Not lethal, but serious

ECB stress tests: The European Central Bank is becoming increasingly vocal in its opposition to a Greek debt restructuring. That has led many to believe that its own balance sheet would suffer a body blow in such an eventuality. But a Breakingviews analysis suggests that is not so.

A restructuring designed to bring Greece’s public debt to a manageable 90 per cent of GDP would inflict a loss of only euro 12.3 billion on the ECB as a result of its direct holding of sovereign bonds. Restructuring Irish and Portuguese debt along the same lines would add another euro 3.5 billion loss — taking the total hit to euro 15.8 billion. This would be a significant blow, amounting to about 19 per cent of the euro system’s euro 81.2 billion of capital. But it wouldn’t put the ECB in danger.

After such a hypothetical restructuring, the euro system’s balance sheet would be leveraged 29 times, against less than 20 times in early 2007. This would probably prompt the ECB to turn to its own shareholders — formally the national central banks, but de facto the 17 euro zone governments — to fund another capital increase on top of the euro 5 billion injection it has already had over the past year. That would be embarrassing but, in the scheme of things, chicken feed.

The real danger is if a default of peripheral nations was accompanied by a collapse of their banking systems. Euro zone central banks have currently lent euro 242 billion to Greek, Irish and Portuguese banks, secured on assets from government debt to domestic mortgages. It would only take a 27 per cent loss on these loans to wipe out the euro system's capital once added to the hypothetical losses on direct government bond holdings. Furthermore, the Irish central bank may have lent up to euro 50 billion to the country’s institutions via the so-called emergency liquidity assistance facility.

But the ECB will not face such a nightmare scenario so long as Europe has sufficient support measures in place to recapitalise and fund weak banks in case of a sovereign default. The absence of such a safety net so far is a glaring hole in Europe’s crisis-management tools.