65% Chance of Banking Crisis by End November: Think Tank

CNBC,

Wednesday, 9 Nov 2011 | 6:48 AM ET

There is a 65 percent chance of a banking crisis between November 23-26 following a Greek default and a run on the Italian banking system, according to analysts at Exclusive Analysis, a research firm that focuses on global risks.

Having tested a number of assumptions in a scenario modeling exercise, the Exclusive Analysis team warned it is becoming less and less likely that EU leaders will simply “muddle through” and have made some bold calls with clear timelines on when the euro zone will be thrown into a major financial crisis.

The most likely outcome according to their analysis is a sudden crisis in which the US, UK and BRICs nations  refuse to provide funding via the IMF for the euro zone. In a world where predictions are made with no time lines, the paper makes some bold predictions which can be held to account over the next three weeks.

In the worst case scenario, Exclusive Analysis expects the governments of Greece and Portugal to collapse due to a lack of consensus on how to handle the debt crisis leading to social unrest. German opposition to handing more funds to the EFSF  rises, leading Germany’s parliament to actually reduce the money available to the bailout fund.

“In face of that, China and the other BRICs give clear signals that they will not support the bailout fund. The EFSF turns to the ECB  , which refuses to print out the amount of money the former needs to bailout the PIIGS. In face of the EU's failure to boost the EFSF, the European banks refuse to accept the 50 percent haircut on the Greek debt. Both the IMF  and the ECB suspend payments to Greece,” said the report released on Tuesday evening.

Between November 18-22, French debt, under Exclusive Analysis' most likely scenario, is downgraded leading to the interbank lending market freezing up with new governments in Greece and Italy “faced down by protestors in their attempts to implement more austerity”.

Civil unrest follows in Spain following the election of a new government which pushes through even tighter austerity measures, and Portugal announces it cannot meet financial targets putting its bailout cash from the IMF and ECB at risk.

“Increased fear that these economies will default creates bank runs in Greece and Portugal and a downgrade of French sovereign debt from AAA to AA. EFSF is subsequently downgraded to AA+” said the report.

“The spreads applied to the debt of all PIIGS increase with yields on Italian bonds  reaching 7.3 percent. In a second contagion effect, depositors in Spain and Italy fear a banking crisis in their own countries, which end up creating a series of bank runs and a collapse of the interbank credit market as banks know that most of their counterparts are at risk. Greece defaults.”

This doomsday scenario comes to a head between November 23-26 when Greece leaves the euro to print money and rescue its banking sector. The new currency falls quickly and depositors lose out as their investments are converted into the new local currency.

“The government default on the sovereign debt  and the banks default on their foreign debt, which causes a banking crisis across Europe. Italian bond yields rise and exceed 7 percent and the country faces bank runs, in face of which the government freezes deposits and defaults on the sovereign debt”.

So far so scary. For those looking for some hope, the Exclusive Analysis report predicts a 25 percent chance that the EU will continue to muddle through. In this scenario new politicians in Greece, Italy and Spain are given some breathing room by voters to find new solutions to the crisis until the end of the year. Portugal still fails to meet its fiscal targets, putting its bailout cash at risk, and French debt is still downgraded on prospect of Greek debt default.

“However, the new governments in Italy, Spain and Greece are given a honeymoon period by protestors and euro zone counterparts, which prevents a market rout.”

In January and February, Greece defaults but the fallout is contained as a new deal on 70 percent haircuts is agreed. Spanish and Italian bond yields hit 7 percent.

Ade Onitolo from Exclusive Analysis, a research firm which focuses on global risk, told CNBC "it just strikes us that all the responses to this crisis, all the boxes that you need to tick, cannot be ticked and history is going to prove itself again that market wrath comes faster than we expected."

“Civil disorder continues in Portugal and Spain, reducing their ability to implement austerity packages. Sovereign ratings in Spain and Italy are downgraded and the prospect of rescue feels imminent as far as analysts are concerned,” warns the report in its muddle-through scenario.

“However, the UK and US governments reduce their objections to the use of IMF resources to fund the EFSF, which, together with a Greek default, improves market conditions and halts the rise in yields on the Italian and Spanish debts.”

With Spain and Italy entering IMF programs, the debt crisis rubbles on in 2012 and 2013 before things turn nasty as Greece defaults and recreates the drachma.

“Markets close to Italy and Portugal again towards end-2012 and civil unrest resume, starting off a second cycle of crisis and speculation about the future of the euro zone.”

If that is the muddle-through scenario, then we are in for a very nasty end to 2011 and years of euro zone debt crisis. But Exclusive Analysis does predict a 10 percent chance that the crisis is resolved.

In this good news scenario Greece still defaults before the end of the year, but “stronger political leadership in other PIIGS contains the fallout”.

“New governments in Italy, Spain and Greece are given a honeymoon period by protestors as they attempt to implement more austerity; a real sense of national unity is constructed with respect to the crisis.”

The new governments are seen as more credible and the US, UK, IMF and BRICs agree to make more funds available to the EFSF.

“The new ECB head is persuasive of the need for the ECB to purchase more bonds from national governments. Greece defaults in November, but under the new technocratic government the process is orderly and banks agree to accept 70 percent haircut on their credit. France recapitalizes its banks and suffers a sovereign downgrade,” said the report.

In the first two months of 2012 France and Germany reach an accommodation on ECB lending and fiscal rules which means the ECB becomes a lender of last resort in return for statuary limits on the amount the so-called PIIGS can borrow, a condition demanded by Germany.

“Market conditions improve and PIIGS bond yields decrease following these successful negotiations. Italy and Spain are emboldened by their lower yields and by the Franco-German pressure to negotiate a restructuring of their debt with creditors with a view to smoothing and lengthening the maturity profile.”