Ioannis Glinavos (@iGlinavos), Senior Lecturer, University of Westminster https://iglinavos.wordpress.com/
The European Central Bank’s (ECB) actions regarding Greece, particularly since Syriza’s political victory, have drawn considerable criticism. This piece examines the gradual tightening of Greece’s financial situation within the framework of ECB regulations and considers potential outcomes if a resolution for Greece’s urgent funding requirements isn’t reached by June 2015.
ECB Halts Greek Government Bonds as Collateral
Since accepting its initial bailout in 2010, Greece has largely been unable to secure funding from markets except through domestic T-Bill issuances. Continued assistance from the Troika hinges on successful completion of regular reviews. Greece has not received bailout funds since mid-2014 due to the unsuccessful completion of its last review.
Without bailout disbursements, the Greek government resorted to borrowing from its commercial banks to finance deficits. Despite an inability to secure long-term funding in bond markets, Greece increased borrowing through short-term treasury bills. This was possible because these banks could borrow from the Bank of Greece (BoG), which in turn, could borrow from the ECB as long as Greece remained part of the euro. Greek banks were compelled to accept more government debt for political reasons. Additionally, a sovereign default would render existing government debt holdings worthless, potentially leading to increased state ownership – a difficult situation for domestic banks. Therefore, the cessation of EU/IMF lending did not restrict Greece’s budget or borrowing. It was as if Greece had received ‘bailout’ funds indirectly, resulting in a quicker increase in Eurosystem debt.
Before February 2015, while discussions regarding the final assessment were ongoing, Greece continued to finance itself through the ECB. This was accomplished by selling bonds to commercial banks, who then used these bonds as collateral with national central banks (NCBs) to obtain necessary funds (through the ECB). As interest on correspondent account balances (NCB-ECB) is only the ECB discount rate, this financing method is inexpensive. In practice, the ECB had attempted to dissuade NCBs from misusing these accounts. Since the beginning of the crisis, the ECB had been urging Greece, Ireland, and Portugal to seek bilateral rescue loans and EFSF/ESM funds instead of relying on their banks and ECB credits to manage deficits and rollovers. The success of this, however, depended on the ECB accepting state paper as collateral. Prior to 2008, only A-rated paper was eligible. This was lowered to BBB- in October 2008 to allow for a significant expansion of ESCB credit. When Greece faced a potential credit rating below investment grade, the ECB, in May 2010, removed this minimum rating requirement for the Greek government.
This ‘concession’ for Greece ended on February 4, 2015, when the ECB’s Governing Council revoked the minimum credit rating waiver for marketable instruments issued or guaranteed by Greece. This suspension aligned with existing Eurosystem regulations, given the uncertainty surrounding the program review’s outcome.
ECB Limits ELA
Loss of direct access to ECB credit lines forced the BoG to rely more heavily on Emergency Liquidity Assistance (ELA), which is not bound by ECB collateral regulations. While ELA is intended for short-term use, the Irish central bank’s extensive utilization of it set a precedent. The ECB Council could direct the BoG to cease ELA use, but this appears improbable considering the Irish case. The mechanics of ELA (governed by limited rules outlined in a concise two-page document) involve the NCB making a request, which the ECB typically fulfills unless two-thirds of the governing council objects. ELA can only be granted to ‘solvent’ institutions and cannot directly finance a state, as that would breach the Treaty’s No-Bailout clause. Furthermore, the ECB clarified that the so-called Securities Market Programme portfolio of Greek bonds held by the ECB cannot be restructured. Doing so would equate to an overdraft for Greece, violating Article 123 of the Treaty on the Functioning of the European Union. Nonetheless, the ECB continues to support Greek banks by permitting gradual ELA increases, effectively offsetting the outflow of deposits stemming from the slow-motion bank run that began when elections were announced in late 2014.
However, supporting Greek banks and indirectly aiding Syriza through them are distinct issues. The ECB has been actively discouraging Greek commercial banks from acquiring more government T-bills. In March 2015, reports surfaced that the ECB had advised Greece’s largest banks against increasing their exposure to (short-term) Greek government debt. The ECB formally incorporated warnings about limiting Greek T-bill holdings at Greek banks within its legal framework. By March 2015, Greek banks held roughly €11 billion of T-bills, with the Greek government operating under a Troika-imposed limit of €15 billion in T-bill issuance (total outstanding). The ECB’s new legal framework implied that Greek banks would be unable to bridge the potential €4 billion gap if foreign investors chose not to reinvest in maturing T-bills. An official cap on the volume of T-bills Greek banks could leverage for ELA funding (€3.5 billion as of March) was already in place.
Adding to these measures were subtler changes that restricted Greek banks’ ability to draw liquidity from the Eurosystem. In March, the ECB adjusted regulations concerning state-guaranteed bonds, a separate issue from the aforementioned sovereign bonds no longer accepted as collateral for Greece. While the ECB had barred commercial banks from using sovereign bonds as collateral for direct borrowing, it had continued to accept commercial bank bonds guaranteed by the Greek state. This practice ended with the Governing Council’s adoption of Decision ECB/2013/6. Effective March 1, 2015, this decision prohibits the use of uncovered government-guaranteed bank bonds issued by the counterparty or a related entity as collateral in Eurosystem monetary policy operations. Following measures implemented in July 2012, which limited counterparties’ use of their own issued uncovered government-guaranteed bank bonds, this decision ostensibly aims to ensure equitable treatment of counterparties in Eurosystem monetary policy operations and streamline legal provisions.
