Investment bank Morgan Stanley has warned the ramifications of Greece exiting the euro are more serious than markets are anticipating, with a full-scale eurozone collapse now more likely.
In a note sent out to clients on Friday the firm raised its in-house forecast of a eurozone collapse by 10%, now giving it a 35% chance of happening.
In the note, from Morgan Stanley's European research team, it said: "While a eurozone break-up is not our base case scenario, we raise our subjective probability to 35% from 25%."
Morgan Stanley also reduced the timescale of a possible break up to 12-18 months, from its previous forecast of five years.
In the note the investment bank maintains the most likely scenario from Greece exiting the single currency will be an eruption of contagion, most notably affecting Italy, Spain, Ireland and Portugal.
However, Morgan Stanley adds there is still time to limit the damage a Greek exit would cause, drawing up five policy responses which it said could help stabilise the eurozone.
1. More aggressive ECB policy action
Morgan Stanley argues more long term refinancing operations (LTRO's) are required to avert the threat of further contagion.
"Widening the scope of eligible collateral would be a key feature to avoid further contagion and bank failures in the event of dislocation," the note said.
"It is also possible the LTRO could be made available for even longer maturities, but this is less important than widening the collateral pool, given banks can access unlimited funds on a daily basis."
2. Recapitalisation of peripheral banks
Morgan Stanley argues peripheral banks are in dire need of being recapitalised either by sovereign states or the European Financial Stability Facility (EFSF) fund.
The bank said the intervention may avert the threat of a ‘bank run' if Greece exits the euro.
"The recapitalisation could help to stop a possible run on bank deposits, together with ECB action, but it only serves to buy time," it said.
3. A federal deposit guarantee scheme
Morgan Stanley is calling on governments to jointly guarantee bank deposits across the euro area, a proposal which has also been put forward by Italian Prime Minister Mario Monti.
"If the proposal is implemented there would be a limited degree of pooling between national schemes to create a pan-European safety net," Morgan Stanley said.
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