The ECB increased its emergency liquidity assistance for Greek banks from €50 billion in February 2015 to approximately €90 billion in June 2015 (Financial Times 2015). Its actions were accompanied by a discussion among academics, politicians and practitioners regarding the legitimacy of emergency liquidity assistance. Some have even accused the ECB of deliberately delaying the bankruptcy filing of already insolvent Greek banks.
In a recent paper (Götz et al. 2015), we analyse the underlying economics of the emergency liquidity assistance programme and the complex interrelationship between the EU, the ECB and the Greek banks, with a particular focus on the political economy of a monetary union with incomplete fiscal union. We conclude that the ECB’s actions cannot be classified as delaying the filing for insolvency.
Lender of last resort in a currency union without fiscal union
To avoid bank failures that occur because banks are (temporarily) illiquid, Bagehot (1873) calls for a so-called lender of last resort, standing ready to provide funds to illiquid but solvent banks. Central banks have typically assumed this role, as they are best suited to credibly offer liquidity to banks in today’s financial system.
The Eurozone provides lender of last resort facilities to distressed banks via the national central banks. The national central banks provide emergency liquidity assistance to solvent but illiquid institutions. According to the guidelines, the ECB can object to emergency liquidity assistance with a two-thirds majority vote cast of its Governing Council if it “considers that these operations interfere with the objectives and tasks of the Eurosystem”.
The question of liquidity assistance and bank solvency needs further examination if a bank operates in an environment that renders the viability of its business model and solvency considerations contingent on political decisions at a higher level outside the bank’s scope. Problems tend to arise if a major borrower of a bank is also its sovereign, especially when the sovereign’s solvency depends on decisions regarding the provision of funds on a supranational level. In the currency union, the decision to provide additional funding to a country, in times of financial distress, depends on a consensus among European policymakers. Additional funding for the Greek government, for instance, depends on the Troika and the Eurozone finance ministers.
In a monetary union, ultimately, the higher level decision of whether or not to grant assistance to a troubled country bears on the solvency of the (national) banks. Depositors will reasonably condition their behaviour (and whether to run on a bank) on the outcome of the decision-making process at the supranational level. Note that this is an important insight – the assessment of a national bank’s solvency is intertwined with the decision at the higher level. By the same line of argument, if a needed rescue package is denied at the supranational level, then the country’s banks are likely to become insolvent, and emergency liquidity assistance has to be rejected.
Putting the pieces together: Is Greece 2015 a case of delayed filing of insolvency?
Clearly, a comprehensive and detailed analysis of the current solvency of the Greek banking sector requires bank-specific portfolio data, as well as information obtained from ongoing supervision and monitoring of Greek banks. We provide a short assessment of the Greek banking sector based on publicly available data and information obtained from the ECB’s recent (October 2014) Asset Quality Review as well as the stress test.
The most recent book capital and regulatory capital ratios (before Syriza took power) suggest that Greek banks are sufficiently capitalised (by international standards) and may therefore be considered to be solvent:
- Equity-to-asset ratio (weighted average across 4 Single Supervisory Mechanism banks as of 31 December 2014) of 9%;
- Common Equity Tier 1 ratio (weighted average across 4 Single Supervisory Mechanism banks as of 31 December 2014) of 13.96%.
Similarly, data provided by the Single Supervisory Mechanism and information from the most recent stress test suggest that capital shortfalls in a severe downturn would be small relative to banks’ book equity or relative to Greek GDP. We use two shortfall measures:
- A regulatory shortfall measure (the ECB’s official assessment) – the stress scenario is the adverse scenario. The regulatory benchmark is the Common Equity Tier 1 ratio that is defined as Common Equity Tier 1 capital divided by risk-weighted assets. The ECB applies a hurdle rate of 5.5% in the adverse scenario. The calculated capital shortfall in this scenario is €8.7 billion, which is about 30% of the Common Equity Tier 1 capital of these banks at this time.
