A Risk Management Assessment: Is a Breakup of the EU Inevitable?

Summary

• Once considered taboo, leaders in Europe are contemplating changes in the structure and make-up of the Eurozone.
• Debt problems, and the challenges of dealing with them, have rattled the financial markets for months and most expect volatility to be the norm for some time to come.
• We continue to believe that the most likely scenario is for the Eurozone to remain largely intact as we expect European leaders will  eventually do what they  can to avoid the great uncertainty (and enormous risks) of an EU breakup.  
• Greece is unfixable and thus likely to default; while other PIIGS countries (too big to ‘bail’) will continue to seek sporadic cash injections in exchange for fiscal concessions.

For the last two years as the debt burdens of several European countries have worsened, we have written about the fragility of the EU as an effective economic and monetary union.  Yet we have also commented that the Maastricht Treaty which formed the basis of the EU in 1992 did not allow for an exit strategy of its members, and up until recently few have viewed a breakup of the EU as practical.  Why?  If a country other than Germany left the Euro system and established a new currency it would likely see a sharp devaluation in its new currency, and significantly higher issuance costs which would make it even more difficult to pay back its debt.

Today, thirteen years since its launch, Europe’s common currency is in crisis, and talk of some type of a Eurozone breakup scenario is increasing, most notably among political leadership in Germany and, to a lesser extent,  France.  Once considered taboo, German Chancellor Merkel and French President Sarkosy refer to the concept of a “two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected.”

There is no question that the EU debt crisis is destabilizing global financial markets, and is probably the biggest impediment to a return to growth at the present time. This paper seeks to identify and summarize the key risks and stress points inherent in any possible breakup of the Eurozone and evaluate the risk implications of several “break-up” scenarios. While we present discrete scenarios, in practice numerous possible permutations exist between the extremes of departure by a single country and the exit of all 17 members.

Assessing the Stress Points in a Break-up

There are infinite ways an EU break-up could play out but like any engineered structure, the stress points can be analyzed and the impacts understood from a risk management perspective.  Below are some likely stress points should a break-up of the EU occur.

Stress Point #1: Banking Sector and Sovereign Default risk
With connections among sovereign debt, currencies and the financial system, the European banking sector is highly integrated.  Dependencies exist on the money-market for balance sheet funding and on the derivative markets for asset protection.

• European banks have expanded their lending activities into a multitude of European countries, exposing most of them not only to their domestic country, but to a range of other European countries as well. Not all banks have adequately diversified.  French banks for example, hold concentrated exposures to select countries.
• The banking sector holds significant amounts of government debt. Most banks have a tilt towards holding their domestic government debt, but typically hold significant amounts of non-domestic Euro debt as well. A devaluation or restructuring of this government debt would erode bank capital.
• European banks have improved their capitalization levels over the past years, but leverage is still a problem it appears very unlikely that the industry would survive the systemic stress created by the default of a large European sovereign or of a group of smaller Euro countries.

Stress Point #2: Currency mismatch
Deep, efficient, and stable financial systems are built on the pillars of rule of law, assurance of creditor rights, information and business transparency, well codified regulations, and computerized market infrastructure. If the Euro were to break up, all of these pillars would be shaken.

• The European banking sector has constructed its balance sheet under the assumption that all Euro investments have no specific currency risk attached. As such, all of these investments remain unhedged (and remain unhedgable). A break-up of the Euro would thus expose significant exchange rate risks and asset liability mismatches.
• A break-up scenario of any type would be very costly and complicated to handle for the banking sector as it exposes banks to a multitude of credit and currency risks. Realistically, a full break-up of the Euro as discussed in the scenarios would imply a collapse of the financial system (unless it receives significant support from central banks or surviving sovereigns).

Stress Point #3: Asset Prices
Clearly, the prices for assets both real and derivative, is a key stress point. The ability to confidently assign a value to any marketable security will be severely undermined if the market itself breaks apart.    

• In all scenarios of a Euro break-up, we would expect an extreme level of market volatility and uncertainty. In such scenarios we should see a strong flight to quality into all assets that are perceived as the safest and most risk-less. In the case of a Euro break-up, these will predominantly be foreign assets, especially US dollar-based, as well as gold, Yen, and Swiss Francs. Risky assets like equities will strongly underperform. Assets in core countries such as Germany will be perceived as less risky and will outperform assets in peripheral countries.
• Risk aversion and a fall in consumption, a break-down of the financial system and thus lending activity, and the loss of wealth will hinder economic activity and very likely trigger a strong recession across the current Eurozone. Given the importance of the EU, we would also expect lower growth in the rest of the world.

