The impact of haircuts

EU Zone bank failures under various haircuts February 2nd 2012

I’ve created a model tracking banking sector exposure, country by country, across the EU. This was created from the EBA Bank Stress Tests, which were conducted Q2 2011.

A key assumption of my model is a 7% Tier 1 ratio; this defines the amount of money banks have to set aside to cover losses (so depositors aren’t impacted). This parameter can be changed and in fact this is very low – many banks run higher, sometimes much higher capital ratios. It is important to understand that as banks set aside more money in the form of Tier 1 capital they can withstand higher losses but these capital reserves impact profitability.

Considering all the chatter these days about Greece and the proposed bailout (in the form of debt relief, aka “haircut”) I decided to model the 70% Greek haircut scenario, calculate the number of insolvent banking institutions, and continue the exercise across all the peripheral nations.

In other words, what’s good for Greece (debt cut by 70%) is good for Italy, Ireland, Portugal and Spain). I’ve done this incrementally, nation by nation. The results aren’t pretty. Even if Greece and only Greece gets a 70% haircut, we forecast 45 banks failing (yes, I know the banks names but won’t disclose). The hit to EU GDP under this scenario is 0.68%. If we assume that ALL EU peripheral nations received a 70% haircut then we see some 65 EU banks failing with a hit to EU wide GDP of 3.08%.

Caveats: we have no idea when default protection these banks may have taken out. Also bank portfolios aren’t static, and for certain many have hedged or otherwise divested of sovereign debt. In essence, this represents a worst case scenario. One can only hope.

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