ELA: Easy as ABC?

There was an unusual sense of calm among eurozone leaders at last week’s summit in Brussels. The pain from the constant headache of the debt crisis seemed to have been dulled by a 1-trillion-euro aspirin. The European Central Bank’s decision last week to launch a second round of longer-term refinancing operations (LTRO), with eurozone banks borrowing more than 500 billion euros to top up their liquidity, appears to have calmed the markets and politicians. So much so that French President Nicolas Sarkozy essentially declared the crisis to be over.

Putting aside the questionable enthusiasm of a president seeking a second term in upcoming elections, the December LTRO, when the ECB also lent more than 500 billion euros, and last week’s liquidity operation have at the very worst bought the eurozone some time. Some of the LTRO money was spent by the banks on snapping up their government’s bonds, which has led to yields dropping for countries like Italy and Spain, which were facing unsustainable borrowing costs.

The pacifying effect of the second round of LTRO was not an experience shared by Greece. The offer for private bondholders to take part in a debt restructuring scheme, or PSI, led to credit rating agencies deeming Greece to be in “selective default,” which meant the ECB could no longer accept Greek government bonds as collateral from banks in Athens.

This was a foretaste of the nightmare scenario for Greece, in which it goes into an outright default, its banks don’t have access to liquidity and the financial system collapses, forcing the country out of the euro as it would need to start printing money. None of this happened last week because the ECB gave the nod for Greek banks to be financed through emergency liquidity assistance (ELA). This means that the banks are able to borrow from the Bank of Greece, rather than the ECB, by putting up collateral that is theoretically more risky than bonds, such as small business loans or mortgages.

Greek banks have turned to ELA several times over the past couple of years. It’s not clear exactly how much they’ve borrowed in this way but some estimates put it in excess of 30 billion euros. The difference with the past few days is that Greece has essentially been in default and, despite that, the roof did not cave in on its financial system and the need for it to exit the eurozone did not come up once in the European debate. Could it be that the last few days have given us undeniable proof that Greece can default and remain in the euro?

Athens University economics professor Yiannis Varoufakis is one of the experts who argue that it is up to the ECB whether Greece can default on its debt but not need to return to the drachma. “All that it would take to allow Greece to stay in the eurozone, in a better state than it is today (and less austerity for that matter), is the continuation of the present ECB policy toward Greek banks,” he wrote in a blog post last month. “As for those who argue that the ECB will take an aggressive stance, think again: The ECB will not knowingly take steps which will destroy the eurozone.”

However, staking the country’s future on successfully second-guessing the ECB could be a very dangerous tactic. It would need a two-thirds majority decision by the Central Bank’s governing council for the Bank of Greece to be denied the right to fund local banks through ELA. But ECB politics means that it could only take one or two important members — such as the head of Germany’s central bank, Jens Weidmann, to swing the decision and stop the liquidity program. Although there is no concrete evidence to suggest this would happen, Germany’s hardline stance on the Greek issue over the past few months is not a cause for optimism either. In fact the Bundesbank president wrote to the head of the European Central Bank, Mario Draghi, last week to express concern about the quality of collateral the ECB is accepting in return for its liquidity operations and the threat this could pose to national central banks, the German one in particular.

There is also a question of whether ELA would be sustainable in the event of a Greek default. Although it gives Greek banks access to liquidity, this comes at a considerable price. ELA funding is reported to use a spread of at least 200 basis points over the ECB marginal lending facility rate. This means that Greek banks are currently borrowing money from the Bank of Greece at a rate of at least 3.75 percent, while lenders in other eurozone countries that have borrowed via the LTRO are doing so at a rate of about 1 percent.

ELA also places the Bank of Greece and the Greek government in a precarious position because unlike in the case of LTRO, the Greek central bank rather than the ECB is the one that bears the credit risk. UBS analyst William Buiter recently warned that member states’ central banks creating liquidity but also bearing the risk of doing so is leading to the “balkanization” or renationalization of the eurozone’s common monetary policy, which he regards as preparing the path for the eurozone exit of the countries involved. Buiter argues that the risk, and losses, should be shared across the Eurosystem.

ELA, though, is not totally risk-free for the eurozone due to the way that deposits are transferred through a central payment system, known as Target2.

“When a depositor in a peripheral economy moves their funds to a bank in another eurozone country, the payment is processed through the eurozone’s settlement system, creating a claim between the national central bank of the peripheral lender and the rest of the Eurosystem,” explains Neil Unmack of Reuters. “If it started to look like a country was seriously at risk of leaving the eurozone, depositors might move funds en masse to stronger countries, like Germany, with the banks in weaker countries funding the deposit run through ELA.”

In this situation, the claims between peripheral central banks and those in core eurozone countries would build up to potentially worrying levels. It was reported that by January the Bundesbank’s total exposure was already more than 500 million euros. Weidmann’s letter to Draghi confirmed Germany’s concern about this development. He suggested that either the Frankfurt-based bank accept better collateral or for peripheral central banks to provide their own collateral to the ECB, which would give the Bundesbank a claim on Greek assets, as well as those of other countries. “He might as well have suggested sending in the Luftwaffe to solve the eurozone crisis,” wrote Financial Times commentator Wolfgang Munchau. “The proposal is unbelievably extreme.”

While this debate is going on, Greek banks continue to hemorrhage. In January, savings fell by another 5.2 billion. They are now down to under 170 billion euros, which is almost 20 percent lower than a year earlier. If this continues, or if Greek savers at some point lose all trust in their government and the EU-IMF rescue program, then the question of whether ELA or any other vehicle could be used to prop up Greece’s financial system could prove academic.

