ECB decision could be critical in Greek debt crisis

If Greek debt is downgraded again, much will depend on whether the ECB decides to keep accepting it as collateral.

Already cut to junk status by Standard & Poor's, Greek debt is teetering on the brink of further downgrades – which could jeopardise its use as collateral with the European Central Bank (ECB). If the bonds become ineligible as collateral, it would deprive the country's banks of up to €17 billion in funding, according to one estimate.

On April 8 the ECB agreed to accept debt rated at least Baa3/BBB– by at least one ratings agency as collateral beyond the end of the year, making permanent a 2008 concession intended at the time as a temporary crisis response. Standard & Poor's already rates Greece below that level. Fitch downgraded the country to BBB– on April 9; Moody's, meanwhile, cut it to A3 on April 22, still three notches above the ECB's eligibility threshold. Both agencies also warned further downgrades are possible.

David Watts and John Raymond, New York-based analysts with CreditSights, say this could have alarming consequences for Greek banks. "It is admittedly unclear to what extent Greek government debt is being used as collateral in ECB open market operations," they wrote yesterday, "but it would appear to be reasonably meaningful."

An estimated 8% of the Greek banking industry's balance sheet is supported by the ECB. One of the four largest banks, the National Bank of Greece, underpins 45% of its ECB repos with Greek government debt. If this is typical across the industry, it would mean €16 billion–€17 billion of funding for Greek banks would be cut off by the downgrades, they estimate.

There are several options for the ECB. It already plans to introduce graduated haircuts on collateral rated BBB+ to BBB– from the start of next year – it could extend this system, and make it effective immediately, to allow even downgraded Greek debt to serve as collateral, albeit at a steep discount. It could even decide to continue accepting Greek debt as collateral without a haircut, regardless of its credit rating, until the graduated haircut scale kicks in next year. (Depending on the status of Greek debt in January 2011, the scale might have to be extended downwards.)

Watts and Raymond downplay the risk to existing financing arrangements underpinned by Greek debt in the event of a universal junk rating: though the rules are ambiguous, they write, "we tend to feel the ECB would not risk adding a liquidity crisis to the mix by demanding all financing backed by Greek government bonds be unwound immediately".

Downgrades to Greek banks, meanwhile, would not block their use of ECB open market operations for funding – as long as the national bank judges them "financially sound", they would be able to participate, according to Raymond and Watts.

The ECB has nailed its colours to the mast over Greece, with bank president Jean-Claude Trichet calling a default "out of the question" earlier this week. It is therefore possible that the bank might decide to emulate its €60 billion support of the covered bond market last year with a purchase of Greek debt. But this would be a risky move – if the contagion spread to other eurozone nations such as Portugal and Spain (whose debt is already falling in price) the ECB would come under great pressure to shore their debt up as well, and such a purchase programme could be several times larger than the 2009 covered bond support.

Meanwhile, UK banks will not be affected directly by the problems of Greek debt: Credit Suisse analysts estimated yesterday that the industry's total exposure to Greece and Portugal is only £25 billion, plus another £75 billion to Spain, or roughly 2.5% of total funded assets. The most exposed are Barclays, with £40 billion of mainly Iberian exposure, and RBS, with between £30 billion and £35 billion of predominantly Spanish exposure, they wrote.