What happens if Greece leaves Euroland? Part 2
0Thoughts on what happens if Greece leaves Euroland and what this might mean for other economies: Part 2
Focusing on how losses may flow through the ECB
How Greek losses flow through the ECB, should they materialize, will be a test for the existing protocols and policies of ECB member banks, and will likely establish a precedent as to how substantial ECB losses will be dealt with in the future. This obviously has enormous implications for policymakers because the ECB has almost €200bn of exposure, in various forms, to Greece. Although the ECB has the capacity to handle this magnitude of loss, how they choose to recognize it and share it between member central banks will have second- and third-order consequences on political decision making, both at the ECB and more broadly in the EU. Below, we break down the types of ECB exposures that exist, along with a description of how they differ from one another.
1. Standard operations undertaken on behalf of the Eurosystem accounts for €123bn of the ECB’s Greek exposure.
The majority of ECB actions in general and for Greece in particular (including ECB repo lending and bond buying), are conducted under the Eurosystem’s standard risk sharing framework. The ECB’s Eurosystem exposure to Greece is comprised of €80bn of lending to Greek banks and €43bn under of SMP purchases. In theory, default risks from these exposures are pooled across all Eurosystem member banks, regardless of which individual NCB happened to engage in the money losing transaction. So, even if there are large amounts of risky lending showing up on the balance sheets of peripheral national central banks, and these loans are funded using loans from the Bundesbank (via its Target 2 surplus), the plan is that the risks from these transactions are, in fact, expected to be much more spread out across the Eurosystem. Realistically this is more likely to be adhered to for small losses than systemically large ones.
2. Non-Standard operations undertaken for the benefit of individual NCBs account for €65bn of Greek exposure
Unlike standard operations which are shared by the Eurosystem, these operations are the sole domain of the individual central banks and are deemed to occur outside the traditional Eurosystem. For Greece, these operations consist of the Bank of Greece’s €50bn ELA and €15bn of NCBs’ non-monetary purchases of Greek government bonds. In theory, this means the credit risk for these transactions is borne solely by the NCB making the loan. Again, these loans are considered to occur outside the Eurosystem because they are being made with different standards and terms then those agreed to for the Eurosystem as a whole. Therefore, they are NOT a shared risk of the Eurosystem. In the event of a central bank default (and a departure from Euroland), losses incurred through these activities would likely become an unsecured claim of the Eurosystem against the new central bank, though there is not statutory consideration of this event. The likely outcome is that this will be negotiated but we don’t know.
3. Eurosystem loss absorbing capacity is large, but taking losses could cause political problems
The Eurosystem has a variety of buffers to absorb losses which could total more than €1trln even before making a politically unpalatable capital call on its member National Central Banks (which would likely be a fiscal event for Euroland governments). However, it is worth noting that the vast majority of this capacity comes from the flexibility of the ECBs’ governing council to “create” gains or assets via accounting to offset losses. Regardless of the orthodoxy of their potential capital, given that much of the ECB’s lending is marked to market, this amount is likely to be more than sufficient to absorb losses from their current €1.2tn in peripheral exposure. Although utilizing accounting changes to take losses of this magnitude could be more politically challenging for the ECB and EU than the technical capacity, below we outline the mechanisms by which the ECB could absorb losses.
In the event that a loss occurs, the ECB’s governing council has a prescribed process for how those losses are taken, first through the reserve account and then from a clawback of monetary income. But, in addition to the use of reserves and monetary income, the ECB’s governing council has pretty broad latitude to revalue assets to offset losses. The two largest valuation actions that the ECB governing council could take are the revaluation of its gold (this is interesting because the ECB doesn’t own most of the gold, the National Central Banks do) and assigning a valuation to its future seniorage profits (the ECB probably has broad latitude to value all future profits). Both of these revaluations, while apparently within the powers of the ECB governing council, are not what would be considered conventional capital. But importantly, taking these valuation actions could prevent ECB losses from becoming a fiscal event for Euroland countries via a capital call. It may be that these two changes alone could allow the ECB to offset losses well in excess of €1tn, but it is hard to be precise. The ECB also has more traditional reserve accounts, annual seniorage and capital which are small relative to these large valuation items.
While these numbers could be a bit higher or lower, the issue that matters is the flexibility that the ECB governing council has to utilize valuation accounting to prevent a capital call.
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
