Spectre of ‘bank runs’ fueling Euroland woes

With the more well off households and companies in peripheral economies moving money out of some domestic banks, the spectre of so-called ‘bank runs’ rears its head. This may force the ECB to add more settlement cash to the system in the near term. This may be seen as quasi quantitative easing, but if the ECB does now add more cash this will likely be just to ensure that there is sufficient cash to accommodate people seeking to withdraw their own cash. On this basis, any ‘printing money’ now by the ECB makes banks ‘safer’ for depositors but does not add to the money supply in the wider real economies. In the same way the LTROs added little to the Euroland M3 aggregate, and just made it more likely that people would be able to access their cash at will without causing bank failures.

A clear problem for the ECB is that by keeping commercial banks in the periphery open, depositors can shift funds from banks in the Euroland periphery into the core, thereby worsening the periphery’s implied balance of payments deficit. Under the terms of the Euro, Germany’s Bundesbank is supposed to offset peripheral economy balance of payments deficits by expanding its TARGET2 lending to the periphery. This need to expand the Bundesbank’s TARGET2 exposure almost infinitely in order to cover the balance of payments deficits in the periphery was already visible under the LTRO schemes a few months ago and as the stresses in the periphery and the capital outflows mount, the need for TARGET2 funding from the Bundesbank must be rising. The Bundesbank have already written a public letter to the ECB complaining about its need to keep lending to the periphery via TARGET and the quality of the collateral and other terms that it was being offered in exchange. Since then the problem has got worse.

If the ECB were not to add more settlement cash to the system (or were not to allow national central banks to do so on its behalf), then there would be the very real prospect of domestic banks being obliged to close in the face of bank runs, followed by the imposition of capital controls. At that point, the crisis would become global not least because changing the legal basis of contracts in the cash and futures markets without proper planning would create huge upheaval and uncertainties.

If there is to be orderly change, with partial brake up of the euro, we should expect that the European regulatory and legal professions would need at least six months to put in place a suitable fit-for-purpose functioning framework for dealing with the practicalities.

In the interim the ECB or its national agents will simply have to offer more LTRO-type facilities and the core will have to offer more fiscal transfers and debt forgiveness to and of the periphery.

From a practical perspective, the Bundesbank will have to fund much of this through further TARGET lending, and whilst the Bundesbank would be uncomfortable, it would have little choice, with the ECB likely forced into another multi-trillion Euro balance sheet expansion in the next few weeks or months. As with the efforts to date, this reactive policy should not be confused with deliberate quantitative easing.

There is the possibility that funds flow from the euro which would then fall in value, which in turn could cause overheating of the German economy, and long term intra-Euroland competitiveness imbalances could be solved by higher German inflation and a weak euro. However this scenario depends on euro weakness leading to German inflation, which given the weak credit demand environment may not be achieved.

Our summary perspective is that in the near term, the challenge is to avoid disorderly failure of the euro. The Euroland authorities will have to buy time over the next few days and weeks by not only accommodating the bank runs by adding more liquidity to the system, but also by further compromise of the Bundesbank’s balance sheet, by obliging it to lend sufficient money to the periphery to cover the latter’s growing implied balance of payments deficits.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla