Stress-test message to banks: Prepare for possible Greek default

If investors doubt Italy's ability to pay its debts, the eurozone crisis would become far more serious

Probably the most significant announcement by the European Banking Authority after publishing the results of tests of the resilience of European banks - so called stress tests - was not the headline-grabbing one, to wit that eight out of 90 banks had flunked the tests (or nine, if you include the German bank Helaba which walked out of the exam in a huff at the last minute).

The shortage of capital to absorb losses in those banks, 2.5bn euros ($3.5bn; £2.2bn), is a rounding error in the context of the losses that could be foisted on the financial system if there were a chain reaction of further crises within eurozone economies

It was what the EBA had to say about banks that only narrowly passed the tests, and have significant exposure to the state debts of Greece, Ireland and Portugal, that reverberated.

The EBA said it recommends that these banks be forced by their respective national regulators to raise additional capital as a protection against possible further losses from loans going bad, with a deadline of 15 October for the formulation of remedial plans and 15 April 2012 for implementation.

Now this matters, because it is the first time that an EU institution has hinted that there is a realistic possibility of default by Greece, Ireland and Portugal.

The important point is that the stress tests forced banks to make provision for losses on their loans to distressed nations, such as Greece, from a change in the terms of those loans that would fall short of actual default.

But if, as the EBA says, those estimated losses may not be the worst that could happen, the implication is that default is no longer unthinkable.

And the EBA is insisting that plans to cope with such a default have to be drawn up by vulnerable banks within three months. That suggests a restructuring of Greek sovereign debt - which would see a formal reduction in the value of that debt - is a more imminent prospect than official pronouncements by eurozone governments and EU officials would suggest.

As it happens, the stress-test results imply that if a default were confined to Greece, it would be painful for some banks but not devastating for the integrity of the European financial system.

The results also suggest that if a reduction in the value of what Greece owes were followed by Ireland and Portugal insisting that they too should be let off some of their debts, the consequential losses would be just about bearable - though there would have to be a fair amount of help for banks from eurozone, especially German, taxpayers.

That said, the end of the wedge would become perilously thin if the tumbling dominoes of sovereign defaults destroyed investors' belief in the ability of Spain and - especially - Italy to honour their financial obligations.

So after what traders described as the scariest week of trading in European debt markets since the creation of the eurozone - with some investors not wishing to touch Italian government debt - it is increasingly clear that a restoration of confidence in the integrity of Europe's currency union probably requires a more comprehensive and far-reaching plan than just sorting out Greece.

PS See Thursday's post for more on this - and also my chat with Paul Mortimer-Lee of BNP Paribas on this morning's Today programme.