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By David Brierley and Saad Sarfraz

This article is the first in SNL FINANCIAL’S series of Data Dispatches and features analyzing the European Central Bank asset quality review and stress test.

It was a symbolic journey.

The future head of the European Commission, Jean-Claude Juncker, chose Greece as his first official journey. Speaking Aug. 4 in Athens, Juncker praised Greek reforms but demanded further savings, remarking: “I have never said that austerity is over.”

That leaves Greece’s banks with unfinished business despite the reform and rescue program undertaken with the EC/ECB/IMF troika. High on the list of challenges, SNL FINANCIAL data shows, are nonperforming loans, the recovery of which is questionable at best and which could require billions more euros of bank capital.

The budget and TRADE deficits of Greece have fallen continuously since 2009 but remain high; unit labor costs have also fallen but still were higher in 2012 than 2000; and a savage recession has cost roughly a quarter of output. The first-quarter debt-to-GDP ratio reached 174%, according to Eurostat.

Nevertheless, a weak recovery is underway and the budget deficit is improving. Reinhard Cluse, an economist at UBS, told SNL FINANCIAL that the EU was committed to helping the nation deal with its debt: “We expect to see positive growth in 2014 and, for the first time, a primary surplus. The other European nations will have to respond, and we anticipate the further extension of debt maturities and postponement of interest payments.”

An IMF spokesman said at a July 24 press briefing in Washington that with Greece reaching a primary surplus, the issue of Greek debt and its sustainability would be discussed from September.

Any optimism requires qualification. For many Greeks, the current experience is truly miserable and scarcely improving. Bank of America Merrill Lynch economist Athanasios Vamvakidis told SNL that with deflation of about 2.0% expected in 2014, “nominal GDP growth is negative. … Much depends on what the ECB is going to do to address deflation risks.”

Concerns are also growing about the ECB asset quality review and stress test. Vamvakidis said the stress test “is a risk but Greece has been through two stress tests based on BlackRock reports, quite severe stress tests.” He said the ECB could be very cautious ahead of assuming eurozone bank regulatory duties and want to impose extreme scenarios in the test, but that this would create “other negative surprises” in the eurozone.

“We would not single out Greek banks. It is not in our base case but the banks might need to increase their capital down the road given the increase in nonperforming loans,” Vamvakidis said.

Cluse was also sanguine, given that the Hellenic Financial Stability Fund still has €11 billion of troika FUNDS to disburse after the banks’ recapitalization.

However, reports from Greece indicate widespread and growing concern, notably that the test is ostensibly to be based on 2013 figures and not include the four leading banks’ restructuring plans. Such an approach might uncover significant capital holes, it is feared.

This is not without justification, as SNL figures demonstrate. At year-end 2013, Alpha Bank AE, Eurobank Ergasias SA, Piraeus Bank SA and National Bank of Greece SA showed impaired loans gross of reserves that comfortably exceeded their core Tier 1 capital.

Under normal circumstances, the first-quarter 2014 capital figures, which are slightly lower than at year-end and reflect first-time reporting under Basel III, would be considered adequate. Yet they proved insufficient. In March, the Bank of Greece determined that the quartet and two smaller peers needed €6.38 billion in additional capital.

Investor excitement over the recovery in the European periphery amid falling Greek sovereign bond yields saw the big four raise equity capital totaling over €8 billion — Alpha Bank €1.2 billion, Eurobank €2.86 billion, Piraeus Bank €1.8 billion and National Bank of Greece €2.5 billion.

The Greek bank investment case centers on their ability to benefit from a bank oligopoly, on falling FUNDING costs and on improving efficiency and asset quality as the economic cycle turns. Yet there are indications that MARKETS do not quite believe this optimistic scenario. Concerns about the ECB stress test saw Greek bank share prices fall sharply Aug. 6. At one stage, Piraeus had fallen some 10%.

