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.