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ELAphant in the room

30 Jan 2015 By George Hay, Neil Unmack

The 25 members of the European Central Bank’s governing council must be experiencing unpleasant feelings of déjà vu. In 2012, they allowed bust banks in Cyprus to build up the equivalent of over half the tiny state’s GDP in so-called emergency liquidity assistance (ELA) from the island nation’s own central bank. That deferred Cyprus’ bail-in, but at a high cost. The eventual rescue and bail-in were more painful when they became unavoidable in 2013. It may be hard to avoid something similar in Greece.

European banks that suffer outflows of deposits beyond their cash reserves have two ways to continue functioning. Lenders with plenty of high-quality collateral can park it in Frankfurt in return for cash. Those with lower-quality assets to pledge can swap these for ELA provided by their national central bank, which theoretically bears the associated credit risk. Cyprus also introduced a third, extreme solution – capital controls that restricted customers’ ability to withdraw funds from bank accounts and take them out of the country.

Greek banks are currently on the road to needing ELA, and the ECB has granted preliminary permission for the Bank of Greece to provide such assistance. The election of radical left-wing coalition Syriza on Jan. 25 means Greeks, fearing euro exit, have stepped up deposit outflows: 9 billion euros, worth 5 percent of GDP, left the system in January alone.

If the pace of outflows picks up, the ECB will have a problem. In the short term, it can’t really do anything other than let Greek banks build up ELA. In the October stress tests, its own banking regulator found that all four big Greek banks had sufficient capital. Cutting them off from liquidity would rouse popular ire in Greece, where 70 percent of the population currently wants to stay in the euro zone. Capital controls could change that.

Public relations are also important in Germany, though. The closer Greek ELA usage gets to its 2012 levels of 120 billion euros, the bigger the potential losses in the euro zone payments system if the country actually leaves the euro zone. The losses could be limited with capital controls, which have been tolerated reasonably well in Cyprus. But what proved bearable in Cyprus may be much more destabilising for Greece.


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