Mario Draghi’s mantra that the European Central Bank is a rules-based institution is being tested to breaking point by Greece.
The question of whether Greek lenders still meet the solvency and collateral requirements for the 83 billion euros ($93 billion) of emergency funding they currently receive is becoming ever more pressing. The ECB president, who will head a meeting of his Governing Council on Wednesday, warned this week that a positive answer can’t be taken for granted.
The Greek government’s struggle to unlock bailout funds to pay its debts automatically casts a shadow over the nation’s banks, whose financial health is tied to state guarantees on their assets. The dilemma for Draghi is that curtailing central-bank liquidity could tip the country toward capital controls and political turmoil.
“Greek authorities may depict capital controls or the closure of the Greek banks as unjustly imposed upon them,” said Malcolm Barr, an economist at JPMorgan Chase Bank in London. “We doubt that the ECB will do anything without there being clear political backing.”
As euro-area finance ministers prepare to meet in Luxembourg on Thursday, the likelihood that Greece will be able to bridge its differences with its creditors is dwindling. Jeroen Dijsselbloem, who will chair the meeting, told reporters in the Hague on Wednesday that while a deal is still possible, “it’s up to the Greeks now to come up with a number of alternative proposals.”
Failure to reach an agreement would “mark the beginning of a painful course that would lead initially to a Greek default and ultimately to the country’s exit from the euro area and, most likely, from the European Union,” Bank of Greece Governor Yannis Stournaras said in a policy report on Wednesday.
Consequently, investors are increasing their bets that the country will miss around 1.54 billion euros of repayments due to the International Monetary Fund by the end of the month. Credit-default swaps signal an 81 percent probability of default, up from 79 percent on Friday.
The risk to Greek banks is highlighted by ECB data showing that about 42 percent of the CET1 capital of the four largest Greek banks at the end of 2013 was made up of deferred-tax assets, which have since been converted into a direct claim on the state. First-quarter earnings by Eurobank Ergasias SA showed that as much as 74 percent of its tangible equity is made up of government-backed tax credits.
Any kind of default-like by Greece, such as not paying the IMF at the end of June, would make it next to impossible for the ECB to maintain that the banks continue to be solvent.
At the European Parliament in Brussels on Monday, Draghi reiterated that the ECB is a rules-based institution, and that Greece will be dealt with on that basis. He also came close to saying that the day the Governing Council has to change its stance is nearing.
“At this stage, the Greek banks are solvent,” he said. “The situation is in evolution and so we will have to look, as we’ve been doing actually in the last few weeks, we will have to monitor the situation very closely to see whether the conditions for the assessment of the collateral are still in place and, more generally, on the health of the banking system.”
The ECB could argue that the rules require it to end its support for Emergency Liquidity Assistance and force the Bank of Greece to call in the loans. Officials might also adjust the discounts applied to the collateral banks post to more accurately reflect the changed credit risk. They could choose to place a hard cap on the emergency liquidity.
‘Business as Usual’
Alternatively, the Governing Council could decide to wait to see progress in the political talks, while allowing ELA to rise further to counter deposit outflows from Greek lenders.
Draghi said it should be “absolutely clear” that the decision on Greece’s bailout program must be taken by politicians rather than by central bankers, signaling a reluctance to take the lead.
“Until the moment there is a default, it’s business as usual,” Governing Council member Klaas Knot told the Dutch parliament on Tuesday. “As long there is a perspective of an agreement between creditors and Greece which could prevent a default, the collateral we accept will be valued according to normal rules.”
Since the ECB cut off Greek lenders from its standard financing operations in February, forcing them to borrow from their national central bank, it has approved an increase in the cap on ELA 16 times. In a sign that deposit flight is accelerating, policy makers last week raised the limit by 2.3 billion euros, the most in almost four months.
History may point to Draghi’s next move. In 2013, after Cypriot lawmakers rejected a proposal for a bailout deal that involved taxing insured bank deposits, the ECB raised the stakes by threatening a withdrawal of ELA support. All sides complied, and a revised deal was voted through four days later.
Should the Governing Council cut ELA, the cascade to capital controls and euro exit might start, according to Raoul Ruparel, co-director of Open Europe, a London-based think-tank.
“If deposits erode but they can’t raise ELA then a funding gap opens,” he said. “If Greece doesn’t think there’s a chance of a deal then I think it could quite quickly move from capital controls to Grexit. The ECB would give some kind of warning, as they did with Cyprus.”
For more, read this QuickTake: Greece’s Fiscal Odyssey