Monday 21 May 2012

Greek Bank Marathon. European Deposit Guarantee.

Hardly a day passes without another article appearing on how Greece is going to collapse and the trigger for it is going to be a Bank run. This is how the simple scenario goes. Depositors withdraw their cash either physically or by electronic transfer abroad; the private banks collapse and Greece exits the Euro. Others say that a bank run on deposits may be a wakeup call to all those who want to vote for the anti-European parties and so it may be a good thing after all. Here we argue that a traditional bank run would be very hard to materialize in Greece or any other European country as long as the ECB supports the NCB.
Greek Deposits
Simply withdrawing cash does not cause a bank run. Modern banks and the Eurosystem does not work that simple. Depositors are withdrawing their saving from Greek bank for 2 years now. This is not a bank run it is in fact a Marathon (See graph below, BoG data). Once upon a time, total money (M1+M2) were around 250billion. In fact the Greek bank’s interest rate cost was so high that when deposits fled many reported higher earnings! I know it sounds absurd but borrowing money from the ECB at 1% and investing in a high coupon Greek bond was more profitable. Their cost of funding was 1% whereas paying depositor cost more! These days are over. Greek bonds went bust and deposits were reduced to 189billion(end of March12) with household representing 165billion. In other words they lost close to 61billion of the deposit base. So how does the system survive? Why don’t we see endless queues outside Greek banks? After all, for all practical purposes banks are bust awaiting recapitalization funds. The reason is simple. As long as there is cash in physical form to satisfy the Greek depositors and electronic cash to balance the banks they can survive for a long time. Currently there are about 20billion of currency in circulation in Greece. If the vaults of the Bank of Greece have another 20-30billion and they can fly some cargo airplanes loaded with paper cash in time from across Europe then depositors would not feel the insecurity of not touching their cash with their bare hands. But what would happen to the banks? How are they going to replenish the lost money from their vaults? The unlimited ECB repo facility and the marvels of ELA (Emergency Liquidity Assistance) comes to the rescue of the Greek banks as they did with the Irish and Belgian banks, among other, some time ago. If the Greek banks have some worthy collateral to pawn with the European Central Bank then they can recover the lost deposits. If not then they will ELA it.
ELA as an Early warning sign of Euro exit.
The ELA is an oddity. It was designed to be “printing” of money by the local NCB in cases of emergency, for small amounts and for a limited period of time. In other words the ECB allowed the NCB to print (metaphorically speaking. No actual physical printing occurs. Instead they are electronically generated) as long as it was the liability of the NCB and ultimately the state. This means that money generated by the ELA process have the backing of the Greek state and not the Eurosystem. Forget about the fact that the Greek state is bust, the Greek ELA was last week 54billion and aims higher! The ELA is designed to accept collateral of lesser quality and haircuts. The interest rate changed although a secret number has been estimated at slightly higher than the ECB’s Marginal Lending Rate.
In fact if there ever was to be an exit of Greece from the Euro and the monetary union this is how it should be done. All funding moves from the ECB repo to the Greek ELA and Greece then redenominates them into the Greek drachma. Thus an early warning sign of impeding conversion may be the heavy reliance of the Greek banks on the ELA rather than on ECB repo. One of course needs to distinguish the case were there is no acceptable collateral from the case of Euro-exit.
A very interesting question arises if Greece redenominates to Drachma with all the Euro currency in circulating in Greece. The Greek central bank in the process would have exceeded their currency quota by many billions as they try to satisfy the Greek appetite for physical currency. Would the excess money be owed to the ECB? Probably yes. As Greece leaves, their share of currency would have to be cancelled from the ECB balance sheet.
In fact, if Greece and Greeks need to improve their chances of weathering the brewing cyclone they have to get their cash out Greece or at least out of the banks and in their matrices. This way the losses would fall on the Target2 NCB’s when and if Greece decides to leave the monetary union.  So, perhaps this is the prudent and patriotic thing to do.
Pan European Deposit Guarantee
Many have asked for a pan-european deposit guarantee. Namely, a joint guarantee of all bank deposits by some authority or by the ECB or by the European states. Currently, all states have a deposit guarantee scheme with various terms. The problem of course is that if the state is bust then that guarantee is not worth much. Can a pan-European deposit guarantee scheme be introduced? Would it help?
As we explained earlier the real danger for the banks is not a run on their deposits as these do not form a big part of their funding support anymore and in any case if the ECB stands ready to fund either by ELA or by Repo then there is not much of a point.
The real problem is how to price this deposit guarantee. A depositor would be indifferent on whether to deposit his money with BCCI (dubbed Banks of Crooks and Criminals) or DB (Descent Bank). This in fact would encourage bad practices as bad banks and their directors would know that there is no danger of being molested by disgruntled depositors. Hence, banks should pay for this insurance and depositors should be aware of this too. Perhaps the right to opt out may be given to depositors too.
Another problem arises from the fact that banks are still national in their character. They lend locally and they invest in local government bonds. If a country’s economy is not going well or if the state goes bust then other states would pick up the bill. Is this politically acceptable? The answer is probably yes if there is fiscal union and no if the current system persists. 
The concept of a traditional bank run does not seem to apply in the modern system especially if the central bank and the state are prepared. The case of Northern Rock is a counter example but one can easily argue that it took the system and the BoE by surprise. In the case of Greece we are running on empty for some time now. The authorities know this and are getting prepared. This is why we have not seen scenes of panic. Money is withdrawn daily for the past 2 years and the BoG was able to handle it. The problem is that this money is not used to produce anything, exacerbating the recession and hardship. If the ECB or Europe decides to change policy it would be because they want Greece to go. Fleeting deposits even at an accelerating pace would not cause a Euro exit. Cutting the BoG from the Eurosystem will