Bickering creditors and the role of the ECB

Frances Coppola has written a nice analysis of what the ECB has done recently, and how that has helped or hindered the Greek situation. On the one hand the ECB should provide liquidity to the Greek banking system, on the other, as part of the Troika, it is enforcing harsh rules on Greece.

That is not good:

It is the conflict of interest between ECB-as-creditor and ECB-as-liquidity-provider that makes the ECB ineffective as a lender of last resort. And because NCBs [national central banks] are controlled and restricted by the ECB, they too cannot act as lenders of last resort. So the Eurozone banking system effectively has no lender of last resort.

I think we should go back to first principles. A central bank was never “Dealer of last resort” or “Creditor to the a Sovereign in difficulty of last resort” in the past. These are new roles, only with QE has the Central Bank become a dealer, only with the purchasing of Greek bonds a creditor. These functions were completely absent in in the past. For the ECB they became necessary after the 2008 financial crisis. They were certainly not envisaged when the Euro system was set up. And certainly not roles traditionally assumed by central banks

Why not go back to a position where the role of a central bank should only be lender of last resort to commercial banks with liquidity issues?

In her conclusion, Frances says, “the “doom loop” between sovereigns and banks must be broken: the funding of banks must be separated from the solvency of sovereigns…”

But is this true? Should banks and state be indeed separate? Maybe the two should be intricately linked, as a government borrowing in its own currency from its banks can never be insolvent, as long as banks provide credit. So the commitment of the ECB to provide liquidity for whatever reason should be absolute. Even if the commercial banks support the sovereign.

That would mean in practice, that as government bonds become expensive to issue, and doubts over its insolvency grow, it is the NATIONAL private sector banking system which provides finance to the state. Why not? As the ECB is lender of last resort to the banking system it would have to support that. As long as commercial banks are solvent, that liquidity should be provided. The ECB would not have any concern about the solvency of the sovereign. It would be assumed to be always solvent.

So that is exactly the opposite what Schaeuble and German economists (council of economic advisors) argue, they want Grexit, and agreed insolvency procedures.

But if we do not want that, we would a system by which it is impossible for countries to become insolvent, by commercial banks stepping in as lender of last resort to countries.

Now this is not such a new idea. France and Canada successfully financed their respective state spending in the past like that. Greece should arguably do so now.

Here is a revolutionary idea: Let the 240bn loan from EU institutions/countries and IMF be repaid by the Greek private sector banks who grant a loan to Greece.

Move all 240bn funding from European public sector creditors and IMF to the Greek banking system. What would that mean? The Greek private sector banks increase their total balance sheets by about 60% by granting total loans of 240bn to the Greek state. In return the Greek banks could grant the Greek state extremely beneficial rates on their loans, even lower than the rates currently being granted. Just by splitting the difference of the interest cost saved (which comes to, say, about Euro 4bn) between the commercial banks and itself, both the banking system and the country would benefit from a repatriation of the loans.

Greece would save about 2bn of interest per year it currently has to send abroad, more that 1% of its GDP. These foreign transfers lead at the moment to a deterioration in its current account balance, which would now improve. On the other hand, the Greek banking system can book in 2bn more profits each year, which would increase its capital base from retained profits. If the Greek private sector retained the profits for a few years, the need to re-capitalise the Greek banking system would go away.

The only drawback is that the ECB would have to agree to take on Greek state risk as collateral for further funding. It should do so, and increase ELA by 240bn, from its current level of 90bn, if need be.

The total risk to the EU from Greece would not change, the ECB now taking on the risk from the other public creditors. So in future the Greek banking system has only one creditor, the ECB. The Greek sovereign is only indebted to its banks, rather than about two dozen creditors (if each country is counted, plus the institutions). It is the current multitude of lenders to Greece which make the existing arrangement unworkable, as different lenders seem to have different agendas. All creditors have to agree to one common way forward, which they are unable to do. This uncertainty is deadly for the Greek economy, as the threat of Grexit always looms large.

Arguable, an arrangement of Greek banks lending to the Greek state is similar to what was in place before the Eurocrisis started in 2009. The only public sector risk to the ECB then was the Greek banking system, before the risk of Greek insolvency in 2009/10 changed all that.

But that banking system originally suffered because private sector funding for the Greek banking system, European interbank-lending and bonds, was withdrawn after there was doubt about Greek’s solvency. European banks withdrew their funds from the Greek banking system, Greek government bondholders sold their bonds, European banks withdrew even more funds from Greek banks, etc., until much more recently it was the Greek savers withdrawing funds.

Now clearly the solvency of Greece is not in doubt any more, or would Europe otherwise have offered Euro 86bn in re-financing?

So if taken on a national level, the linkage between banks and sovereign solvency is not a “doom loop”, as Frances puts it. In fact it could be a “virtuous circle”. The ECB allows Greek banks to finance the Greek state. Everything else now becomes redundant: All the creditors currently arguing with each other (e.g., Germany vs IMF over debt relief) would become friends again; other institutions like ESM/EFSF would not be needed; all the EU countries countries not really wanting to lend money to Greece could breath a sigh of relief. Everybody would get repaid and get their money back! The ECB takes on all the risk, via the banking sector.

Given the current heated discussions among creditors, and their inability to come to any kind of useful settlement which would include granting debt relief, that has to be a better option. So therefore the best way forward is linking the state with the national banking system, which would grant debt relief (in terms of halving interest rates), provide further funds for re-capitalising Greek banks, and makes it much easier to negotiate as there is only one creditor now.

Now, what about the supervision of the Memorandum of Understanding, the Greek credit agreement, who would police that, if a troika becomes redundant? Do we want the ECB then to police this memorandum?

Now here, of course, politics comes in again. Do we really need a troika to set precise terms of macroeconomic management, or is it sufficient to make sure that Greece sticks to an agreed repayment plan on the 240bn loan, while also agreeing to not to take on any more debt? The 240bn would become like a mortgage, to be repaid over, say, 50 or 100 years. At 1% interest rate, or less, whatever the Greek banks, Greece, and the EU decide is appropriate. After all in a commercial loan environment to companies, that is what happens, some financial rules are set, (like the Maastricht criteria, for example) and financial penalties ensue for the borrower, if they are not adhered to. We never, ever have bankers go into companies saying that cost of pensions contributions are too high, or a price increase should be implemented. The managers know best, and that must be the assumption for each new government elected in a country, also in Greece. The people there have spoken, and they want Syriza to govern.The EU should not interfere, as long as loans are repaid, and no further loans taken on, the Greek government should do what it likes.

In summary, that is what a new Memorandum of Understanding would look like:

So the EU, probably the commission, and Greece, just set come covenants, like in a commercial loan agreement, and make sure, that repayment will happen, and if not, some sanctions will take place. The covenant would say, each month the amortising loan is to be repaid by x. The financial penalities could be, for example, the withdrawal of funding from the EU agricultural aid fund, or the inability to access the EU structural growth fund. They make up about 6bn of funding for the Greeks per year. Arguably it was the threat of losing these funding sources for the Greek state which made the Greeks sign the harsh terms on the 13th, which they are now trying to implement.

So, the EU and the IMF could save themselves a lot of headache, meetings, controversy and ultimately failure, by pushing that big monkey, the 240bn debt, which is sitting on their shoulders, onto the shoulders of the Greek banking system. It would be good for the Greek banking system (increased capital through certain profits), and the Greek state (lower interest costs), good for the Greek current account balance, and in fact provide some debt relief which would otherwise be impossible.

And good for the creditors, who, in fact do not provide direct loans any more, over which nobody can agree. The bickering would stop.

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