At this stage, the impression in Brussels seems to be that the ECB has not ruled anything out, nor has it ruled anything in regarding what its position would if Greece defaulted. Its uncomfortable relationship with ELA is evident from the fact that a statement on the Greek case a few days ago was the first time the ECB had used the term “emergency liquidity assistance” in one of its press releases. ECB chief Draghi appears much more proactive than his predecessor, Jean-Claude Trichet, but the Germans hold sway in the organization and they remain skeptical, as emphasized by Weidmann’s letter. ELA may turn out to be a safety net for Greek banks in case of an outright default, but relying on this prospect appears to be a huge gamble: a toss of the last euro coin Greece may own.

Nick Malkoutzis

3 responses to “ELA: Easy as ABC?

  1. Please bear in mind that the primary issue is not the LTRO. The primary issue is the Target-2 cash settlement system of the Eurozone. Why?

    The LTRO can be controlled by the ECB. Should the ECB no longer want make new 3-year loans to the Greek banking sector, they could simply state that collateral is not sufficient. No collateral, no money.

    The Target-2 is uncontrollable. It was controllable until about 2 years ago when the ECB still enforced their collateral requirement but since then it has gotten out of control. In the “old days”, Target-2 funding for Greece was seldom higher than about 20 BN EUR. By mid-2008, the climb to ever higher peaks started.

    Mind you: Target-2 is nothing other than an unlimited credit card. The issuer of the card (ECB) has put itself into a position where it has to pay; period. Greeks withdraw another 30-40 BN EUR in deposits this year? No sweat! The ECB has to replace the funding via Target-2. It’s cute for Yanis Varoufakis to say that “the ECB will not knowingly take steps which will destroy the eurozone”. In practice, the ECB’s freedom of action is much more limited than “knowingly taking steps”.

    It is one thing to make a new loan under LTRO. The ECB can make a conscious decision whether or not to make it. Under Target-2, there is no conscious decision to advance more funds. Instead, bills are getting presented for payment and you either pay or not. And if the ECB did not pay, nasty things would happen. So, the ECB really cannot “knowingly do anything wrong” because it no longer has freedom of action.

    By allowing the uncontrolled use of Target-2 (beginning over 2 years ago), the ECB has made itself subject to blackmail. Mind you, total Target-2 claims (mostly against PIIGS-countries) are now around 750 BN EUR (the Bundesbank alone had 547 BN EUR at the end of February). Should the Eurozone fall apart, those 750 BN EUR+ will be worth exactly zero. Nada! At that point, the ECB will have a small recapitalization problem (its equity is about 10 BN EUR!) and the national Central Banks will be called upon to replenish capital. None of the NCBs has enough of an equity base to do that without a recapitalization on their own part — and that is when tax payers have to cough up money through the budget.

    Now comes the real cute part. The Bundesbank may have 547 BN EUR in Target-2 claims (by far the largest portion of all Target-2 claims), but it is liable for only 27% of the total. Why does the Bundesbank have so much more in Target-2 claims than, say, Finland? Probably because Finland has a smaller current account surplus with Greece and because Finnish banks had never extended so much short-term credit to Greek banks.

    So one day, the Finnish tax payers may have to come up with money to recapitalize the ECB via their NCB in the percentage of the total Target-2 claims which they are responsible for. The Finns will be surprised. They will wonder why they should come up with money because someone else made loans to, say, Greece. And it will really get interesting when the Bank of Greece is called upon to come up with its share of the ECB-recapitalization. I suppose the BoG will have to increase its Target-2 liabilities to finance that…

    Again, LTRO and Target-2 are two completely separate issues: LTRO is controllable; Target-2 no longer is. Countries like Greece now have the assurance that they can finance their current account deficit (i. e. their living standard) and their deposit withdrawals via Target-2. Stopping Target-2 altogether would rip the Eurozone apart and make all claims worthless. Stopping it only for Greece would probably rip Greece apart and no one wants to be responsible for that.

    Think of AIG when sub-prime imploded and their CDS were called. The immediate action was to stop the issuance of any new CDS. That was a management decision. Suppose management could not have legally made that decision, then some fellow at the London office of AIG would continue to write CDS like it was going out of style because he got a bonus on the volume. No one could stop him from doing that and the more CDS he wrote, the greater the bill for the US tax payers. That’s the situation which the ECB is in with Target-2.


  2. ELA is just part of the bag of tricks Merkel is using to buy off time, she doesn’t really have.

    Merkel has much large issues to solve, all of her own making. They include:

    1. Adequately capitalizing ESM (to the tune of 3 Trillion euros vs. 1/6th of such amount provided so far)
    2. Resolving her differences with the ECB (which are many and growing larger by the day)
    3. Resolving even stronger differences with the IMF(which refuses to participate in further aid to Europe, unless Merkel ponies up), and
    4. Coming to terms with Holland elected to power in France, which is the end of the Merkozy era.

    As you can see ELA is like the little bush while the entire forest is burning behind it.

    Merkel continues to display a complete lack of depth in dealing with the Euro crisis, which is only getting bigger under her watch and in a manner indicative of the despair surrounding her lack of leadership.

  3. As all global markets watch with horror an out-of-depth Merkel engage in nonsense inspired PSIs (thus destroying trust within the financial system itself),said global markets have an acute sense of a slow moving train wreck.

    And to make things worse, not only we are dealing with an amateurish Germany but also with a chancellor that is at odds with every player of any consequence. Punctuated differences with the ECB, inability to adequately capitalize the ESM and open discourse with the IMF. And to top it all off an on-going saga of German incrementalism, minimalism and obstructionism.

    Just looking at the evidence, the verdict is inescapable. Merkel and Germany are big time destroyers of trust the world over.

    Dean Plassaras.

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