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Der Spiegel Identifies the Missing Link

The ECB’s Emergency Lending Authority is Keeping Greece Alive

by MARSHALL AUERBACK

Greece has moved off center stage, as Spain has become the preoccupation de jour for Europe’s increasingly embattled authorities. But one has to wonder how the Greek banking system has managed to sustain itself over the past several months, given widespread deposit flight and the country’s ongoing solvency challenges.

Well, we now have a better idea, courtesy of a leak to the German weekly news magazine Der Spiegel, which has published information about ECB plans to keep Greece on its feet until the next tranche of European Union-International Monetary Fund aid is paid out.  According to Der Spiegel, the ECB has chosen a detour via the Greek central bank under its so-called “Emergency Liquidity Assistance” (ELA) program:

“Now, information has leaked regarding how the ECB plans to keep Greece on its feet until the next tranche of European Union-International Monetary Fund aid is paid out. The ECB has chosen a detour via the Greek central bank. It will allow it to issue additional emergency loans to the country’s banks. These in turn are supposed to use the money to buy up Greek bonds with short maturities. This will scrape together €4 billion, according to the plan.”

Although the context of the Der Spiegel article suggests that the ELA has been activated here for Greece as a short-term bridging measure, it is almost certain that the program has already been used extensively by the ECB to keep Greece alive.  Perhaps this is what Mr. Draghi meant when he suggested that he would do “whatever it takes” to keep the euro alive?

We have long speculated that the main source of funding for Greece over the last several has been the European Central Bank’s ELA program, given that it has become virtually cut off from Target 2.  To reiterate: Under Article 66 of the EU treaty there is complete capital mobility within the Eurozone. A citizen in any country can hold deposits in the common euro currency in banks domiciled in other countries. To meet this opportunity the banks in Europe’s northern core improved the banking facilities they offer to prospective deposit and loan clients on Europe’s periphery. Guaranteed freedom of capital movements and the introduction of the common currency opened the door for citizens in the periphery countries to move their deposits to banks domiciled in the northern core, and those northern core banks facilitated that transfer in every way. As a result it is virtually costless for a Spanish citizen to conduct all of his euro business with a German bank.

Given this ease of capital movements there had to be in the Euro area a quiet automatic payment system that would deal with transfers from banks in one country to banks in another. Initially the architects of the European monetary system thought that the private “markets” would accomplish all the needed financial transfers. If a Spanish bank lost deposits and a German bank received deposits, the interbank market would allow the German bank to immediately and profitably put the money to work and in doing so allow the Spanish bank to fund its deposit loss.

And apparently this is how things went in the early years of the euro. In 2007 German banks had direct claims on banks on the periphery of over 800 billion euros. However, when the Great Crisis occurred in 2008-2009 market confidence ebbed and private sector interbank lending dried up, especially to the European periphery. As a result German bank claims on banks in the periphery have since fallen in half.

What made up the difference? First, the payments transfer system through the system of European Central banks called Target 2. Target 2 refers to Trans-European Automated Real-time Gross Settlement Express Transfer. It is the euro system’s operational tool through which the national central banks of member states provide payment and settlement services for intra/euro area transactions. Target 2 claims can arise from trade and current account transactions as well as from purely financial transactions.

Recently financial transactions have become dominant. Funds have been taken out of banks on Europe’s periphery and have been deposited in banks in the north of Europe, principally in Germany. The bank receiving the deposit places those funds with the Bundesbank (or other recipient national central banks); in doing so it has its funds delivered through the Bundesbank (or other recipient national central banks) to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction. The so-called Target 2 outstanding balance is the net position of such claims between two European countries.

There are specific collateral requirements that must be met for Target 2 funding of banks to occur. Sometimes banks with deposit losses cannot meet those collateral requirements. However, there are other Lender of Last Resort channels, such as the “Emergency Liquidity Assistance” program, that can come into play.

When banks in some Eurozone countries – in this case the periphery – have funding problems and don’t meet Target 2 collateral requirements, they can borrow under the ELA.  This is the program now likely being used to keep Greece afloat.   As the Der Spiegel  article notes, such assistance is extended by single national central banks to their banking systems, in this case the Bank of Greece.

In theory, the risk is borne at the national level. The national central bank in a country like Greece with commercial bank deposit runs ultimately funds its ELA financial assistance to its commercial banks from the ECB. That ECB funding for ELA is above and beyond Target 2 funding.  In theory, because as the German article points out, the ECB is no longer accepting Greek national bonds, so what else is available as decent collateral?  It is true that the collateral requirements imposed upon a commercial bank for obtaining ELA funds is less than the collateral requirements needed for obtaining Target 2 funds, but one wonders how Greek commercial banks, facing an acute deposit run, can offer up anything as value.  The Elgin Marbles perhaps?

As the German publication notes, the irony is that the ECB is no long accepting Greek government bonds as collateral for its refinancing operation: “But the Greek central bank — which in reality is little more than the Athens branch of the ECB — is still allowed to accept them.”

So what we have here functionally is uncollateralised lending to Greece on the part of the ECB, as what kind of collateral could the Greeks actually offer at this juncture which would in reality be acceptable and creditworthy?

No matter what Mr Draghi says publicly, privately he does appear to be using every trick at his disposal to keep the eurozone from blowing up, and one suspects that this aggressive use of ELA is what is getting the Germans so exorcised right now. The ELA support to Greece is likely already in excess of 100 billion euros by virtue of the silent bank run sweeping across the Eurozone. One can only imagine the magnitude of the support ultimately required for the likes of Spain or Italy.

Perhaps this covert ELA support is what the ECB President meant when he delivered his “Whatever it Takes” speech in London in late July. It also likely explains why the Germans are getting more vociferous in their complaints about open-ended commitments to the periphery countries. No doubt deploying the logic of his ancestral countryman, Mr Draghi might not be breaching the letter of the law of the Maastricht Treaty, but he is certainly breaking its spirit, on the Machiavellian grounds that the end – preserving the euro – justifies the means.

It is probably no coincidence that this information was leaked to a German publication. If one were to speculate on the source, a likely candidate is the Bundesbank, which is trying to put a halt to this whole process.

It is true, as Gavyn Davies argued in the Financial Times a few days ago, that as long as the national central banks are willing to allow these ECB support programs to continue indefinitely, then the single currency simply cannot break up: “That is what makes it a single currency.” But Davies also recognized that potential losses under the ECB’s lender of last resort programs after a euro break up have become a political issue within Germany, undermining market confidence in the ultimate stability of the euro. And if the European Monetary Union were to break up, it would mean that today’s huge contingent liabilities facing Germany under both Target 2 and now, increasingly, under the ELA, would become real ones – likely in the range of trillions of euros.

And if the German Government (which has remained conspicuously quiet in the wake of Mr Draghi’s now famous speech) decided under public pressure from the Bundesbank (as well as mounting concerns within the German body politic) to be tough and draw the line on further lender of last resort financing, people would fear bank closures and a dagger in the heart of an unstable ECB. Any other government that puts in question the resulting unstable financial equilibrium would run the same risk.

Is the relative summer calm about to be disrupted by the release of this sensitive information?

MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at MAuer1959@aol.com