wolfgang Schaeuble last week urged the Greek government to stay in the monetary union, he signaled that a departure would be manageable as European authorities “react in such a way as to ensure that the consequences are as contained as possible.” Bank of France Governor Christian Noyer told journalists in Paris last week that “whatever happens in Greece” won't place any French financial institution in difficulty.

A year ago Schaeuble said a Greek exit would create an “exceptionally difficult” situation that would be “hard to control,” 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 countries of Germany, France and the U.K. used funds from the ECB in December and February to insulate their southern European units against losses should one or more country exit the euro.

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

Insulating Units

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

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

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

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

The cash and near-cash holdings of the 10 biggest banks jumped 77 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 Federation and CEO of Nordea Bank AB, the largest bank in Scandinavia, said a Greek exit from the euro zone is unlikely and won't be disastrous for the region's banks if it does occur.

“We've come to a level in Europe where that can happen without any major repercussions for the rest of Europe,” Clausen said in an interview in Copenhagen on May 11. “Every bank in Europe will prepare for this, but to think it will impact the European economy and banks in general, that will not happen.”

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

Loan and currency losses in the event of a euro breakup may reach $1.1 trillion across German, French, U.K., U.S., Swedish, Swiss, Dutch, Austrian and Belgian banking systems, analysts at Paris-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 bank runs and soaring risk premiums on government bonds of weaker countries, and that ultimately breaks up the entire euro zone.”

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Banks Not Ready for Greek Exit

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