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.