- The stress scenario is a systemic financial crisis with a global stock market decline of 40%. SRISK (a measure of systemic risk) is our measure for a bank’s capital shortfall in this scenario, assuming a 5.5% prudential capital ratio with losses approximated using the Volatility Laboratory (V-LAB) methodology (from NYU) to estimate the downside risk of bank stock returns. The calculated capital shortfall in this scenario is €4.4 billion, or about 17% of the banks’ Common Equity Tier 1 capital.1
Figure 1. Aggregate banking sector deposits and repos of non-monetary financial institutions
Data source: Bank of Greece.
Since the stability of the Greek banking sector was indicated by the ECB’s asset quality review and stress test results, concerns regarding the solvency of Greek banks probably did not enter the discussion regarding the magnitude of the emergency liquidity assistance to Greek banks, which was already in place by late 2014. Moreover, the depositors’ run on Greek banks did not occur until the new Syriza government took power and the risk that Greece might leave the Eurozone increased. As shown in Figure 1, the withdrawals of deposits considerably accelerated, following the change in government.
An interpretation of the rationale behind the emergency liquidity assistance decision
In its lender of last resort role, the ECB shall evaluate the solvency of national banks based on the status quo and not take into consideration how its actions will affect the decision making progress at a higher level. A termination of emergency liquidity assistance by the ECB would have preempted the higher-order decision-making process of policymakers at the supranational level. Greek banks would have become immediately illiquid, leading to a depositor run, possibly rendering the entire banking system unstable. Most likely the functioning of the real economy would be severely inhibited, putting further constraints on the decision regarding a Greek rescue package. Hence, there is no alternative route for the ECB Governing Council than to prolong and extend the emergency liquidity assistance credit line. We conclude that the ECB’s course of action is commensurate with its role of a lender of last resort. From an economic point of view, it cannot be classified as delaying the filing for insolvency.
Conclusions and recommendations
There are two supplementary issues relevant for policy considerations surrounding the ELA instrument and bank solvency assessments:
- First, the evaluation of stand-alone bank solvency by market participants seems to be based primarily on speculation as opposed to factual evidence.
We therefore ask for greater transparency, especially in relation to stress test results.
- Second, transparency regarding the central bank’s actions as the lender of last resort would help to better understand its actions in times of crises.
This is particularly relevant when the ECB’s actions can be interpreted as pre-empting the political decision-making process. Hence, we encourage the ECB to be less opaque in explaining its motivation for providing emergency liquidity assistance and to disseminate more detailed data on the size and composition of outstanding emergency liquidity assistance positions.
Acharya, V and S Steffen (2014a), “Falling Short of Expectations – Stress Testing the Eurozone Banking System”,. Working Paper, NYU Stern School of Business.
Acharya, V and S Steffen (2014b), “Benchmarking the European Central Bank's Asset Quality Review and Stress Test – A Tale of Two Leverage Ratios”,. Center of European Policy Studies Working Paper Series.
Acharya V, L Pedersen, L Philippon and M Richardson (2010), “Measuring Systemic Risk”, Working Paper, NYU Stern School of Business.
Acharya V, R Engle and M Richardson (2012), “Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks”,. American Economic Review Papers & Proceedings 102(3)::3, 59–64.
Bagehot, W (1873), Lombard Street: A Description of the Money Market, SMK Books, London.
Brownlees, C and R. Engle (2015),. “Volatility, Correlation and Tails for Systemic Risk Measurement”, Working Paper, NYU Stern School of Business.
ECB (no date), ELA procedures.
Financial Times (2015), “ECB approves rise in emergency loans to Greek banks”, 19 June.
Götz M R, R Haselmann, J P Krahnen and S Steffen (2015), “Did emergency liquidity assistance (ELA) of the ECB delay the bankruptcy of Greek banks?”, SAFE Policy Letter No. 46.
1 This capital shortfall measure has been implemented based on Acharya at al. (2012) and Brownlees and Engle (2015). The data are provided by New York University’s VLAB (see http://vlab.stern.nyu.edu/welcome/risk/). The theoretical motivation for the measure can be found in Acharya et al. (2010). Acharya and Steffen (2014a, b) use this methodology as benchmark test to investigate potential weaknesses of the asset quality review.