In defence of the (conflicted) ECB

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Everyone has been so transfixed by Yanis Varoufakis's "Plan B" revelations that his defence of the ECB's Mario Draghi passed unnoticed. Here it is, transcribed from the Lamont tape by Peter Spiegel at the FT:

Mario Draghi has handled himself as well as he could, and he tried to stay out of this mire, the political mire, impressively. I have always held him in high regard. I hold him in even higher regard now, having experienced him over the last six months. Having said that, the European Central Bank is set up in such a way that it is so highly political, it is impossible not to be political.

Don’t forget the ECB, the central bank of Greece – because that’s what the ECB is, it’s the central bank of all our member states – the central bank of Greece is a creditor of the Greek state, and therefore it is also [break in audio] once it is the lender of last resort, supposedly, and the enforcer of fiscal austerity. Now, that violates, immediately, the supposed distinction between fiscal and monetary policy. It puts Draghi in a position where, in acting as a creditor when we came into power, he had to discipline us, he had to actually asphyxiate us sufficiently in order to yield to the demands of the creditors, while at the same time keeping our banks open. So God could not do this in a non-political way.

In other words, the politicised nature of the ECB is an inevitable consequence of the political construction of the Euro. Draghi, along with his deputy Vitor Constancio, have been trying to steer a course through a very narrow channel lined with vicious rocks. On June 28th, they had to squeeze the ship through too tight a gap, and inevitably tore a large hole in the hull. The decision to restrict liquidity to Greek banks was in my view intended to be a politically neutral decision. But the consequences for the Greek economy were disastrous. From that moment on, the ECB could no longer be regarded as neutral. It had entered the game on the side of the creditors.

Yanis goes on to identify the fundamental conflict of interest that forces the ECB into an overtly political role. In its role as central bank, the ECB is ultimately responsible for maintaining liquidity in the European financial system in accordance with its inflation target. It is also responsible for financial stability, which means maintaining liquidity not only to the financial system as a whole but specifically to parts of it that are in danger of collapsing due to local liquidity constraints. As Yanis says, it is the "Lender Of Last Resort" for banks - including Greek ones.

But is it, really? Not everyone thinks so. The ECB provides liquidity to the European financial system through its monetary operations. But emergency liquidity assistance (ELA) for distressed banks is provided by national central banks (NCBs) within the Eurosystem. Therefore, some argue, the NCBs, not the ECB, are the lenders of last resort. In support of this argument they point to the final paragraph from this piece of legislation from the ECB:

Responsibility for the provision of ELA lies with the NCB(s) concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB.

So, the argument goes, the ECB is not liable for any losses arising from ELA, therefore it is not the lender of last resort.

If the NCBs had complete freedom to issue whatever liquidity they saw fit and accept whatever collateral they considered appropriate, with haircuts of their own choosing, they would indeed be lenders of last resort even though - as the legislation makes clear - they are issuing "central bank credit" on behalf of the whole Eurosystem. But NCBs do not have such freedom. They can only issue ELA to the extent permitted by the ECB and in accordance with the eligible collateral framework established by the ECB. The ECB can - and, as we now know from Greece, does - restrict the provision of ELA by NCBs:

However, Article 14.4 of the Statute of the European System of Central Banks and of the European Central Bank (Statute of the ESCB) assigns the Governing Council of the ECB responsibility for restricting ELA operations if it considers that these operations interfere with the objectives and tasks of the Eurosystem. Such decisions are taken by the Governing Council with a majority of two-thirds of the votes cast.

The restriction is supposedly to ensure the consistency of monetary policy across the whole Euro area. But the ECB's restriction of ELA to Greek banks was not done for monetary policy reasons. Nor was the subsequent raising of collateral haircuts. The ECB's press release on 28th June cited the breakdown of the talks and the expiry of the bailout programme. These are political, not monetary, reasons.

To be sure, the effect of the growing political instability was to degrade the quality of the collateral pledged by Greek banks for ELA funding, since it consisted of Greek sovereign debt and other debt securities guaranteed by the Greek sovereign. But the whole point of a lender of last resort is that when there is a systemic bank run - as there has been in Greece for the whole of this year, and acutely after the breakdown of the talks - it will accept as collateral assets that are degraded in value. A true lender of last resort by definition must be able and willing to accept losses.

