Why The ECB Allowed The Cypriot Banks To Default

At his April 4th press conference, ECB head Mario Draghi explained why the ECB cut off emergency liquidity assistance (ELA) to the Cyprus banks and forced them to default:
"I think one should always be mindful of what the ECB can do and what it cannot do. We cannot replace capital that is lacking in the banking system. That is quite clear...
When the (ECB) Governing Council objected to Emergency Liquidity Assistance (ELA), it acted within its mandate. It objected to extending ELA to non-viable banks and thus did not replace what could have been fiscal action. ELA can be extended only to solvent and viable banks. Now, in the absence of a recapitalization programme, these Cypriot banks would not have been solvent and viable. At that point in time, the Governing Council assessed there was no programme in place, and that’s why it had to do what it did."

In a nutshell: the ECB’s mandate does not permit it to lend to insolvent banks. This means that, for eurozone countries lacking adequate fiscal resources to recapitalize their banks, their problem banks will have to default on their liabilities unless Germany is willing to contribute to the bailout via the ESM.

This is a dangerous policy, because it requires depositors to make an assessment of the solvency of a country’s banking system, and of the country’s willingness and ability to recapitalize its banks. These are both very complex decisions which effectively convert a substantial portion of eurozone bank deposits into risk assets. In other words, they are no longer money, and depositors are now investors. When deposits are no longer money, they tend to decline.

I must say that this is a very un-European way to view bank deposits. Not long ago, deposit defaults were unheard of. Now they are policy.

In 1997-98 during the East Asian financial crisis, many observers said that “China's banks are next”. They said this because no one believed that the big Chinese banks were solvent (although there was no way to be sure). The reason these people were wrong was that, in China, bank solvency didn’t matter. The government guaranteed the banks, and the People’s Bank was happy to lend against that guarantee. The People’s Bank did not demand that China recapitalize the banks because it took no risk that the banks would be wound up. Thus, the system remained liquid despite its probable insolvency.

This approach to bank solvency was pretty standard throughout the world, except in Hong Kong and the US. It certainly operated in France and Germany, where the Bundesbank and the Banque de France routinely lent to insolvent banks with the understanding that ultimate solvency was a fiscal matter. When WestLB and Credit Lyonnais were going through their travails, no one was worried that they would be cut off from central bank liquidity.

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Even in the US, when the big TBTF banks were in trouble in the early nineties, the Fed never (to my knowledge) threatened to cut off their liquidity. It did communicate with Treasury about the problem, but it didn’t make any threats.

Requiring banks to be solvent in order to receive central bank liquidity only makes sense if there is a competent fiscal authority to maintain bank solvency. The eurozone has that in some countries, but not all. It is now up to depositors to make that judgement.

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