Fears of Greek default sparked bank response

If opponents of allowing Greece to default on its sovereign debt needed any more ammunition to argue that it is a wrong-headed strategy, this was the week that provided them ample firepower.

The prospect of a Greek bankruptcy – made more real by senior German officials openly discussing its likelihood at a time of unresolved brinkmanship with Athens over yet more austerity measures – forced the world’s largest central banks to open the taps to Europe’s financial sector at levels not seen since the darkest days of the Lehman Brothers crisis in 2008.

The connection between one of Europe’s smallest economies and France’s largest banks appears tangential. Those who support a Greek default, a near consensus among mainstream German economists, argue that Greece’s small size and lack of a systemically important banking sector means a collapse would have manageable consequences.

In its downgrade this week of Société Générale, the lowest rated of the three major French banking groups, Moody’s said the bank’s €1.9bn ($2.6bn) holdings of Greek bonds “are not a significant concern”.

But the cold calculus of the balance sheet has had little effect in the hot house of the trading floor. For the financial markets, the prospect of a Greek collapse suddenly became frighteningly real, raising questions of whether the German-led group of healthy economies will remain willing to support any of the eurozone’s high debtors for long.

That has led to sell-offs in Spanish and Italian bonds, undermining European banks, which includes much larger holdings of Italian than Greek debt, and unnerving institutions – particularly US money market funds – who normally provide Europe’s banks with the dollars they need to run daily global operations.

“If you look at Greece alone, it casts a long, dark shadow on everything,” said Sony Kapoor, head of Re-Define, an economic consultancy. “Their [European policymakers] inability for a year and a half to overcome the problems of one of the smallest countries of the eurozone calls into question their capacity to handle the bigger questions we’re dealing with now.”

The quick and overwhelming action by central banks contrasted with the incremental and slow-moving response of Europe’s elected leaders.

Eurozone finance ministers on Friady again delayed a decision on Greece’s next €8bn aid payment and signalled that they did not expect reforms agreed two months ago – cited at the time as a masterstroke to boost the bloc’s crisis response – to be passed through 17 eurozone parliaments for another month. Even that timetable may be optimistic.

Senior European officials believe the new reforms, particularly the overhaul of the eurozone’s €440bn bail-out fund so it can become a multipurpose bank and sovereign firefighter, could be the beginning of a genuine European monetary fund with broad, centralised powers to intervene in national economies.

The fund is likely to become the core of a new, more integrated eurozone, which is now touted by politicians as varied as George Osborne, the UK chancellor, and Guy Verhofstadt, the former Belgian prime minister who has become the European parliament’s most ardent advocate for a United States of Europe.

But for that to happen, Germany, above all, must take the first step. A vote in the Bundestag on the new measures, which allow the bail-out fund to buy bonds of struggling eurozone countries and to inject capital into struggling banks, is scheduled for the end of the month.

Although passage is assured, with the opposition Social Democrats backing the plan, allies of Angela Merkel, the German chancellor, are increasingly nervous that she may not be able to win a majority within her own coalition, where talk of Greek defaults has been loudest.

Ms Merkel’s allies have pushed European leaders to tone down talk of plans for a European monetary fund and the creation of bonds collectively backed by all 17 countries, both which would require changes in the EU treaties, until after the vote. The European Commission, which is expected to issue an analysis of the eurobond plan shortly, now appears likely to wait until a week after the German vote.

“The Germans are quite sensitive about plans for treaty change,” said one senior European official who works closely with Berlin. “It makes sense to be in a co-operative relationship with them. You don’t want to spoil the party.”