ECB increasingly concerned over aid to Greek banks

Der Spiegel ran an interesting article on the current state of the Greek banking system.  The article confirms several of the points that your humble blogger has been making since the start of the financial crisis.

• In a modern banking system with deposit guarantees and access to central bank funding, banks can continue to operate even when they have negative book capital levels.

• Depositors do not run on the banks or even jog so long as they think the sovereign can perform on the deposit guarantee.

• Depositors will jog if not run to the bank if they think that the deposit guarantee will be honored with a new currency worth substantially less than the currency the deposit was originally made in.

According to Der Spiegel,

The European Central Bank is keeping Greek banks afloat with emergency assistance even though urgently needed banking reforms have been put on hold in the election campaigns. 

As Greeks withdraw money from the banks amid fears of a euro exit, the ECB's own risk exposure is mounting. 

When the head of Greece's central bank, George Provopoulos, recently met with his European counterparts, the session turned into a confession. His fellow Greeks had just withdrawn €800 million ($1.022 billion) from their bank accounts, within just a few days....

Most Greek banks are currently cut off from the usual ECB lines of credit. They no longer have sufficient collateral. A number of banks are even currently operating without sufficient capital as a risk buffer for their activities. Indeed, Provopoulos had to accept last week that yet another crop of Greek banks were branded as unfit for ECB refinancing.

The points in the highlighted text are crucial.  The reason that Greeks are withdrawing their deposits is not  that banks are operating without sufficient capital.  It is the fear of having their deposits devalued through substitution of drachmas for their euros.

These zombie banks are being kept alive with help from the so-called Emergency Liquidity Assistance (ELA) -- a rescue aid program managed by Provopoulos. At every session of the Governing Council, he has to have these special allocations approved. 

For the time being, he has succeeded. Last Tuesday, the ceiling for the amount of aid that Provopoulos is allowed to give his banks was even raised again, from roughly €90 billion to €100 billion. But the Council is harboring increasing doubts about this permanent subsidy.... 

At the same time, the risks are mounting on the central banks' balance sheets. 

Already back in February, Greek banks had accumulated more than €106 billion of debt alone in the TARGET2 internal payment system of the euro zone's central banks.

Debt that is backed by the best collateral that was held by the Greek banking system.

But the central bankers are particularly annoyed as they once again have to play the role of major bankroller because the political system is failing to address the problem. Indeed, in the Greek election circus, it looks like the issue of urgent reform of the country's ailing banks may be given short shrift. 

Nevertheless, funds are available: The most recent bailout package for Greece includes €50 billion to recapitalize the financial sector. The euro partners have even already transferred half of this money to Greece. 

The legal conditions for the bailout have not been clarified, though. Originally, private banks were supposed to raise roughly 10 percent of their recapitalization from private investors, or run the risk of being nationalized. Investors are, however, hard to find.... 

By the end of last week, not even an initial bridge financing of €18 billion had flowed to the banks -- funds which the interim government under Loukas Papademos had approved in a rush before the election on May 6....

Not using government funds to bailout the Greek banks is a good thing.  The investment of these funds in the banks would have no impact on the on-going run on the banks by depositors.  These funds could be better used elsewhere.

According to an analyst with the Moody's rating agency, the Greek banks have in the meantime become "economically insolvent," and thus urgently rely on assistance from the rescue fund....

Regular readers know, and the Bank of England's Mervyn King's shouting from the rooftops has helped, that EU banks are insolvent.  The market value of their assets is less than the book value of their liabilities.

Greek banks may have never indulged in high-stakes gambling on the US real estate market, but after they entered the euro zone, they aggressively expanded their lending operations. 

Now, they are threatened with massive defaults. 

Furthermore, the country's financial elite is closely linked to the political arena. At the beginning of the crisis, this prompted the banks to purchase huge amounts of sovereign bonds. The partial debt waiver by private investors a few weeks ago suddenly took an enormous bite out of the banks' remaining capital reserves. This so-called haircut cost the country's four largest banks alone €24 billion. 

To make matters worse, nervous customers have been pillaging their bank accounts since the beginning of the crisis. The banks have already lost one-third of all their deposits.

Some of Europe's central bankers are nevertheless no longer willing to allow themselves to be endlessly tapped for cash. Belgian Luc Coene has already openly warned that even the ELA payments must "absolutely" be stopped if the Greek banks are actually hopelessly bankrupt, and not merely illiquid.

As part of rebuilding the Greek banking system, Greek banks need to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details so that market participants can assess exactly what is the true condition of the banks.

Those that are hopelessly bankrupt and do not have a franchise that would allow them to generate future earnings to rebuild their book capital levels should be closed.  The rest of the banks the ECB should continue to support.

"Contrary to widespread belief, monetary policy is not a panacea," wrote Jens Weidmann, the head of Germany's central bank, the Bundesbank, in a recent newspaper article. 

Zero interest rate policies have demonstrated that monetary policy is not a panacea.  However, what we are talking about here is a central bank performing as a lender of last resort.

He is primarily concerned with the lax approach to the collateral that the banks use to acquire fresh money. Standards have been repeatedly lowered during the crisis. According to an Athens banker, the regulations are now "very relaxed." 

The banks have simply submitted massive quantities of their own bonds to the central bank -- after the government stamped them with a state guarantee. 

But what will this guarantee still be worth if Greece becomes insolvent? The dubious bank bonds along with Greek government bonds make up roughly 60 percent of the collateral that Greek banks have supplied to obtain cash injections.

At first blush, this appears worrisome.  The reality could be quite different.

Remember that central banks do not lend 100% of the value of the collateral.  Instead, they apply a haircut.  It is entirely possible that the market value of the collateral that the Greek banks have pledge still exceeds the amount of money the Greek banks have borrowed.