Could Greece prove fatal for Europe's banks?

Confidence in southern Europe's banks is caving in, signalling a new and lethal stage of the region's debt crisis. And it's doubtful any national promises of deposit protection can be kept.

The eurozone debt crisis has now morphed into a new and deadly stage, with fears that the region could be about to witness full-scale bank runs.

Last week, investors were rattled by reports that Greeks had withdrawn €5 billion ($US6.4 billion) from the country’s banks after elections held on May 6 failed to produce a government. They were also unsettled by a report in the Spanish newspaper El Mundo that customers had withdrawn more €1 billion from the ailing Bankia, which had recently been partly nationalised by the Spanish government. Even though Madrid subsequently denied the report, the damage was done.

Investors are worried that the European debt crisis has now reached its final, fatal stage, with confidence in the banks collapsing. For months, wealthy individuals in countries such as Greece, Spain and Italy have been quietly shifting billions of euros into bank accounts in the United Kingdom, Switzerland and Germany. But, until recently, there were no signs that ordinary citizens were pulling their funds out of local banks.

The problem is that once depositors start to lose their faith in the stability of the local banks, it’s difficult to stop a fully-fledged bank run, with long queues of panicked customers forming outside the banks. Banks, which typically hold only a small portion of their deposits in the form of ready cash and lend the rest out to borrowers, struggle to raise enough money to meet the huge demand for withdrawals.

One way to contain the panic would be for the European Central Bank to pump additional liquidity into the region’s banking system. This would go some way to reassuring depositors that banks have sufficient funds to cover their withdrawals. But the ECB has limited room to move. It has already flooded European banks more than €1 trillion in cheap three-year loans through its money recent long-term refinancing operations program. Now some banks are now running out of assets – such as government bonds – that they can use as collateral for further ECB loans.

The ECB has now cut off a number of Greek banks from using its refinancing operations because they lack sufficient collateral. These banks now depend on emergency loans from Greece’s central bank to keep them afloat.

Of course, governments in countries such as Greece and Spain will try to stem bank runs by promising that all bank deposits will be protected. But there are doubts whether such promises will be credible.
After all, ordinary citizens are now flocking to pull their money out of Greek banks because they fear that the country’s political instability makes it increasingly likely that the country will leave the eurozone, and that the value of their savings will be slashed once the drachma replaces the euro.

What’s more, when Moody’s cut the credit rating of 16 Spanish banks last week, it noted that the Spanish government had little capacity to rescue the country’s troubled banking sector.

As a result, an increasing number of commentators argue that the European Central Bank should take the dramatic step of guaranteeing all eurozone bank deposits. This, they argue, would reassure ordinary citizens in countries such as Spain and Greece that their savings are safe, and put an end to the damaging flight of capital out of southern Europe.

But such a step would also drastically increase the scale of the ECB’s losses if a country such as Greece ultimately left the eurozone. Already, the ECB has a massive exposure to Greece, including around €45 billion in Greek government bonds and about €80 billion in loans to Greek banks.

Will Germany – which has provided the bulk of the ECB’s capital – give its blessing to a move that will see an exponential increase in the bank’s potential losses?