The fact is, as SNL data shows, there remains a major NPL problem. The past will not simply fade away; someone will have to pay and the banks are clearly in the front line, given the indebted sovereign.

Nikos Lianeris, a bank analyst at Alpha Finance, told SNL that Greece faces “pressure from the IMF and the troika to handle NPLs in a more aggressive way. The Athens government is pressing the ECB to take a more lax approach.”

The ECB and IMF want the banking system free to FUND growth. Lianeris did not see the much-mooted alternative of banks trading out their NPLs as viable.

Reporting Aug. 4 from Athens, Handelsblatt wrote that negotiations over loan books have been ongoing for weeks between banks, government and business associations. No credible concept has emerged from a host of ideas, including an NPL haircut. This prospect, however, seemingly contributes to many not servicing their loans even though they could do so.

At year-end 2013, the four Greek banks had roughly €350 billion in assets, of which €82.66 billion were impaired, with €29.41 billion covered by reserves. NPL ratios — gross impaired loans as a percentage of gross loans to customers — ranged from 25% for Piraeus to 48% for Alpha Bank.

Before the capital increases, NPLs comfortably exceeded capital and reserves. The capital needed to lift reserves to 60% of impaired loans, a figure broadly seen as acceptable by European banks, would have amounted to some €20 billion at 2013-end. On this pro forma basis, there would remain a €12 billion hole in the Greek banking system post-rights issues.

This calculation excludes accounting issues, retained profits, asset sales and other efforts to strengthen capital and asset quality. It does indicate, however, the potential scale of the problem. It might be larger under severe stress test conditions and if asset quality has fallen further since the last BlackRock survey.

“Who knows?” Lianeris asked, pointing out the difficulty of valuing loans when there is no MARKET for the underlying collateral, not even for small residential properties in Greece.

The IMF suggested in June that there might be a €6 billion hole, but Poul Thomsen, IMF mission chief for Greece, admitted June 10 that NPL recovery is “the key issue.”

Credit quality continues to decline though the rate of NPL creation is slowing, at least at Piraeus. Arguably the strongest of the four, it reported an NPL ratio of 37.9% at the end of the first quarter, with a 51% coverage ratio. It has some €26.6 billion of business and retail NPLs in its recovery banking unit, effectively its bad bank. It talks of “laborious work” here.

Given that such a large percentage of loans are affected, it is hard to see recovery procedures not impinging on future creditworthiness and lending. The banks continue to deleverage in 2014, according to ECB figures. It is clear from Handelsblatt that the willingness of Greek business to clear past debts is not growing, hitting new lending.

Debt generally is the issue and growth the answer to ensure the sustainability of both sovereign and Greek bank debt.
This emphasizes the risk presented by deflation. One solution might be to create a bad bank as in Ireland and Spain — a route repeatedly rejected in Greece, Lianeris said. The ECB and IMF might force a rethink.

Politics are a critical challenge. Vamvakidis said stability in Athens had been critical to the recovery and to the ability of the country to meet troika demands. “The No. 1 risk is political,” he said, pointing out that the government has just 152 votes in a 300-seat parliament and that 180 votes are needed to elect a new president in 2015.

Further reforms will be tough to sell politically. Vamvakidis thought that the timetable would be less tight because many key reforms — to the labor MARKET , pensions and tax, for example — had been delayed. Thus he expected debt discussions only to take place after the troika program has been completed. Others such as Cluse expected an earlier solution.

Brussels might bolster the current government by reining in the role of the much-criticized troika, according to a Guardian report Aug. 4. It suggested that a lighter-touch “reform for debt relief” scheme might ease public frustration, in turn wounding the far-left Syriza, which promises to rip up the bailout deal.

This might eliminate controversy around the troika and obtain renewed Greek commitment for reform. Certainly, the hope will be that further external FINANCIAL aid will not be required and that Greece itself will enjoy the freedom to implement the required measures. Yet the state of Greek banks’ balance sheets means that the ECB could demand much more capital — and some might well have to come from outside Greece.