Draghi’s commitment to do ‘whatever it takes’ to preserve the Eurozone undoubtedly has the support of the European political elite, particularly the German political elite. However, every balance sheet has two sides. If ‘doing whatever it takes’ implies that the ECB’s balance sheet is to expand, a further consequence is that its creditors (i.e., for the most part banks keeping cash reserves with it) are more exposed to its failure. As the following note (which is based on my next column in Standpoint) explains, the ECB’s dominant creditors nowadays are German banks, which keep over €750b. cash reserves with the Bundesbank. (See the chart on p. 2 below.) If the banks that borrow from the ECB (which nowadays are predominantly from the PIIGS [Portugal, Italy, Ireland, Greece and Spain] cannot repay their loans, and if the ECB’s modest capital of about €10 billion is exhausted by other losses, Germany’s banks are theoretically liable to a maximum loss of the full €750b. or so.
I say ‘theoretically’, because Eurozone governments would be expected to recapitalize the ECB and to prevent such losses. In this disastrous situation they would of course – well, presumably – carry out the recapitalization. But the cost of the recapitalization would add to nations’ budget deficits and public debts. Further, the German constitutional court has just given its legal endorsement to the €150b. German commitment to the European Stability Mechanism. If the PIIGS’ banks and governments cannot repay in full their debts to the ECB and the ESM, the losses fall back on Germany. We are of course talking about losses that could reach €200b., €300b. or more. The following note (see chart on p. 3) also shows that the pattern of PIIGS’ borrowing from the ECB has changed. Whereas in 2009 the ECB was lending mostly to banks in Ireland, Greece and Portugal, in the last 18 months its new loans have been mostly – indeed almost exclusively – to Spain and Italy.
The two sides of the ECB balance sheet
Germany’s rising financial exposure to Eurozone failure
Is the drama of the euro better understood as farce or tragedy? As in the best traditions of the Whitehall Theatre, people come and go between plush hotel rooms with no idea of why there are there or what they are doing. For the actors and actresses involved, the politicians, bureaucrats, economists and the assorted hangers-on, it has all been a lot of fun since Jacques Delors published his famous report on European economic and monetary union in 1989. The cast has changed from time to time, but the European political elite’s efforts to create the single currency have kept everyone entertained for over 23 years.
Except that the whole exercise is now becoming far more serious than the impresarios of ‘ever closer union’ thought possible. Germany, the top impresario in European integration since it began in the 1950s, could face a bill running into hundreds of billions of euros if the single currency area cannot hold together. But the more emphatic its commitment to preserving the Eurozone, the larger are the sums at stake and the greater is the potential for loss. Even worse, the entire project of European integration could be blighted if the Eurozone has to be restructured. Germany’s determination to model a continent after its own image would again have led to geopolitical tragedy.
As always in international finance, the details are technical and complex. Individuals and companies settle payments across their accounts at commercial banks. The commercial banks, in turn, settle debts between themselves at a special kind of account, their cash balance at the central bank. In the Eurozone banks can make payments to other banks only if they have a positive balance at the European Central Bank. If a Eurozone bank has more payments going out than coming in, it must attract new euro cash deposits or obtain a loan from another bank. If banks in one Eurozone country (read: Germany) do not trust banks in another Eurozone country (read: Spain) and refuse them new loans, banks in ‘Spain’ may be unable to meet their liabilities as they fall due and so are forced ‘to close their doors’.
And the growing indebtedness of Spain’s and Italy’s banks
Bankers have long known about the risk that, even if they run profitable businesses with good assets and strong franchises, they may not be able to fund their assets. One function of central banks has therefore been to ‘act as a lender of last resort’, or as a provider of ‘emergency liquidity assistance’, if inter-bank funding becomes difficult. So the growing distrust between banks in ‘Germany’ and ‘Spain’ has over the last two years had to be met by large loans from the ECB to Spain’s banks and indeed, in practice, to banks in other troubled PIIGS (Portugal, Italy, Ireland, Greece) nations.
A striking feature of the chart above is that since mid-2011 the composition of the Eurosystem’s claims on banking systems has changed radically. The global financial crisis began in mid-2007, but in the early years banks in Spain and Italy were regarded quite favourably, and certainly in a better light than – say – the UK clearing banks and specialist American housing finance intermediaries. The Eurozone crisis was then very much a crisis of Greece, Portugal and Ireland. Their banks were unable to roll over their inter-bank borrowings and were forced to ask for last-resort loans from the ECB/the Eurosystem instead. Happily, the ECB was in late 2008 and for most of 2009 much more easy-going in its provision of loans than, for example, the Bank of England. However, from early 2010 the ECB withdrew the so-called ‘non-standard facilities’ and from mid-2011 worries spread from Greece, Portugal and Ireland to Spain and Italy. The chart above shows the surge in ECB lending to the Spanish and Italian banking systems since the middle of last year. This surge in ECB lending has latterly been facilitated by the restoration of ‘non-standard facilities’ in December 2011, in the form of over €1,500 trillion of ‘long-term refinancing operations’.
The two sides of the ECB’s balance sheet must match. The loans to the PIIGS banks are the ECB’s assets; they have their counterpart liabilities in cash balances maintained by banks from Germany, the Netherlands, Luxembourg and Finland. The ECB’s capital is tiny relative to its overall balance sheet, a mere €10 billion relative to about €3,000 billion. What happens if the PIIGS’ banks do not repay to the ECB the €980 billion which, according to the latest data, they owe to it? Clearly, somebody must lose. Who is that? The answer is the banks from Germany, the Netherlands, Luxembourg and Finland, which at present have positive balances at the ECB of over €1,050 billion. The Maastricht Treaty of 1992 included a specific no-bailout clause (article 125 of the Treaty on the Functioning of the EU). This prevented, or seemed to prevent, one nation being obliged to honour the debts of another. But, despite all the seemingly clever stage management, the impresarios blundered. They overlooked that, in the normal course of banking operations, the ECB could incur debts that were in reality those of Eurozone member nations. The first big rescue loan in the Eurozone, to Greece in May 2010, was largely between governments and used a let-out clause in the TFEU (article 122 on emergency support because of ‘natural disasters’). But since then the rescue operation has been conducted across the balance sheet of the ECB. It is widely and correctly understood as a ‘backdoor bailout’.
Spain, Italy and the others will receive more credit from the ECB in coming months, with the support of a German government anxious somehow to keep the euro intact. The credit will be extended partly by yet more lending from the ECB to cash-strapped banks, and partly by ECB purchases of peripheral government bonds. But the larger the ECB’s balance sheet, the greater is Germany’s possible future loss. Der Spiegel has invented a beautiful word for the looming disaster, ‘die geldbombe’. What a super title for a future Whitehall farce.Tags: Associated Press, Bank of England, Central bank, Europe, European Central Bank, European Union, Germany, Jens Weidmann, Mario Draghi, Quantitative easing