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"Bonds Don't Bring Breakups, Banks Do"; UBS Says Europe Risks Bank Runs On Grexit

Earlier today, we reported that Germany is preparing a contingency plan to deal with the fallout from a Greek default, the odds of which analysts are now putting at even money. According to Die Zeit, Berlin is looking at options to keep the Greek banking sector solvent (i.e. make sure there are still euros in the ATMs) even in the event Athens misses a payment to the IMF next month. Germany also indicated it was prepared to let Greece go should Tsipras, Varoufakis, and their merry band of Syriza socialist saviors be unwilling to adopt reforms in exchange for assistance to the banking sector. In the event the Greek government remains steadfast in its “where’s our money” approach to negotiations, Brussels will reportedly assist the country in transitioning back to the drachma. In the midst of the (continuing) drama, UBS is out with a new note which warns against adopting the idea that a Grexit would prove to be an isolated event. Here’s more:

Investors seem to have embraced the belief that if Greece were to walk away from the Euro, it would walk alone with minimum contagion to other countries. This belief is dangerous. UBS does not believe Greece will leave the Euro as our base case scenario. However, if Greece were to depart, there a distinct possibility that other countries would join Greece in exiting the monetary union. This is because of the way contagion is spread in a monetary union breakup, and it could happen within months of a Greek departure…

The chart gives some indication of the complacency of markets. Interest in a Greek exit from the Euro (as signified by Google searches for the somewhat irritating portmanteau "Grexit") recently reached an all-time high, but the relative concern for a wider Euro area problem has seemingly fallen far below the levels of 2011 and 2012. 

UBS goes on to caution investors against attempting to take anything away from an assessment of eurozone sovereign spreads vis-a-vis GGB yields. The logic is simple: spreads simply don’t mean anything in the face of excessive monetary easing:

The complacent suggest that while Greece continues to have significant fiscal problems, other member states in the Euro area have fewer significant fiscal problems (as reflected by bond prices), and thus a Greek exit from the Euro would not provoke a reaction in other bond markets…

 

This syllogism seems appealing, but it ignores the distorted nature of modern bond markets. Indeed it is a moot point as to whether a bond yield today contains any useful information about the real economy or the risks that surround it, given the consequences of financial repression acting in concert with quantitative policy…

 

Bond markets are unlikely to be the catalyst for a monetary union breakup, and probably not a terribly good signal of the threat. Investors should take little comfort from the current narrowness of bond spreads or the behaviour of Euro area government bond markets. 

The simple fact of the matter is that it is redenomination risk that could fuel an EMU breakup. That is, if people no longer believe that the union is indissoluble and instead begin to view the whole ill-fated experiment as little more than a set of fixed exchange rates, all bets are off and it won’t even matter who is solvent and who isn’t when the depositors are beating down the doors.

When examining the risk of contagion from any possible Greek exit from the Euro we come back again and again to the fact that in every monetary union collapse of the last century, the trigger for breakup was not the bond markets, current account positions, or political will, but banks. If ordinary bank depositors lose faith in the integrity of a monetary union they will hasten its demise by shifting their money out of their banks – either into physical cash, or into banks domiciled in areas of the monetary union that are perceived as "stronger". Both of these traits were evident in the US monetary union breakup, and have been in evidence in more recent events this century. The contagion risk after a possible Greek exit arises if bank depositors elsewhere in the Euro area believe that a physical euro note held "under the mattress" at home today is worth more than a euro in a bank – because a euro in a bank might be forcibly converted into a national currency tomorrow. In a breakup scenario it is more likely that retail bank deposits withdrawn will end up as physical cash, owing to the difficulties of opening and using a bank account in a different country.

 

This is not a question of banking system solvency. Highly solvent banks will be subject to deposit flight if it is the value of the currency in that country that is uncertain…

 

The contagion story is serious. Even if a depositor thinks that there is only a 1% chance their country will exit the Euro, why take a 1% chance that your life savings are forcibly converted into a perceived worthless currency if by acting quickly (and withdrawing deposits) one can have 100% certainty that your life savings remain in Euros?

 

If Greece were to walk away from the Euro, then the policy makers of the Euro area would have to convince bank depositors across the Euro area that a Euro in their local banking system was worth the same as a Euro in another country's banking system, and that the possibility of any other country exiting the Euro was nil. If that double guarantee was not utterly credible, then the risk of other countries joining Greece in exiting the Euro would be high.

 

This suggests that financial markets are treating the risks around Greek exit with too little regard for the probable dangers.