As Greece moves from one repayment deadline to another, you can be forgiven for thinking that the country’s main daily challenge is finding the money to pay its public sector workers and meet its debt servicing obligations. While this remains an important challenge, the greatest risk for Greece emanates from the deteriorating liquidity situation of its banks. For it is precisely this risk that could unintentionally trigger the nightmare scenario of Grexit – the accident that all the key players in the unfolding Greek drama are working hard to avoid.
In times of crisis, a country’s banks are reliant on the lender of last resort – the central bank – for liquidity. They can borrow from the central bank under normal monetary policy operations but this requires pledging high-quality assets, such as investment grade bonds, as collateral. But these assets can be scarce, especially in crisis-stricken countries like Greece.
In these extreme circumstances, central banks supply emergency loans known as Emergency Liquidity Assistance (ELA) to banks that are solvent and can pledge other good-quality collateral such as performing loans and government securities. Central banks know that if they refuse to supply ELA, a liquidity problem in one bank can easily turn into a systemic crisis involving widespread bank panics.
In the interests of prudence, central banks apply significant haircuts to the value of assets pledged as collateral, depending on risk. For example, if a bank pledges collateral valued at £100m and the haircut is 50%, the bank will receive £50m of ELA.
In the eurozone, the provision of ELA is the responsibility of national central banks but it is subject to eurozone rules and the non-objection by a two-thirds majority of the ECB Governing Council. The Governing Council needs to be persuaded that ELA doesn’t interfere with the objectives of ECB monetary policy (which prevents the individual eurozone members’ central banks from financing government deficits).
ELA provision by a national central bank ultimately depends on it having access to euro liquidity including banknotes supplied by the ECB. If, for whatever reason, a national central bank is unable to supply euro liquidity to its affiliated banks, the country concerned can face economic and financial meltdown, since the payments system will cease to operate and only cash transactions will take place (relying on banknotes that are already in circulation).
Frequent talk of a Grexit during the crisis has eroded confidence in Greek banks. Depositors suspect that Grexit would automatically lead to their deposits being re-denominated into drachmas that would quickly lose value. To avoid this risk, depositors have been transferring their money to banks outside Greece or hoarding cash.
Deposits have, therefore, fled the Greek banking system. Since 2010, deposits have declined by more than 40% to around €145 billion. In the first quarter of 2015 alone, the net outflow reached €22.5 billion. Daily deposit outflows of €500m were not unusual. As a result, a chart of Greek bank deposits can easily serve as a barometer of the crisis or, more precisely, the perceived risk of Grexit.
Not surprisingly, deposit outflows have been largely replaced by central bank liquidity including ELA. This has now reached €120 billion (including €79 billion of ELA) and Greek analysts are hinting that collateral buffers are running low . There is also talk of higher collateral haircuts being applied by the ECB to account for this increased risk – which could make a rapidly deteriorating liquidity situation even worse.
But the deposit outflow and ELA figures by themselves do not tell the whole story regarding the extent of the banking system’s vulnerability to bank runs (of a slow or fast nature). That story can only be told by those who closely monitor the ongoing daily outflows. Only then is it possible to appreciate that in such a fragile environment any day can turn out to be doomsday.
With banks’ liquidity buffers close to being exhausted, access to additional ELA restricted and deposit outflows not abating, the Greek authorities may soon be forced to take extraordinary measures to protect bank liquidity: they may be forced to impose restrictions on the banking system including capital controls. In their mildest form, capital controls will prevent transfers of money abroad for investment purposes and withdrawals of large amounts of cash. At their most severe, such restrictions would only allow depositors minimal access to their money that would only allow them to buy everyday essentials. This would significantly disrupt economic activity and further damage confidence. They are also likely to create additional uncertainty, unless they are credibly considered to be temporary.
Furthermore, as euro liquidity and revenues dry up, the government and other entities may be forced to issue IOUs in order to meet payments – promises to pay euros in the future (a recent, albeit short-lived, precedent occurred during the California budget crisis in 2009). These IOUs could soon become a parallel currency, the precursor to Grexit that everyone fears. The IOUs would likely start trading at a considerable discount, reflecting the creditworthiness of the issuer, but the mere existence of an alternative form of payment that enables some transactions to take place would help to avert complete meltdown.
If successful, the parallel currency may end up pulling the Greek government further away from reaching an agreement with its creditors. A default of the Greek sovereign could be the final blow in this nightmare scenario, which would trigger a chain reaction of credit events that no one may be able to prevent or foresee.
Grexit and all the uncertainty that could emanate from such an event may turn out to be the mother of all self-fulfilling prophecies, despite all the key players working hard to prevent it. Unless, of course, an agreement between Greece and its creditors on the missing details of the reforms agreed on February 20 is reached pretty soon.