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