Last week was not short of volatility with a three party central bank bingo and the nonfarm casino to cap it off. Markets went into the week with extreme expectations and as it became clear that central banks would do nothing concrete, the disappointment loomed.
Still, Draghi seemed to pull yet another rabbit out of its hat by explicit reiterating the irreversibility of the euro and also explicitly mentioning that there would be no going back to the Lira or the Drachma. Empty words to buy time you might say. Not quite and while the ECB may certainly now buy as many peripheral bonds as it wishes if it deems convertibility risk to be a real issue money is already trickling into cash strapped peripheral economies through the arcane tool of emergency liquidity assistance (ELA) by which the national central banks can support specific banks deemed to be illiquid. The most important news coming out last consequently came late Friday night when Reuters reported that,
The ECB's Governing Council agreed at its meeting on Thursday to increase the upper limit for the amount of Greek short-term loans the Bank of Greece can accept in exchange for emergency loans, the newspaper said in an advance copy of the article due to appear in its Saturday edition.
Until now the Bank of Greece could only accept T-Bills up to a limit of 3 billion euros ($3.70 billion) as collateral for emergency liquidity assistance (ELA) but it has applied to have this limit increased to 7 billion euros, the daily said, citing central bank sources.
The ECB Governing Council gave this wish the green light, the paper said.
The move should enable the Greek government to access up to an extra 4 billion euros of funds, the paper said, adding that this should ensure the country keeps its head above water until the "troika" of the European Union, the European Central Bank and the International Monetary Fund decide on the disbursement of the next tranche of money from its aid program in September.
I would recommend anyone to read this note by Morgan Stanley from 2010 as well as this more recent research note by Citi's Chief Economist Buiter. Both provide a good re-cap of what the ELA is, why it is where and how it is used. The main definition from the Eurosystem's own documents is useful however;
One of the specific tools available to central banks in a crisis situation is the provision of emergency liquidity assistance (ELA) toindividual banks. Generally, this tool consists of the support given by central banks in exceptional circumstances and on a case-bycase basis to temporarily illiquid institutions and markets. This support may be warranted to ease an institution’s liquidity strains, aswell as to prevent any potential systemic effects, or specific implications such as disruption of the smooth functioning of payment andsettlement systems. A credit institution cannot, however, assume automatic access to central bank liquidity.
The provision and magnitude of the quantity of ELA in operation at any given point in time is not aggregated by the ECB or the Eurosystem, but will instead be reported by the national central banks. This is logical as it is explicitly stated that national central banks take on the market risk. Yet, the question market participants are now obviously asking themselves is what this means in the case of an irreversible euro. The following quote from the 1999 ECB annual report is crucial.
The main guiding principle [for the ELA] is that the competent NCB takes the decision concerning the provision of ELA to an institution operating inits jurisdiction. This would take place under the responsibility and at the potential cost of the NCB in question.
The ELA as it is described here is then an operational tool the national central bank can use in a situation where a specific financial institution is in trouble. Examples of such usage of the ELA was the €42 billion guarantee granted by the German government to Hypo Real Estate in 2008 through a special purpose vehicle (SPV) who itself tapped the Bundesbank for liquidity through the ELA and which then got collateral from Hypo. In 2009, the Belgian bank Fortis was also given access to the ELA on the eve of its collapse with loans, according to Barclays, amounting to about €54 billion.
These two cases are examples of the intended use of the ELA facility in so far as goes the fact that both Germany's and Belgium's current ELA balances are 0 (as far as we know from current data).
Using the ELA as a bailout fund
The ELA has been active at several occasions during the crisis, but the usage of the facility in Ireland and Greece represents a completely different use of the facility than the one originally intended. According to figures compiled by Citigroup Ireland has had a constant use of the facility since 2008 with the central bank in Ireland providing anything between €40 and €60 billion since 2010. Most recently, Greece has also taken to the ELA to the tune of about €55 billion .
Such constant use of the facility was never envisioned and suggests that the ELA is being used as additional bailout funding in countries where negotiations with the IMF/EU bailout party has hit a snag. This is evident in Greece where the ECB effectively pushed the country into ELA funding earlier last month as Greek government bonds were deemed unacceptable as collateral until the Troika had completed its review.
Thus, The wording of the Reuters article above thus suggests a wholly different use of the ELA, namely as a very last resort used simply to keep the lights on in a country in tight negotiations with its bailout counterparties. Of course the price of such funding is higher, but this is a technical point here which is irrelevant for a country on the edge. It is not difficult to see how precarious this could be for the ECB which could effectively be forced into kicking a country out of a the euro by shutting off ELA funding. More specifically, this would happen by the ECB effectively instructing its counterparties that whatever reserves created by the national central bank in question. But even more precarious could be the process by which the ECB first deems an individual country's bonds ineligible as collateral only to have to accept that the national central bank takes such bonds in collateral for ELA funding.
