Debt restructure need not be Greek tragedy for banking system

Financial markets are increasingly certain a Greek debt restructuring is coming and European policymakers fear the worst.

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Last Updated: May 15, 2011

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As Juergen Stark, a member of the European Central Bank (ECB) board, put it: "In the worst case, a debt restructuring of a euro-zone member could put the consequences of Lehman's bankruptcy in the shade," referring to the collapse of the US investment bank Lehman Brothers, which exacerbated the global financial crisis.

But there is also a best-case scenario, where Greek debt is restructured in a way that does not threaten the banking system.

The simplest way to achieve this would be to require banks exposed to southern European debt to raise more capital. The second round of stress tests by the European Banking Authority is ostensibly designed with this end in mind.

By showing who is weak and who is strong, proper stress tests would also limit counter-party risk. Lenders would have good information on with whom they should do business.

But Europe's track record does not inspire confidence that the next round of tests would be much more rigorous than the last. Raising capital is expensive, encouraging stakeholders to deny rather than acknowledge problems.

Plan B would extend the maturity of Greece's debt. The Greek government could simply announce it was exchanging its bonds for new ones maturing in, say, 30 years.

There would be no write-down of principal, or "haircut" for creditors, only more time for repayment. Banks would be spared having to acknowledge losses.

But this would still leave Greece with an impossibly heavy debt burden. A reduction of 40 per cent, whether in the form of reduced interest or principal, is needed to bring the debt-to-GDP ratio below 100 per cent, at which the country has some hope of meeting its payment obligations.

Fortunately, there is another way: emulate the Brady Plan, under which commercial banks, together with the US, the IMF, and the Paris Club of sovereign creditors, restructured and took haircuts on the debt of Latin American and eastern European governments at the end of the 1980s.

Two of my northern California neighbours, Peter Allen and Gary Evans - both veterans of the Brady Plan - have explained how a similar plan could be implemented today.

First, the new bonds could be structured so that write-downs incurred by the banks count as tax losses, reducing the hit to their profits.

This would amount to using governments' fiscal resources to facilitate a Greek restructuring. But if taxpayer money is at risk anyway, as it is today, why not use it creatively?

Second, the ECB could offer to provide special treatment, "secured financing", on the new debt to make it attractive to investors.

Third, regulation could be used to reconcile Greece's need to restructure now with the banks' wish to wait until their balance sheets are stronger.

Under the Brady Plan, an accounting rule called FASB 15 allowed restructured loans to continue to be booked at their original face value, as long as the sum of interest and principal payments on the restructured instrument at least equalled that of the original credit.

New bonds, on which interest was paid towards the end of the duration, could be given the same accounting value as old ones on which interest was paid earlier.

This special accounting treatment could be phased out over time, requiring banks to acknowledge their losses but only once they were able to do so.

Fourth, the new instruments could be tailored to give banks and official lenders a stake in the country's success.

Under the Brady Plan, a country's payments were indexed to its export prices or terms of trade. The equivalent for Greece would be to index payments to its rate of GDP growth, thereby automatically adjusting its debt to its payment capacity.

Bonds of this sort have worked elsewhere, notably in Argentina's recent debt restructuring. They have not been without controversy, with investors complaining that the Argentine government manipulates the statistics.

But Europe has an obvious solution to this problem. It's called Eurostat, the EU's statistics agency.

So rather than worrying that they might be approaching a Lehman moment, European policymakers would be better off designing a Greek debt deal tailored, like the Brady Plan, to avoid this fate.

The twist to this story is that the head of the Paris Club at the time of the Brady Plan was none other than Jean-Claude Trichet, the current president of the ECB.

The Paris Club under Mr Trichet provided Poland with a 50 per cent reduction of its debt, on the condition that the country's bank creditors take a similar haircut.

What better legacy for an outgoing ECB president than to dust off his notes and explain to other European policymakers how the lessons of the Brady Plan might now be applied?

Barry Eichengreen is a professor of economics and political science at the University of California in Berkeley. His latest book is Exorbitant Privilege: the Rise and Fall of the Dollar.

* Project Syndicate