Speculation is rife over whether the Euro can survive, and if so in what form. As a result, UK banks – under the watchful eye of the Financial Services Authority – are stepping up contingency planning efforts to address various break-up scenarios.
First step in banks' planning exercise is to identify the outcomes that could transpire. The possibilities range from a Greek default and exit from the Euro to full disintegration of the currency bloc.
Next step is to determine the potential effects of the different scenarios on the real world. The impacts fall into four broad categories:
- Any break-up would result in the emergence of new currencies, bringing the prospect of appreciation/depreciation among the new and existing ones.
Credit and counterparty impacts
- Banks in affected countries, as well as any other counterparties hit by second order impacts, may end up defaulting. Credit default swaps could be triggered. In addition, banks may find counterparties' collateral redenominating, or plunging in value. Firms will demand higher quality collateral, but as the scope of what is deemed acceptable narrows it will become more expensive.
- Euro exits could provoke a massive liquidity shortage and another, even bigger, credit crunch. There could also be operational impacts, with settlement and payment systems failing, causing market infrastructure to fall over.
- For example, these might include imposition of capital and currency controls.
Once prospective real world impacts have been identified, banks need to consider how those would affect each of their different business lines. The assessment should include customer-facing activities across their retail, commercial and investment banking divisions, as well as supporting functions such as treasury, operations and finance.
From the assessment steps highlighted above will come two sets of outputs:
- These are the actions banks should be taking now to mitigate the risks that would arise from the Euro fracturing. Examples include reviewing contracts with counterparties to determine under which currency and legal jurisdiction the contract falls, or minimising exposure to certain countries and/or institutions.
- It is important to identify a clear programme of short, medium and long term action steps to be ready for all eventualities. What immediate actions would you need to take in the event of any of the scenarios occurring? What will be your response over the medium term? How will it alter your longer term strategic goals?
For the time being there is still hope an orderly resolution to the Euro crisis can be found. But while we may hope for the best, it is imperative banks prepare for the worst.