The credit risk implications of a eurozone breakup21 May, 2012
We started this year with two articles on the potential for a eurozone breakup in 2012. The first article focused on why we thought a breakup was a credible threat. The second article focused on prudent risk management actions that energy companies can take to prepare for a breakup. Recent events in Greece mean there is no longer any doubt as to the imminent threat of breakup. But in reviewing our list of prudent risk management actions it strikes us that credit risk poses the most under-estimated threat to energy companies across Europe.
This crisis is all about credit
At the core of the ongoing financial crisis is a classic credit bust caused by the build up of unsustainable debt levels across many of the world’s largest economies. The causes of the crisis are complex, although they mostly stem from imbalances that have resulted from rigid exchange rate mechanisms in China and Europe. But resolution to the crisis, in the form of reduction of the debt overhang, can only happen in three ways: austerity, growth or default.
Austerity has been tried over the last three years but is being politically rejected across Europe (reference this month’s election results in Greece and France). It takes a serial optimist to conjure up a scenario of robust and sustainable growth given ongoing deleveraging and a slowdown in China. This brings into focus default as the remaining option, either soft default via inflationary policy (a possibility for those countries that still have control of their currency) or hard default via an explicit refusal to honour debt obligations. In this environment credit risk should be in the front of everyone’s minds.
Europe’s banking system is fundamentally compromised
A Greek default in isolation would be a relatively small problem for its euro-neighbours. The great unknown is the extent to which this default would cause a chain reaction across other heavily indebted countries within the eurozone, specifically Spain, Italy and France. The transmission mechanism for this contagion would almost certainly be the European banking system, significant parts of which are on government or central bank funded life support. The scale of Europe’s banking problem is summarised in Table 1, measured against the ailing US banking system for comparison.
The European banking system has $62 trillion of ‘assets’ as measured by their balance sheets. On the other side of this are $62 trillion of liabilities supported by just $18 trillion of GDP. If a eurozone breakup starts a chain reaction of hard defaults and associated cash hoarding, it is very difficult to see how the banking system will remain functional. The ability for governments and central banks to act as a last line of defence in preventing this scenario has been seriously compromised since 2008 on both a financial and political level.
Table 1 highlights how important banks are as a source of corporate loans in Europe (providing 85% of total corporate lending). So a systemic banking crisis will quickly impact the ability of companies to borrow on both a long and a short term basis. This increases the risk of the most dangerous credit related threat to energy companies, a downward credit spiral. A disorderly eurozone breakup may trigger a self reinforcing loop of tightening collateral, withdrawal of funding, delayed payment and default. Adding to this risk is the fact that a constrained credit environment quickly impacts market liquidity, compromising the ability of energy companies to manage market risk exposures.
Analysis of credit risk associated with a eurozone breakup
Energy companies typically have well established processes for measuring and controlling credit risk. But these often rely on:
(i) Historical price and/or default data
(ii) Credit rating agency implied default probabilities
Given that there is nothing resembling the current credit crisis in a standard historical dataset, any measurement relying on historical calculation is of limited value in analysing credit stress associated with a eurozone breakup. The reactive rather than proactive record of rating agencies in assessing default risk does not inspire confidence that their default probabilities add much value in a breakup scenario either.
Instead in our view the most effective approach for breakup credit risk analysis is well structured stress testing and reverse stress testing. In practice this means analysing the impact of margining and collateral requirements, suspended payments, hard defaults and the withdrawal of bank loan facilities (such as cash revolvers). Reverse stress testing can be particularly useful in focusing on which events could compromise a portfolio of counterparty exposures.
Greece may well reach a renegotiated compromise with its creditors so the eurozone can limp through the summer in tact. It is also possible that the fallout from a Greek eurozone exit may be contained by further central bank intervention to prop up Europe’s crippled banking system. But to re-emphasise the conclusion of our previous article on risk management preparation for a eurozone break up:
It could be argued that focusing on the impact of a disorderly eurozone breakup that may never occur, is a waste of valuable time and resources. We strongly disagree with this logic. The magnitude of the threat from an external shock of this scale warrants careful risk analysis and contingency planning to preserve portfolio value and ensure business continuity. Taking a structured approach to the analysis of conditions of extreme market and credit stress is likely to be a valuable exercise in understanding portfolio risk regardless of the outcome of eurozone events.