For a central bank to increase haircuts on pledged assets because of raised sovereign risk undermines the "lender of last resort" function. After all, banks turn to the lender of last resort precisely because every other lender has raised haircuts so much that borrowing becomes impossible. There might be some justification for refusing as collateral for normal monetary operations the bonds of a sovereign actually in default, as the ECB did when Greek sovereign bonds were briefly downgraded to "selective default" at the time of the 2012 PSI restructuring. But in my view there is never justification for refusing emergency funding to banks in a systemic bank run. In restricting liquidity to Greek banks, therefore, the ECB was not only failing to act as lender of last resort itself, it was also preventing the Bank of Greece from acting as lender of last resort. In effect, Greek banks have no lender of last resort. Indeed - since we must assume that banks of other distressed sovereigns would be treated similarly - none of the Eurozone banks have an effective lender of last resort.

Why is the Eurosystem ineffective as a lender of last resort? Because the Eurozone political leadership is dangerously obsessed with preventing central bank financing of governments.

All banks pledge as collateral the debt of their own sovereign and sometimes the debt of other sovereigns too. Some banks - as in Greece - also pledge other debt securities that are guaranteed by sovereigns. So sovereigns effectively guarantee the funding of commercial banks. This is true even in the Eurozone where sovereigns do not issue their own currency and therefore can only guarantee bank funding to the extent that they have the fiscal space to borrow. Pledging sovereign debt or sovereign-guaranteed debt as collateral exposes the central bank to sovereign funding risk. If the sovereign is distressed, such use of sovereign debt as collateral can maintain funding to the sovereign even if it is shut out of markets. Jens Weidmann of the Bundesbank regards this as a form of monetary financing of government and therefore outlawed under Article 123 of the Lisbon Treaty.

This is questionable, frankly, but as Weidmann is a member of the Governing Council of the ECB it was no doubt a consideration in the decision to restrict ELA to Greek banks. But actually the direct exposure of the ECB to sovereign debt through both normal and extraordinary monetary operations is a much more serious problem. It is this, plus the nature of the ECB's ownership, that causes the conflict of interest that Yanis noted.

Back in 2010-11, when Greece was on the verge of default and the Eurozone was in danger of collapsing, the ECB bought lots of Eurozone sovereign bonds under what was known as the "Securities Markets Programme" (SMP). The purpose of the SMP was to stabilise the yields of sovereign bonds, not just Greece's but also those of other distressed sovereigns, in order to calm bond markets and relieve liquidity pressure for financial market participants. The ECB described this as an extraordinary monetary policy intervention:

The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.

The SMP programme is an example of what Perry Mehrling calls the "dealer of last resort" function, where a central bank intervenes directly in markets to backstop prices by buying up sovereign debt that everyone else is dumping. It is an essential financial stability function which at present in the Eurozone is seriously undermined by Article 123 of the Lisbon Treaty. This poisonous piece of legislation desperately needs repealing, or at least amending to allow the ECB to do its job properly.

The last purchases under the SMP programme were made in 2012, after which it was superseded by the OMT programme, which provides support for sovereign bonds only for countries in a fiscal adjustment program. Unsurprisingly, OMT has never been used - though its legality was challenged by the German constitutional court and finally confirmed in the European Court of Justice earlier this year.

The ECB's LTRO programmes, and - more recently - QE are also applications of the "dealer-of-last-resort" principle, although the ECB's QE is rendered inconsistent and confused by the exclusion of Greece and Cyprus - the very countries that most need a dealer-of-last-resort function. Obsession with avoiding monetary financing of government at times seriously compromises not just financial stability but monetary policy too.

But the effect of the SMP purchases is that the ECB's balance sheet now includes significant holdings of distressed sovereign bonds, including Greece's. Furthermore, the ECB is jointly owned by the Eurozone member states, who are also Greece's creditors. So the ECB's decisions are inevitably skewed towards the concerns of creditors. As Yanis notes, the concerns of creditors forced the ECB to act harshly towards Greece. But the ECB's responsibility for financial stability meant that it could not act so harshly that the banks failed. It was genuinely a conundrum for the governors. What policy stance would both meet the demand of creditors that Greece should be pressurised AND enable the ECB to fulfil its responsibility for financial stability?

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 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. The lack of a lender of last resort is terribly dangerous, since it vastly increases the likelihood of devastating systemic runs. Deposit insurance helps, but since that too is dependent on sovereign solvency there is a gaping hole in the infrastructure supporting the Eurozone financial system.

How to resolve this? The "doom loop" between sovereigns and banks must be broken: the funding of banks must be separated from the solvency of sovereigns, as must the funding of deposit insurance. That means full banking union, common deposit insurance and the issuance of Eurozone-level bonds that can be used by banks as safe assets. The ESM is a step in the right direction, but the current "banking union" is utterly inadequate. Much more needs to be done if the Eurosystem is to become effective as both lender and dealer of last resort.

Image from Greenfields Lawyers.