With this backdrop in Greece, and with a Spanish request for ELA funding coming sooner rather than later Draghi's comments on the irreversibility of the euro are critical. Market participants can consequently now countenance that the ECB will not shut a country out of the ELA and national central banks in Greece and Spain will take note of this. More than a promise to intervene in the secondary bond market through the SMP, the implicit commitment to keep the ELA open could be the real bazooka.
However, it is also clear that the ECB and the EU could end up in a royal mess. Usage of the ELA is essentially, from the point of the ECB, a pull mechanism by which national central banks request funding. This is in line with the operational use of the LTROs in which euro area banks applied for as much funding as they needed and put up collateral to back it. This was not, strictu sensu, a breach of the famous article 101 in the EU treaty prohibiting but it came close in the context of French president Nicolas Sarkozy recommending banks to buy sovereign bonds. The consistent lowering of collateral requirements as well as stories about reverse repos with banks' own securities also added weight to the idea that the LTRO was merely an alternative way to bring sovereign bond yields down.
The ELA then opens up to a much more problematic avenue in which the ECB could end up shouldering the counterparty risk of the invididual national central banks. Going back to the point emphasized by the Buiter and Citigroup it is suggested that the steady use of the ELA at the behest of the national central banks over time may undermine the monetary union itself akin to the developments which ultimately tore apart the Rouble zone (my emphasis).
We think the existence of ELA on a country-by-country basis undermines the monetary union by allowing different monetary, credit and liquidity policies in different member states of the Eurozone. The damage is not (yet) fatal because the GC of the ECB sets the upper limit on the size of the credit an ELA facility can extend and because the GC also has a veto over the terms on which this credit is extended. As noted, the ‘protection’ offered to the Eurosystem by the denial of loss sharing for ELA exposure is only effective if the central bank and sovereign backing the ELA exposure have sufficient loss-absorption capacity.
Clearly, neither the sovereign in Ireland, Greece nor Spain are in any position to shoulder losses in their respective banking system and indeed, the usage of the ELA in countries have opened up avenues liability and loss migration to the very heart of the Eurosystem. With Draghi now putting his weight behind the euro the ECB may find it even more difficult to effectively shut a country out of the usage of the ELA and with Spain about to wind up its own ELA, the ECB may have cornered itself.
While the ELA may always be effectively in-operational due to the lack of collateral we have already seen the ECB backpedaling on several occasions and quite simply, in an emergency a national central bank will accept whatever collateral the domestic banking system can come up with. The ECB is effectively already doing so and it is unreasonable to expect anything less in Greece, Ireland, Spain or any other individual country.
- The use of ELA by countries already in or close to getting an EU/IMF led bailout is hugely contentious because the explicit guarantee from the sovereign towards the national central bank is meaningless. ELA usage in the context of a country negotiating a bailout should be seen as a de-facto expansion of the ECB/Eurosystem's balance sheet. Greece is currently a good example. Draghi could then be seen as taking a stance here by suggesting that a country resorting to ELA financing of its banking system (potentially in connection with sovereign bond issuance used as collateral) would not be shut out if this meant that the country would effectively go bankrupt and exit the Euro.
- The distinction between when a country requests ELA usage either to avoid asking for a bailout (Spain?) or effectively to keep the lights on will be extremely difficult for the ECB to navigate. This plays into the narrative formulated by Buiter and Citigroup that national central bank financing will steadily grow as a function of individual countries objectives. The ECB may of course accept and deny funding on a discretionary basis, but it won't be easy.
- In the context of sovereigns who are obviously unable to properly guarantee the potential losses at the central bank level arising from losses on underlying collateral, the ECB and the Eurosystem could be forced to foot the bill of national central bank losses.
- If Draghi is serious in his message that the euro is irreversible, it will be difficult for the ECB to shut a country out of the ELA if this would mean that the country would effectively be bankrupt and thus potentially exit the euro.
- All this is happening and will happen largely beyond the knowledge of investors as ELA usage is very difficult to track and the institutions, collateral arrangements, haircuts etc are not publicly disclosed.
 - These figures are from Buiter's piece and are best estimates. It is very difficult to get a handle of the real magnitude since the national central banks are, understandably weary about giving out too much information, and since the ECB does not record these transactions on its balance sheet.