The euro zone crisis has European bankers scrambling for their Latin primers. Lex monetae – the legal principle that states can redenominate their currency without defaulting – could leave banks nursing large losses in a euro breakup. There is precious little lenders can do to limit risks on existing bonds and loans. But they are likely to favour foreign law for euro zone contracts in future.
Few current contracts provide for a breakup, and banks have little leverage to change that: why would borrowers agree to give lenders greater protection from what is a real and growing risk? Even where banks wield notional bargaining power, using it is not straightforward. Sovereigns, for example, have traditionally been considered risk-free and, therefore, excluded from posting collateral on derivatives trades. Banks would like to change that, but are loath to do so for fear of exacerbating the crisis.
Instead, banks are focusing on future defences. The simplest way is to ensure bonds and loans are issued outside the euro zone and under foreign law, probably in the established commercial jurisdictions of England or New York state – which offer greater protection for creditors in the event of a default. That is the exception for euro zone states now. Nomura estimates that just 18 percent of euro zone sovereign bonds were issued outside the national market, and many of these were issued under local law.
Private sector bonds should be easier to secure. In the euro zone, two thirds of bonds issued by financial institutions, and 42 percent of corporate bonds, are already issued outside home markets, according to Nomura. Governments may resist issuing new bonds under foreign law. However, investors could then demand a premium for the extra risk.
Lawyers are also looking at inserting clauses governing payouts in a euro zone breakup. Like the “gold clauses” common during the era of the gold standard, such provisions would fix liabilities at a conversion rate to gold, or the dollar. But the dollar and gold can be volatile too. The assets against which the loan is secured could fall further than the newly redenominated currency, leaving the bank worse off.
Banks will have to live with redenomination risk until politicians sort out the euro zone crisis. It could be a long wait.