By Gikas Hardouvelis,

Greece suffers a double crisis, a sovereign and a banking one. Each crisis has fed on the other in a vicious doom loop. The sovereign crisis forced the State to strictly tighten its belt and brought a huge recession. The recession/depression deprived many Greek enterprises and households the earnings necessary to pay back their loans to the banks. Households even withdrew their deposits from the banks. As a consequence, banks were deprived of liquidity and capital and were thus forced to cut back their lending, causing the recession to deepen.

Has this doom loop ended? Is the current feeble Greek economic recovery sufficient to turn the earlier doom loop into a virtuous cycle with higher bank profitability, more lending activity and even higher economic growth? The answer is not straightforward. It requires an in depth look into the history of the banking crisis of the last decade as well as the current workings of the banks and the State.

The present essay is partitioned into two independent and self-contained articles. The first article reviews the history of the Greek banking crisis and gives the reader a good grasp of how the banking system evolved into its present shape. The second article assesses its present health and its future prospects.
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Part II: Present Challenges and Future Prospects

US readers are perhaps accustomed to think most current problems in the financial sector began with the international financial crisis and the Great Recession of 2007-2009. This is not the case for Greek banks. Greece suffers a banking crisis since the time its own sovereign crisis began, not from the beginning of the international crisis. Throughout 2007-2009, when US and European banks faced severe troubles, bank deposits of Greek banks were increasing at a steady pace as Greek households were unaware of the international crisis and felt quite safe. The deposit withdrawal began in early 2010, when the Greek crisis was slowly becoming visible to the public.

A previous article analyzed the recent history of the banking crisis and explained its two separate phases. This article assesses the banks’ current health and future prospects. Greek banks today face an on-going triple witching problem: Non-performing loans on the asset side of their balance sheet, precarious deposits which have stabilized only because of capital controls since June 2015 on their liability side, and a capital base, i.e., the equity money stock owners invest in a bank, which can easily shrink the moment loan problems worsen or the moment regulators decide to become stricter in their assessment of future developments. The three problems are inter-related and feed on each other, yet the major one is non-performing loans.

Non-performing loans

Today Greek banks’ problematic borrower-customer is not the Greek State as it was back on 2010-12 but the Greek enterprises and households, both of whom are severely hit by the ten-year old Greek Depression. Many are already bankrupt, others have difficulty paying back in full their previous loan obligations while some others strategically refuse to repay. Non-performing loans (NPLs) reached 36% of total loans and according to a new stricter definition by the European regulator, the SSM, non-performing exposures (NPEs), which add recently restructured performing loans to the non-performing ones, are now in the neighborhood of 42% of total loans. These percentages have declined a bit in the last six months but remain unprecedentedly high, the highest in the European Union, followed only by Cyprus.

In response to the problem, the Greek central bank together with the SSM have designed an aggressive plan since June 2016 to drastically reduce NPLs and NPEs over three and a half years through write-offs, loan sales and other modes of restructuring and curing. The target ratio for year-end 2019 is 33.9% for NPEs and 20.4% for NPLs. Banks have so far surpassed the targets but the jury is still out whether or not they will succeed, as the plan is back loaded, with most of the reduction taking place in 2018 and 2019.

Critical for the success of the plan is the ability to force strategic defaulters to pay. It is estimated that 30 percent or higher of the existing NPLs are from people who have the ability to pay but refuse to do so, hoping to take advantage of some future debt relief or hoping the courts will delay deciding their case. Auctioning off the collateral that banks hold against those loans is a good way to force strategic defaulters to pay, yet banks are frustrated by the State’s obstacles in the auction process. Most collateral is in the form of houses and many of those houses are primary residences, hence social resistance is strong. Greek households tend to think a house is “theirs” even though they may have borrowed more than 90% of its purchase price.

