By Philipp Halstrick and Stella Dawson
WASHINGTON (Reuters) - Bankers are bracing for a Greek default, and their best hope is that Europe can erect firewalls around the banking system strong enough and soon enough to prevent it from spreading to other euro-zone countries.
So gloomy were bankers from major financial institutions, attending a conference on the sidelines of the International Monetary Fund/World Bank sessions, that they compared the risks of financial market contagion to the collapse of Lehman Bros.
"The direct financial exposure in the European banking system is extremely manageable. What's the indirect impact? You're going to have one massive demand shock," said Vikram Pandit, Citigroup's chief executive officer.
"The fact is we should all expect some sort of a GDP impact if you have a demand shock that's going to be that significant and that's going to have an impact on business."
The biggest fear is that Greece defaulting on its 340 billion in government debt would trigger widespread selling of euro-zone debt causing a much broader financial crisis.
"It is very pessimistic," said another senior commercial banker at an international financial institution. "It (Greek default) is what we have to prepare for. I don't think it is the most likely scenario, but we have to be prepared."
Andreas Schmitz, president of the Germany's BdB banking Association, said an isolated Greek insolvency would be manageable, even though they would have to take writedowns larger than the current 21 percent they have made provisions for.
"But if a wave of bankruptcies sweeps through Europe, the situation looks different; many banks would get into trouble -- and not just in Europe," he told Reuters.
Privately, bankers say they could face 60-80 percent bond losses on a Greek default. Faced with that, they said they would be willing to renegotiate a "better deal" than the 21 percent loss they have agreed to absorb as part of a July Greek bond swap deal, if it lowers the risk of Greek insolvency.
It is the broader contagion that vexes the IMF.
Strains in financial markets are growing and European banks are facing increasing difficulty in tapping short-term funding markets, euro-area bank credit default swap spreads have doubled to about 300 basis points, and European bank stocks plunged nearly 30 percent since early August.
The IMF estimates that these broader problems have increased European bank exposure by 300 billion euros, and urged banks to strengthen their capital buffers and European Union leaders to stand ready with extra help to prevent financial contagion.
Raising bank capital, however, is proving difficult.
U.S. and European banks have raised roughly $100 billion in extra equity capital this year, according to Institute of International Finance calculations.
But Peter Fisher, senior managing director at BlackRock, told the IIF meeting that the decline in bank stocks makes it "pretty challenging" to access private markets, a view bankers shared.
One banker said financial institutions will need state help or EU-wide help to ring fence them and strengthen their reserves.
The IIF, which represents major global banks, said that bank liquidity problems already are spreading worldwide. Poland is seeing sharp withdrawals of funding and Korea, putting downward pressure on their currencies, its economist Philip Suttle said.
To stabilize the situation and prevent a Lehman-style seize-up of financial markets, one senior international finance diplomat said European leaders need to unveil a bailout package of "shock and awe" proportions to cover both sovereign and bank debt .
Only a huge announcement would convince financial markets that European leaders will backstop markets, prevent solvents banks from collapsing and prevent contagion, he said.
European officials were discussing ways to strengthen their 440 billion euro European Financial Stability Fund, possibly leveraging it to the tune of 1-2 trillion euros.
Bankers at the meetings welcomed these discussions to ring-fence the financial system from a disorderly Greek default. Domenico Lombardi, a former IMF official now at the Brookings Institution, said it certainly is needed.
"I believe the strategy that European policymakers are trying to implement is to buy a little of extra time, a few more weeks or maybe a couple of months, in order to get the enhanced EFSF in place so that the European rescue fund with added operational capability ... could recapitalize the European financial institutions," he said.