Clearly, debits issued by sovereign nations leaving the Euro will be the most difficult to value as the ability of these issuers to pay is based on their ability to raise taxes and continue to issue debt. Confidence in the latter at least will be undermined.  Any Euro break-up will likely have important implications for Euro-based sovereigns and financials (mostly Euro-based, but likely global as well). Credit exposures to both types of issuers will likely face significant losses in market value and potential credit losses.

Stress Point #4: Investment Flows and Capital Flight    
As part of a Euro break-up the nature of the Euro may change (see scenarios set out below) and hedging the Euro may no longer be possible. Currency risks between a newly formed Euro and the old Euro or other currencies will be difficult to hedge ex-ante.

• For investors holding assets in Euro, currency hedging would be a nightmare as no structures exist to hedge against the breakup of the Euro. The complexity of the re-implementation of independent spot, forward and futures contracts on the 17 new currencies that would replace the Euro is not trivial.
• Uncertainty in the process of a Euro break-up would likely imply a sharp sell-off of the Euro (at least against the US dollar) based on increased risk aversion. Currency hedging would mitigate losses in this process while unhedged Euro assets would likely depreciate (For a US dollar based investor, the decline in asset prices would be compounded by the currency effect) given the Euro weakness.

Stress Point #5: Credit risks           
As discussed, the financial system will be under significant strain and the creditworthiness of most financial institutions dependent on the financial strength of their national governments. If certain nations default, some financial institutions will default, creating web of losses throughout the financial system. Other financial institutions will require recapitalization by their governments in order to avoid default. This in turn will lead to sovereign downgrades. Again, France is vulnerable to a downgrade due to overleveraging and the exposures of French banks.

• There are significant credit risks in all scenarios as counterparties of derivatives –mostly financials –will face severe issues and potentially the risk of a default. Given the expectation of large market swings, this could imply financial losses (even with regular margining). At the least, institutions may lose the benefits of a risk-reducing derivative overlay at a time of heightened risk.
• In any country that left the Euro, there would be widespread insolvencies. A run on banks in the countries considered close to leaving the Euro would be one of the likeliest triggers to make an exit reality. As the possibility of a Euro exit—and inevitable devaluation of a new national currency—became more credible, depositors would rightly transfer their Euros to banks in other countries.
• Once a country was outside of the Euro zone, domestic loans and deposits would be redenominated in a new, weaker currency. Restrictions on withdrawals would be likely. Banks would probably default on external debt that remained denominated in Euros, dollars or other hard currencies. They would be shunned by international capital markets, and reliant on funding from official sources. A country’s pariah status in global markets, and the likely imposition of capital controls, would mean that banks’ fortunes would be tied almost entirely to activity in the domestic economy, which would take years to recover.

Stress Point #6: Uncertainty around underlying indices
In a break-up certain contracts would cease to exist and not be able to be terminated at an agreed price. The existing fixed income market in Europe tends to be linked to Euribor and Euro-wide inflation indices. Obviously, this may create uncertainties as to what is the interest owed on a bond if the issuing country were to leave the Euro.

• Euribor  based derivatives are commonly used to hedge nominal and real interest rate risks. Usually, swaps are based on Euro LIBOR market rates –these make no reference to an individual country, but are based on a list of Euro banks which tend to be based in core countries. The value of Euribor will be less certain if it continues to be quoted at all. This is extremely significant systemically given the quantum of contracts (deposits, CDs, mortgages, interest rate swaps, etc.) referencing Euribor which may not be able to be settled.

Eurozone Scenarios
Important note:  The scenarios for a “break-up” are described in a generalized way and are meant to illustrate primary outcomes. The reality is that the sequence and timing of contagion would be disorderly. Scenarios may not play out as distinctly as they are represented below. Reality could simultaneously include features of all of the scenarios discussed below or they could play out in sequence. Compounding the economic impacts would be operational risks too numerous to state, consider, or quantify. As there is currently no legal framework for an orderly exit from the Euro, any break-up would result in severe legal issues and challenges that would be unresolved for potentially years.

Time Horizon: For the purposes of assigning probabilities with confidence, we have limited the time horizon for the forecasts to three months from November 15, 2011. 

The table below reviews several primary scenarios and their impact on asset valuations, sovereign default, currencies, financial system, credit risks, effectiveness of traditional hedges, inflation risk, and to some extent operational risk.

The scenarios we have outlined in the following table are:

1.       Base Case (60 percent probability):  Muddle through with no dissolution of Euro

2.       Disorderly Exit of the PIIGS (20 percent probability)

a.        Tail Scenario A: Greece leaves Euro alone (10 percent probability)

3.       Orderly Exit by core countries with new “FrancMark” currency (15 percent probability)

a.        Tail Scenario B: Germany leaves Euro alone (10 percent probability)

4.       Benign Scenario with growth solving problems (5 percent probability) 

Scenario #1: Muddle Through – No Dissolution of Euro (60 percent probability within 3 months)

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