ECB – the last line of defence against banks runs

The European banking crisis dwarfs the European sovereign debt crisis (which is enormous) so that, if the sovereigns were in great shape, they would still have ruinous liabilities from trying to save “their” banks.

We now have both bank and sovereign de-leveragings are underway and as with all great de-leveragings, there is a squabble over who will pay for what. Of course, in this case, the squabble is especially
challenging because there are 17 Euroland countries (with opposing factions in each) with radically different vested interests pretending to act in their “common interest”. In the old days, (that is when each country was a country, had its own central bank that printed its own currency and had its own fiscal organizations), it was pretty easy to anticipate what their monetary and fiscal policies would be in light of their circumstances. However, now that the policy tools and the hands on them are not so neatly aligned with the vested interests, the policy moves are not as obvious.

In all great de-leveragings, governments have always tried the austerity path first, found that it doesn’t work (because of the negative feedback loop) and shifted to have their central banks print money and
devalue. Of course, when the great depressions are broad-based (as in the Great Depression and now), they all want to do this, so the devaluations are against gold and other assets that benefit from this reflation. In the Great Depression of the 1930s, the printing/devaluations took place in a sequence in which one country devalued, which shifted the relative tightenings to those that didn’t print/devalue, which caused them pain and prompted them to print/devalue. Now, Europe is going down this path. Since the appetite of those who have wealth to transfer it to help the debtors is limited and since it is increasingly
apparent that austerity is ineffective, the great myths that “all we need to do is create faith and investors will come” and “austerity and our EFSF/ESM supports will create faith” are being shattered. While there is
an emerging realization that restructuring these countries’ debts will have to occur, it is also understood that the rates at which these restructurings can occur without having a collapse are limited. So all eyes are now on the European Central Bank. However, this “European” central bank represents 17 countries with very different vested interests. While some people think that the ECB “money” can be funnelled to the debtor countries without it costing anyone anything, policy makers with common sense know that’s not true. Naturally, the representatives of the countries who need the support think that the ECB buying their bonds is the sensible thing to do while the others don’t.

Given these circumstances, now is the logical time for the individual European central banks to re-emerge and use the powers that they have (independent of the ECB) to aid their banks and their sovereigns. There is increasing speculation that their facilities may also be used as part of the funding for some sort of IMF bailout mechanism. As they act to support the European financial system, the debt/liquidity that they create will end up as someone’s obligation, so we all need to consider whether what they are doing is
printing or building up greater liabilities for European governments.

The national central banks are not obliged to report their operations in a timely and transparent manner, so there is some mystery about how much lending they have actually done. What is clear is that their
support to European banks has surged over the past year, from basically nothing to over €100 billion, and has likely risen more than what has been reported. These facilities have been key in helping to offset the pain of domestic bank runs, particularly in Ireland and Greece.

So far, the only national central banks largely known to have active Emergency Liquidity Assistance (ELA) facilities are in Greece, Ireland and Belgium, though it should not surprise if the list is longer and not yet known. However, over the past several months, Italian and French banks have been dramatically ramping up their borrowing from the ECB, suggesting that those systems as well are beginning to suffer from a loss of private-sector funding to the point where they are forced to seek support from the ECB. The question now is how much more pressure they can take before they have used up all of the collateral acceptable to the ECB, which would require France and Italy to embark on ELAs of their own.

It is worth keeping in mind that while these ELA programs have been ramping up, there is the potential that their use could escalate much further. The European banking system continues to have a high reliance on risky, short-term wholesale funding, and there is roughly €10 trillion of support that continuously needs to be renewed. The stability of the system is both at the mercy of the counterparty’s willingness to lend and also pressured by the still-declining value of European assets used as collateral
for that funding. These funding gaps will create continued pressure for European banks to de-lever in a controlled manner, either by raising more stable funding or by reducing assets.

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