Suicide is 100% preventable: Varoufakis and Draghi need to make it work

Yanis Varoufakis will meet Mario Draghi, the ECB president, in Frankfurt on Wednesday 4.2.15 hoping to persuade him to maintain liquidity to Greece’s banking sector even after the country’s EU bailout programme expires at the end of February.

Here is where Draghi could help, if a wider agreement is not reached and funding via loans to Greece stops. Garber suggests that Greece could, if it had to, continue to finance itself via the ECB even if support is not forthcoming and it could not sell new bonds to the market because of fears of default. Under this scenario, Greece could sell bonds to its commercial banks, which then deposit those bonds as collateral with the NCB in order to gain the funds needed to pay for the bonds. Correspondent account balances (NCB-ECB) only pay the ECB discount rate as interest, so this is a cheap form of financing. In practice the ECB has tried to persuade NCBs to stop abuse of these accounts. The ECB pressured Greece, Ireland, and Portugal each to seek bilateral rescue loans and EFSF/ESM funds rather than use their banks and ECB credits to finance their deficits and rollovers. For this to work of course, state paper needs to be accepted as collateral by the ECB. Prior to the 2008 crisis, only A- paper was acceptable collateral. This was reduced to BBB- in October 2008 to allow for the large expansion of ESCB credit. As Greece was being threatened with a credit rating below investment grade, the ECB dropped this minimum rating requirement for Greek government in May 2010. If the ECB were to cease accepting the country’s paper as collateral to end this back-door financing, then outgoing payments could no longer be made and the Greece’s banking system de facto would be cut off from the euro. If the country’s authorities kept the banking system open for internal payments at least, the bank deposits in the country would float against the euro currency.

The above demonstrates why Draghi needs to agree with Varoufakis not to pull the plug on Greece by changing the collateral rules. If the ECB changes the rules on what it accepts as collateral, Greece (and maybe also Ireland, and Portugal) could not afford to settle their balance, and they are unlikely to be able to keep managing their payments systems which will remain in deficit into the future. Eventually, they would default on transactions. It is important to reiterate (see earlier posts) that Target2 net balances of NCBs cannot be directly capped without putting into question the basic functioning of the Eurozone currency union. Boone notes that correspondent account balances are critical to the functioning of the euro system. If some central banks decided they would no longer accept claims from another central bank—let us say, hypothetically, the Bank of Greece—this would effectively end the euro area. If euros held in Greek banks become less useful than euros held in German banks, the price of the two will diverge.

Assuming, such a drastic measure is not taken, the government could then use the funds to pay private creditors in other countries who are not rolling over existing debt. The ECB then effectively replaces the old creditors of the sovereign and the lender for ongoing deficits—indirectly via the collateral at the NCB. This is however how a sovereign debt crisis in one of the euro-zone sovereigns becomes a problem for the euro currency and a risk that might overwhelm the capital of the ECB. This is especially so if a sovereign crisis is allowed to fester long enough that the ECB ends up with a significant direct or indirect claim on the sovereign before a default occurs. With these exposures, if any country were to default on its debt and the recovery value were sufficiently low, the collateral covering the NCB’s loans to local banks would be worth far less than the booked loans. In the “Protocol on the Statute of the European System of Central Banks”, Article 33.2 stipulates that: “In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5”.  The dangers described above are aggravated, as Buiter notes, by the huge lack of transparency which exists as regards the terms and conditions of portfolio investment and lending decisions of the ECB, including composition of its outright holdings of securities and of the collateral it holds, the prices at which it buys and sells securities held outright, the valuation of collateral, and the models used to price illiquid securities. This lack of transparency is further enhanced by a lack of consistency and diminished credibility created by the ECB’s waiver of the minimum rating thresholds for the sovereign debt for Greece, Ireland, and Portugal, and the lack of clarity about the rules governing the operation of ELAs.

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@iGlinavos

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6 thoughts on “Suicide is 100% preventable: Varoufakis and Draghi need to make it work

  1. 4 February 2015 – Eligibility of Greek bonds used as collateral in Eurosystem monetary policy operations

    ECB’s Governing Council lifts current waiver of minimum credit rating requirements for marketable instruments issued or guaranteed by the Hellenic Republic

    Suspension is in line with existing Eurosystem rules, since it is currently not possible to assume a successful conclusion of the programme review

    Suspension has no impact on counterparty status of Greek financial institutions

    Liquidity needs of affected Eurosystem counterparties can be satisfied by the relevant national central bank, in line with Eurosystem rules

    The Governing Council of the European Central Bank (ECB) today decided to lift the waiver affecting marketable debt instruments issued or fully guaranteed by the Hellenic Republic. The waiver allowed these instruments to be used in Eurosystem monetary policy operations despite the fact that they did not fulfil minimum credit rating requirements. The Governing Council decision is based on the fact that it is currently not possible to assume a successful conclusion of the programme review and is in line with existing Eurosystem rules.

    This decision does not bear consequences for the counterparty status of Greek financial institutions in monetary policy operations. Liquidity needs of Eurosystem counterparties, for counterparties that do not have sufficient alternative collateral, can be satisfied by the relevant national central bank, by means of emergency liquidity assistance (ELA) within the existing Eurosystem rules.

    The instruments in question will cease to be eligible as collateral as of the maturity of the current main refinancing operation (11 February 2015).

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  2. By restricting Greek bank borrowing to the ELA already, the ECB ensures that Greece needs to think hard about refusing loan money. It brings a catastrophic conflict scenario over use of the ELA much closer. It is a bad decision!

    Bloomberg: http://www.bloomberg.com/news/articles/2015-02-04/what-the-ecb-s-move-on-greek-government-debt-is-really-all-about

    “In a press release that jolted the markets, the ECB announced that it will no longer accept Greek government debt as collateral starting next week. But this news is not necessarily a potential liquidity disaster for Greek banks.
    The Greek banking system is not particularly reliant on Greek sovereign debt as collateral. Figures from the Bank of Greece show that Greek financial institutions currently have about 21 billion euros of Greek sovereign exposure. Furthermore, this debt has already been subject to valuation haircuts of up to 40% when used as collateral at the ECB.
    All collateral that the Greek banks use for ECB operations that is not Greek sovereign debt is still perfectly good to use. This decision of the ECB is against the Greek sovereign, not the Greek banks.
    Further, any shortfall in liquidity will be fully made up by Emergency Liquidity Assistance that will be issued by the Greek Central Bank at its own risk.
    So, all together, the move from the ECB should have very little immediate effect on the Greek banks – provided there is not a complete loss of confidence in the Greek banking system in the coming days – and should be viewed as what it is: The ECB is pressurizing the Greek government.
    The Greek finance minister Varoufakis has been agitating for Greek debt relief since his appointment after January’s election. Today the ECB gave its answer to his moves. If the Greek government does not agree to re-enter a program, then the ECB will not allow its debt to be used as collateral.
    The immediate effects should be seen as limited within market space, but huge within the political realm.
    The ECB has often been accused of placing too much political pressure on governments. Today’s moves shows that it has chosen to ignore those accusations once again and do what it feels is right.”

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