by Paul J. Davies*

Why Greece and Its Banks Need Not Drag Each Other Down

(Fresh bad loans incurred this summer may be less than feared and that could help reduce the size of the third bailout)

If Google is any guide, the panic around Greece is done.

Ahead of Sunday’s elections, searches for “grexit” have fallen to the lowest levels in 2015 even though fringe parties are campaigning to leave the eurozone.

Fears about Greece’s beaten-up banks have also subsided. The Greek central bank said Thursday that emergency lending had been cut for the third time since the country’s new bailout was signed in August. The limit has only come down €1.5 billion ($1.7 billion) out of €90 billion, but it signals that the bank run has stabilized and some deposits are returning.

That doesn’t mean the banks are on a sound footing. European leaders have assured depositors they won't lose any money from a planned bank restructuring, but other investors have no such promise. However, the worst fears about deteriorating credit at Greece’s banks may prove overdone.

A thorough assessment of loan books and capital needs should finish in October. Bad loans were almost 40% of domestic loans across the banks even before a summer of capital controls that severely disrupted the Greek economy.

Expectations are that payment problems will have increased among borrowers forced to live a hand-to-mouth, cash-in-hand existence.

However, executives at two banks say the uncertainty before the third-bailout was signed actually encouraged some settling of bills. People wanted to reduce their deposits in the banking system rather than risk having their funds written down, or converted into a less valuable New Drachma. Unable to take out much cash, they paid debts and bills.

Private investors in the banks also believe that bad debts may not have deteriorated as badly as some fear, especially as Greek GDP grew in the second quarter.

Wilbur Ross, the U.S. investor who has a stake in Eurobank, is worried that the Europe-led assessment of the banks assumes too bleak an economic outlook. Mr. Ross wants an option for existing investors to inject some extra capital and have public funds on standby in case the situation worsens.

In contrast, European leaders earmarked €25 billion in the bailout for a bank recapitalization: equivalent to almost the entire current equity base of the four main banks.

The banks may be in a less perilous state than European creditors feared last month. However, to ensure public faith, the system will need more than the loose facility Mr. Ross envisages.

Luckily, there is a third way. European resolution rules allow public money to buy capital instruments at market rates to heal serious economic disturbance and preserve financial stability—but only if the banks are solvent and not to cover losses incurred or expected.

The asset quality review is likely to show some need for fresh equity, which existing investors could fund. The banks must also then pass a stress test; a precautionary injection of public money into other tier one capital instruments could ensure they pass that.

This option would work only if fresh bad loans turn out to be manageable. However, it would limit losses not only for existing bank shareholders, but also for all Greece’s creditors. A smaller third bailout will hurt less when Greece inevitably gets some debt relief.

* Wall Street Journal