June 15 (Bloomberg) -- The European Central Bank said the threat of the Greek debt crisis spilling over into the banking sector is the biggest risk to the region’s financial stability.
“Greece could have a contagion effect,” ECB Vice President Vitor Constancio said at a briefing in Frankfurt today, when presenting the bank’s semi-annual Financial Stability Review. “That’s the reason why we are against any sort of default with haircuts and any form of private-sector event that could lead to a credit event or a rating event.”
The euro area’s sovereign-debt woes have worsened as investors increased bets that Greece will not be able to pay its debts, sparking the region’s first sovereign default. The risk that euro-area banks holding Greek government bonds will be saddled with losses has jumped, after Standard & Poor’s slapped Greece with the world’s lowest credit rating on June 13.
"The euro area faces a very challenging situation that comes mostly from the interconnection of the sovereign debt crisis and the situation of the banking sector,’’ the ECB said in the review. “In light of the potentially very dangerous implications of sovereign-debt restructuring for the debtor country, including its banking system, a determined and unwavering focus on improving fundamentals” is required.
The ECB and the German government have clashed over how much investors should contribute to alleviating Greece’s debt load, which reached 143 percent of gross domestic product in 2010. While the German government has argued for an extension of the maturities of Greek bonds, the ECB has said it’s against anything that could be interpreted as a default.
Constancio reiterated that the ECB is in favor of a plan for bondholders to agree to roll over their debt voluntarily. The approach is modeled on the Vienna initiative, where banks agreed to roll over loans to units in Eastern Europe at the height of the financial crisis in 2009.
“We are not against all forms of private-sector involvement,” he said. “Some sort of Vienna style initiative could be conceived. It’s not for us to provide solutions.”
While Ireland and Portugal were also forced to ask for external help over the past year, the ECB said there are “encouraging” signs the crisis has been contained.
The crisis needs to be tackled by “adjustment in countries that are more vulnerable in respect of their public finances situation,” Constancio said. “The burden of the adjustment is on the countries themselves by complying fully with the agreements that the three countries have made.”
Banks’ reliance on wholesale funding decreased in 2010 and early this year, according to the report, suggesting the region’s lender are becoming more resilient overall. Constancio said that financial conditions “are improving.”
“A continued normalization of the unsecured interbank market in the euro area has been accompanied by a significant pickup in debt issuance, in particular in covered-bond markets,” the ECB said in the review. Still, in countries facing “acute fiscal challenges,” a lack of access to bank funding continues to be “an Achilles heel.”
The collapse of property markets in some euro nations also poses a risk to the financial sector, the ECB said.
“Concerns derive from potential losses resulting from a need to adjust the book value of depressed property valuations to prevailing market conditions, with a continued potential for further declines and the associated deterioration of the related credit quality in some euro area countries,” it said.
The ECB’s non-standard measures, or the purchase of government bonds and the provision of unlimited liquidity to lenders, proved to be “pivotal not only to maintain price stability but also to foster financial stability,” the report said. The central bank has called emergency measures “temporary,” when calling on governments to find ways to restore investor confidence and contain the fiscal crisis.
“Such efforts are crucial for the effective containment and mitigation of risks relating to sovereign debt in the euro area,” the ECB said in the report.
-- Editors: Simone Meier, Craig Stirling
To contact the editor responsible for this story: Craig Stirling at email@example.com