This obscure practice (now inaccessible to Greek banks) involved a commercial bank effectively lending to itself by issuing a bond not meant for sale. This “phantom bond” was created solely to be presented to the ECB as collateral in exchange for a cash loan. Ordinarily, the ECB would reject such a “phantom bond” as collateral because it creates a closed loop of financing – a manipulation of the concept of collateral and a blatant violation of ECB regulations. To circumvent this, the bank would first secure a Greek government guarantee for its phantom bond. With this guarantee, the ECB would then accept the phantom bond and provide the cash loan, effectively making the Greek taxpayer the unwitting collateral provider.
Several European governments (including Greece) had implemented schemes guaranteeing bonds issued by credit institutions shortly after the 2008 financial crisis to bolster their banking systems. However, this market trend suggests that making own-use government-guaranteed bonds eligible, alongside the suspension of the minimum credit rating, enabled a substantial portion of these increasingly issued bonds to be used in reverse transactions for refinancing ECB credits. Government guarantees are significant for two reasons. First, they expose taxpayers to risk in the event of a bank default. Second, these guarantees can influence the collateral’s valuation and credit rating, thereby affecting refinancing terms. In February 2009, the ECB expanded the acceptance of own-use assets to include those with government guarantees. This, in principle, made it possible to securitize assets into bonds that, while retained and never market-evaluated or rated, could still be used as collateral for refinancing credits due to the government guarantee. Furthermore, the valuation haircuts would be favorable if the guaranteeing government had a higher credit rating than the issuer. As previously mentioned, this option is no longer available.
Could Conflict with the ECB Lead to Target2 Expulsion?
The current conflict could result in Greece defaulting on its consolidated IMF payment due at the end of June. While not guaranteed, if this is classified as a default, it may further weaken the position of Greek banks. Even if the ECB refrains from labeling the Greek banking system insolvent (making it ineligible for ELA), it’s highly probable that haircuts on GGBs would increase, further complicating Greek banks’ ability to pledge collateral for ELA. A further deterioration of relations leading to a comprehensive sovereign debt default (and/or Grexit) would compel the ECB to withdraw support for the Greek banking system, and by extension, the defaulting Greek government. However, it’s challenging to envision the BoG collaborating with the ECB in dismantling the Greek banking system.
Should the ECB prohibit ELA, depriving the BoG of authorized means to lend to its banks, the BoG would be left with a limited set of options. Assuming the government is opposed to issuing its own currency, the BoG would be forced to defy the ECB and continue lending. The alternative – allowing banks to fail due to lack of liquidity – is simply not viable. What measures could the ECB take to prevent this? The only way for the ECB to halt this indirect Eurosystem lending to the Greek government would be to instruct other NCBs to refuse further credit to the BoG, effectively excluding it from the Target2 system. This scenario echoes the dissolution of the post-Soviet ruble zone. However, such a move would obstruct cross-border payments from Greece, effectively forcing the country out of the euro. The free flow of credit between Eurozone NCBs is a fundamental aspect of the monetary union, ensuring that a euro held in a Greek bank is equivalent in value to a euro in any other eurozone bank. As long as Greece remains in the euro, it cannot be cut off from Eurosystem credit. Consequently, Germany and other financially sound eurozone countries will continue lending, regardless of whether Greece defaults on its debt. This lending, if not channeled through a formal loan facility, will occur through the Eurosystem (ECB). This flow of funds will only intensify if uncertainties about Greece’s euro membership trigger accelerated capital flight. The ECB is obligated to continue lending to Greece or any other struggling country that remains within the euro. The ECB (or more precisely, the NCBs comprising the Eurosystem) acts as the lender of last resort, whether it chooses to or not. This presents a paradox: While the ECB cannot legally expel Greece from the Eurozone, excluding it from Target2 would effectively create a separate Greek euro that floats against the established euro, leading to valuation discrepancies. In any case, Greece would almost certainly contest the legality of a Target2 expulsion in the CJEU.
Questions for Mr. Draghi
The Greek government has accused the ECB of placing Greece in a stranglehold. A more accurate description would be that the pressure is specifically on the government. However, the evolving crisis presents the ECB with significant questions. Mr. Draghi should address the following:
How will the ECB handle a default on IMF loans?
Will ELA support continue if credit agencies downgrade Greece to default status?
In the event of a sovereign default, will ELA support hinge on the implementation of capital controls?
How will the ECB respond to ‘unilateral’ actions taken by the BoG in the case of default?
Further Reading:
Ruparel, Even If Deal Is Reached With Greece, The Drama Is Just Beginning
Garber, The Mechanics of Intra Euro Capital Flight,
Buiter, The implications of intra-euro area imbalances in credit flows
Varoufakis, How the Greek Banks Secured an Additional, Hidden €41 billion Bailout from European taxpayers
Whittaker, Eurosystem debts, Greece, and the role of banknotes
Barnard & Peers: chapter 19
Art credit: www.rollingalpha.com