The ghost of Lehman Brothers stalks European financial markets as central bankers warn a Greek debt default could trigger even worse turmoil than the collapse of the U.S. investment bank. But there are reasons to think the damage could be contained more easily.
Investors are better prepared than they were for Lehman's bankruptcy in September 2008. Vulnerabilities in bank balance sheets are clearer. And the European Central Bank has developed a range of tools which it could use to stabilise markets.
As pressure on Greece to take radical action on its debt problem has increased in recent months, ECB policymakers have warned governments in bloodcurdling terms against permitting any default or bond restructuring. "A restructuring would have legal and systemic consequences that are difficult to calculate right now, but would in all probability be bigger than after the collapse of Lehman Brothers," Jose Manuel Gonzalez-Paramo said in April.
Another ECB Executive Board member, Lorenzo Bini Smaghi, said last week that it was not clear how a Greek default would unfold. "What we learned from Lehman Brothers is that we think we know, and we don't know," he said.
Some analysts believe the ECB may be desperate to avoid even a moderate debt restructuring because it has grim knowledge of the European financial system denied to private investors.
"They have looked at the numbers," said RBS economist Silvio Peruzzo. "The ingredients are there to make this very, very bad…It would be a spiral once it started."
The ECB may have another motive, however: for a year it has been tussling with European governments over how much of the burden of the euro zone's debt crises each side should bear.
Worried about inflation and eager to return to its core mission of maintaining price stability, the ECB does not want to be pressured into taking fresh emergency steps to support the financial system. But if it had to, it could.
NO BLACK SWAN
A big difference between Greece with Lehman is the element of preparation. The bankruptcy of Lehman, with over $700 bln of debt, was a surprise; the Greek crisis has been unfolding in slow motion for 18 months.
This has given investors time to reduce their exposure to Greece's 340 bln euros ($485 bln) of sovereign debt. Some 90 bln euros has already been moved onto the balance sheets of the ECB, European governments and the IMF through a bailout of Athens.
Lehman sowed panic partly because there was huge uncertainty about risks on its balance sheet, and those of other firms such as failed insurer AIG. Euro zone governments' balance sheets have been subject to intense scrutiny for the past year.
Europe conducted stress tests of its banks last year and while they failed to identify risks in places such as Ireland, they did provide an unprecedentedly wide picture; results of another round of tests are due on July 13. "A hypothetical Greek default would not be a 'black swan'. Tail risks that have been discussed time and again tend to be far less vicious than those that strike out of the blue," said Berenberg Bank economist Holger Schmieding.
As with Lehman, the biggest risk in a Greek default would be contagion to other parts of the financial system; investors would probably speculate about the possibility of defaults in Ireland, Portugal and eventually Spain. But in contrast to Lehman, efforts to limit the contagion from Greece are well underway. Ireland and Portugal are receiving international bailouts and no longer depend on market funding; Spain has embarked on fiscal reforms that have at least stabilised its bond spreads.
In Lehman's case, U.S. policymakers were forced to play catch-up, hastily assembling untested policies and funding facilities. In Europe, emergency facilities are in place and authorities have experience using them. "Policymakers are aware of the contagion risks. Europe would likely go to great lengths to prevent a U.S.-style policy blunder," said Schmieding.
EMERGENCY STEPS
The ECB's first line of defence after a Greek default would be its policy of offering unlimited loans in the euro money market, still in place after it was introduced in October 2008.
The policy has worked well in the last two weeks as market jitters about Greece have grown. Amounts borrowed from the ECB jumped to 187 bln euros in this week's main weekly refinancing operation from 102 bln euros two weeks earlier.
This has kept money market rates from rising significantly; the Libor/OIS spread, a traditional gauge of how counterparty risks are affecting lending, has been stable around 12 basis points, against 25 bps in May 2010 and over 100 bps in 2008.
In the event of a Greek default, the ECB might resume offering money for longer periods than the current maximum of three months. If needed, "they will reinstate longer-term liquidity up to one year," Unicredit economist Marco Valli said.
Ensuring adequate dollar funding might be harder. The one- year euro/dollar currency basis swap spread , which grows when banks become unwilling to supply dollars to each other, rose briefly last week to its widest in four months when it appeared Greece might be denied its next aid tranche.
Here, however, the ECB could supply dollars by relying on a dollar swap arrangement with the U.S. Federal Reserve, which was reintroduced in May 2010 at the time of the Greek bailout.
Generous official liquidity supplies might not in themselves prevent banks from cutting off lending to each other, or tightening credit standards for corporate loans. But since many Greek, Irish and Portuguese banks have already become unable to obtain market funding, the European money market might not freeze up much further — in contrast to the Lehman case, when many banks suddenly faced funding difficulties.
The ECB has threatened to stop accepting Greek government bonds as collateral if they are declared in default. But its rules permit it to suspend that threat in an emergency.
It could also create a medium-term liquidity facility for banks outside normal money market operations. It considered such a plan for Ireland earlier this year, before suspending it amid an internal dispute over how much aid it should extend.
"That would be a very good solution and one which would address one of the fundamental problems," Peruzzo said.
Another weapon which the ECB could employ is its programme of buying government bonds of weak euro zone states, launched in May 2010. The ECB is reluctant to use the scheme, which compromises its reputation for strict monetary management, and it failed last year to keep Greek bond yields down. But in an emergency, the programme might be used to deter speculators against the bonds of more healthy states such as Spain.
The ECB is estimated to hold about 45 bln euros of Greek sovereign bonds through the programme and a similar amount of Greek bonds as collateral in money market operations.
A full-fledged Greek default or restructuring, cutting the value of the bonds by say 70%, would impose losses on the ECB. But the ECB could probably absorb the losses, relying on capital and reserves held by euro system central banks of 81 bln euros, plus its own capital, which was 5.3 bln euros last December and will roughly double over two years. In an emrgency, it could obtain more capital from governments.
Capital losses due to a Greek default "would not limit the ECB's ability to act", Valli said.
