As odd as it sounds, concerns about the effects of a eurozone sovereign crisis on Europe's still poorly capitalised banks may prove to be the tipping point that leads to a swifter bailout of Greece.
While discussion of contagion may seem very 2008, the problems with Greece, which faces a huge fiscal deficit, are becoming tougher for eurozone authorities to leave uninsured.
That's not just because worries about Greece spread markedly in the past week to Portugal, Ireland, and Spain, all of which saw their financing costs rise.
While Greece is, in the scheme of things, pretty small beer, though crucial as test of the euro project, the combined size of all four countries is large enough to pose a substantial threat to banks across Europe.
According to Bank for International Settlements data compiled by BNP Paribas, foreign bank exposure to Greece is just about €300 billion (Dh1.51 trillion) – a big, ugly number surely, but not the end of the world. Lump in Portugal and Spain and you quickly get up to €1.75 trillion. That figure may not include all of the €400 billion of Spanish structured financings, most of which are tied to the ailing real estate sector.
It seems likely that the sharp jump in the cost to insure weaker eurozone countries against default has been driven by hedging by banks in the opaque credit default swap market.
Shares in European banks did poorly in the past week, but there are no real signs of serious distress yet. If true contagion spread though it would force the hands of eurozone authorities.
That Greece will receive some sort of assistance to allow it to deal with its monumental fiscal deficit is pretty certain, but what isn't clear are the terms of the deal.
Eurozone authorities want to appear as indifferent as possible to Greece's situation so as to extract the maximum amount of cooperation from Greek authorities and its electorate.
Bailouts are judo matches, not boxing
As we saw in the US, with the bailout of banks and AIG, negotiations with firms or countries in difficulties are not one sided.
Rather than a boxing match, in which the stronger party pummels the weaker, it's like a judo match; the idea is to use your opponants' weight against them. To the extent that financial markets are getting exercised about Greece, its negotiating position improves. If Greece becomes an issue that can be conflated with the health of the financial system, the fear of moral hazard – encouaging bad behaviour by insuring its consequences – will fade.
It is not so much that the case for contagion across the European banking system is solid, but rather that the risks are both potentially high and difficult to fathom.
We do know that banks in Europe were less aggressive in writing down bad debts and remain highly leveraged relative to their global peers. They remain dependent on generous liquidity provisions from the European Central Bank.
We also have no idea who is holding the baby. Exposure by banks to weaker eurozone nations is difficult to track. The existence of a credit default swaps market which is traded off exchanges means that there is no way to know who will bear whatever losses might come in the event of a default.
Officials at the Group of Seven finance ministers meeting over the weekend in northern Canada were, at least to some eyes, surprisingly and distressingly sanguine about Greece.
"Europe has become a huge game of chicken, whereby the Greeks are waiting for help from the outside and donors are waiting for Greece to take a step forward," Mohamed El Erian, Chief Executive of bond fund manager Pimco, said on Monday.
Financial markets are part of that game and are pushing at the reluctant donors' backs. It is possible that political considerations, especially in Germany, stiffen the donors' resolve, but, if this plays out like the rest of the crisis, look for financial market alarm to spread to bank. That, ultimately, may force emergency measures to benefit Greece and, possibly, other weaker eurozone nations.
- The writer is a Reuters columnist. The views expressed are his own
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