by Andrew Stuttaford

Now that Greece is in “selective default,” the European Central Bank can no longer accept Greek government bonds as collateral for funding extended to Greece’s banks, bad news as those banks are, in one way or another, on life support supplied by the ECB.  As Ekathimerini’s Nick Malkoutzis notes:

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.

So far, so good then, even if ELA money is somewhat more expensive than the funds with which the ECB has provided European banks under the two giant refinancing operations it has arranged over the last few months. As always in this crisis, however, there’s a catch, in fact several catches:

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. [A] letter  [from Bundesbank President Jens Weideman] 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.

Indeed it could.  Meanwhile, Munchau’s article is worth reading in full, not least for this observation:

[B]y seeking insurance against a collapse of the euro, the Bundesbank tells us it no longer regards the demise of the euro as a zero-probability event. If the Bundesbank seeks insurance, so should everybody else.