Guest Viewpoints

The Doom Loop of a Sovereign and a Banking Crisis, By Gikas Hardouvelis

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.

Part I: The Two Phases of the Crisis

One of the first victims of the Greek sovereign crisis was its banking system. Rumors of an upcoming sovereign default became widespread during 2010 and 2011 and worried depositors began withdrawing deposits from their banks.  From December 2009 to December 2011 deposits declined from 238 billion euro to around 150 billion, which dried up bank liquidity and forced banks to borrow heavily from the European Central Bank.  As a consequence, total lending to the private sector stalled and turned negative by April 2011.

The PSI bankrupts the banks, marking the peak of crisis phase I and leading to the first and massive bank recapitalization

A full blown crisis took place two years into the sovereign crisis in early 2012.  In February of that year the Greek State practically defaulted on its loan obligations through the so-called Private Sector Involvement (PSI).  It was a swap of old Greek Government bonds and loans to the General Government with new bonds of much lower present value, equal to around 20 to 30% of their  original present value.  This caused banks to collectively lose 37.7 billion euro, which represented 10% of their total assets or 170% of their total capital.  In other words, bank stockholders lost their entire investment, yet the loss was even higher.  Stock prices collapsed to zero and bank equity was actually negative.
Banks were recapitalized mainly with borrowed European and IMF funds from the 2nd Economic Adjustment Program 2012-2014.  The process was supervised by the Hellenic Financial Stability Fund (HFSF), a hybrid institution created at that time, whose control is shared between the Greek State and its international lenders.  The HFSF funds infused into the banking system amounted to approximately 39 billion euro, with private investors contributing another 3.2 billion. Four banks considered by regulators to be systemically important were recapitalized, while most of the remaining banks were partitioned into good and bad banks and their good parts were sold to the four systemic banks.  The banking system was thus reshaped into its present highly concentrated form and came under the direct control of HFSF, thus indirectly under the control of the Greek State.

Economy stabilizes in 2014; a second recapitalization exclusively with private funds marks the end of crisis phase I

By 2014 the previous macroeconomic imbalances that had brought the Greek sovereign crisis were cured, GDP growth had turned positive, Foreign Direct Investment (FDI) started flowing into the country and economic sentiment began to rise, catching up to the European trend. Household bank deposits reversed their earlier negative trend and were rising, interbank lending from foreign banks was now abundant for Greek banks and their dependence on expensive Emergency Liquidity Assistance (ELA) funding from their central bank was back to zero in November.

Foreign mutual fund managers moved enthusiastically to buy more Greek bank stocks in a second 8.2 billion euro recapitalization that took place in April of that year, which addressed the scars left by the last leg of the recession of 2013.  No public funds were used for this second recapitalization.

The Europe-wide stress tests on 130 large banks six months later in October 2014  – during the time I was watching over the banks as Finance Minister – did not require an additional infusion of capital into the four Greek banks under examination.  This was partly due to the earlier recapitalization and partly due to the smart legislation enacted in the fall of 2014 on Deferred Tax Credit.  The legislation immunized Greek banks’ capital from future negative shocks to their profitability and, simultaneously, counteracted a recently established restrictive regulatory Basel III measure on the adequacy of the earlier Deferred Tax Assets in counting as regulatory capital.

By the fourth quarter of 2014, the banks not only came out as winners from the Europe-wide Asset Quality Review and the Stress Tests, but they also saw the stock of non-performing loans declining for the first time since the crisis began.  Phase I of the banking crisis was clearly over and so was the sovereign crisis. The future of the country and the banks looked brighter.

Crisis phase II begins in 2015, capital controls are imposed and a 3rd bank capitalization brings bank stock prices close to zero for a second time

Then came the catastrophic first semester of 2015, when an inexperienced and ideologically blindfolded new government followed a collision course with Greece’s European partners and international lenders.  The recovery was aborted.  Economic activity froze and immediately went into reverse.  Fear of loss of savings and wealth permeated the public, deposit fell by another 40 billion euro in just six months, and upon the government calling a referendum to reject the initial creditors’ proposals, a run on the banks took place, capital controls were imposed and asset prices moved deep-south.  The interbank market dried up, dependence on expensive ELA money from the central bank skyrocketed to 2012 levels and non-performing loans began rising again.  Phase II of the banking crisis had begun.

In this new negative environment the European bank regulator (the SSM) moved promptly to reassess the four systemic banks’ health and their collateral values and came up with a 14.4 billion euro bill, which brought their stock price down to zero for a second time in three years.  Many of the foreign funds, which lost their investment money decided to stay and contribute to the subsequent November third recapitalization, taking effective control of the banks and hoping to recoup their losses as the worst seemed to be over.  At the same time, the State through the HFSF stock holdings suffered a loss of close to 25 billion euro together with its earlier majority stake in all four banks.

Viewing those developments from a distance in the US, it may seem ironic that the earlier more conservative Greek governments first caused banks to default and then effectively nationalized them, while the more recent leftist government unwillingly took them out of State control into private hands.  This forced privatization or de-nationalization, however, came at a huge loss and was due to bad management by the governing coalition.  It is diametrically opposite from what happened in the US during the Great Recession of 2007-2009, when the US government infused capital into the problematic banks and later sold its shares at a capital gain.

The banking crisis is not over yet

Since early 2016 the recapitalized banks are struggling to stay afloat, unable to contribute effectively to the Greek economic recovery.  Their loan portfolio is in fact shrinking as new loans to businesses and households are less than the old loans that mature and get repaid.

An in depth analysis of their present state and future prospects comes next, in a follow up article next week: “Greek Banking Crisis Part II: Present challenges and future prospects.”


* Dr. Hardouvelis is Professor of Finance and Economics in the Department of Banking and Financial Management of the University of Piraeus in Greece. He has published in the American Economic Review, the Journal of Finance, the Quarterly Journal of Economics, the Journal of Monetary Economics, the Review of Financial Studies, The Journal of Money, Credit and Banking, the Review of Economics and Statistics, and the Journal of Business among others. He served as the Minister of Finance of the Hellenic Republic from June 2014 to January 2015.


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