Deposits and capital controls

Deposits have stabilized and slightly increased after the imposition of capital controls in June 2015. Capital controls are gradually being lifted so as not to generate a sudden outflow. Today the risk of a third wave of deposit withdrawals is small because the economy is growing. Yet it is hard to imagine deposits will massively return to Greek banks to the levels observed in 2009 in order to finance a future loan expansion and boost economic activity.

Bank capital, stress tests, foreign investors and the IMF

Banks appear well capitalized as total regulatory capital in the system is over 31 billion euro, which is close to 17% of their risk weighted assets. Regulators require a minimum ratio of only 10.5%. This implies banks have an extra cushion of approximately 10 billion euro in regulatory capital. Yet this cushion does not represent hard private equity as two thirds of regulatory capital is DTC (Deferred Tax Credit). Triggering DTC implies infusion of funds by the State and increased State ownership.

From the perspective of fund managers who joined the third recapitalization in November 2015, any losses to capital, however small, are unacceptable. Hence the current worry about the results of SSM’s stress tests. On the other hand, the IMF has a slightly different perspective. According to the IMF, it is better to recapitalize the banks now that the European money is available and earmarked for that purpose, rather than run the risk of being stuck penniless later on in front of a possible future negative shock without any European support. Today there is left-over 19.6 billion euro in the European rescue pool of the 3rd Economic Adjustment Program, which was earmarked specifically for banks.
The results of the stress tests are expected by May of this year. If the bill is high it will affect bank stock prices negatively. Yet my expectation is even a high bill will not bankrupt the banks. In addition to the 10 billion capital cushion, there is a cushion of reserves for non-performing loans of more than 40 billion plus the annual bank profitability cushion. Annual bank profitability is half of what it used to be before 2008, yet it amounts to approximately 4 billion euro.

A daily operating struggle and the “parallel” banking system

Overall, banks operate on a tight rope, gradually reducing their dependence on central bank for funding, selling off non-core assets and many of their subsidiaries abroad, reducing operating costs by shedding off personnel and reducing their leverage, namely the size of their total loan portfolio. This is not good news for the economy. The economy needs a supply of fresh credit to grow but the banks are in a defensive phase in which they need the economy to grow first, so they are able to stabilize their operations, cure their accumulated problems and increase their profitability.

This lack of credit supply has boosted a discussion on a “parallel” banking system. This is the terminology used by the government since it took office in 2015. The government wants to establish a new bank with a clean slate to expedite the extension of loans, particularly to smaller companies. Yet the plan has not materialized as it met the resistance of regulators. Throughout the crisis, the lack of domestic policy credibility may have led European regulators to become suspicious that future Greek politicians may use a new State controlled bank as a Trojan horse for renewed clientelism.

Stricter regulation

Meanwhile regulators in Europe are slowly tightening their grip on European banks. New accounting rules impose stricter provisioning, while the Banking Union in Europe will necessitate stricter rules on the maximum allowable NPL ratios. The current year-end-2019 NPL target ratio of 20.4% is way too high for Greek banks to be allowed to participate in the Union. They will probably need to bring it down to well below 10%, which may require at least another three years of efforts.

The future

Assuming banks manage smoothly their deleveraging process over the next five years and return to normal lending conditions, some bigger challenges await them. After years of following a defensive survival strategy with little domestic competition and the European lenders providing back up support, they may begin facing new aggressive competitors, who are not burdened by the crisis and are more in tune with technological developments in banking services. Their survival is by no means guaranteed. It will have to be earned. All in all, banks are not out of the woods yet and face a difficult road ahead.

Dr. Hardouvelis is Professor of Finance & Economics in the University of Piraeus, Greece. He served as the Minister of Finance of the Hellenic Republic from June 2014 to January 2015. He holds a Ph.D. in Economics from U.C. Berkeley, and M.Sc. & B.A. degrees in Applied Mathematics from Harvard University. In the US he served as Assistant Professor at Barnard College, Columbia University, Research Adviser to the New York Fed, and Associate & Full Professor of Finance in the School of Business of Rutgers University.