The Governing Council of the European Central Bank decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks.Short but not sweet. It''s clear that Cypriot banks cannot survive without this liquidity. There either needs to be an EU/IMF bailout deal agreed by Monday or some deal with Russia to prop up Cypriot banks (although the political implications of this would be significant). Remember the four scenarios that we set out on Tuesday night following the No vote in the Cypriot parliament (which now many other analysts are echoing).
In our flash analysis, we questioned whether the ECB might do this. We noted:
Would the ECB really pull the plug on liquidity to Cypriot banks?The key turning point here will be whether the ECB cuts off Cypriot banks...To pull the plug on ELA the ECB needs a 2/3 majority (15 out of 23 votes) at the ECB Governing Council. Although the Bundesbank and maybe the Dutch and Finnish central banks might vote to turn off the ELA a 2/3 majority is not certain. In fact since Mario Draghi took over the ECB it has not been particularly hawkish. Bloomberg reports that the ECB said after the vote: “The ECB reaffirms its commitment to provide liquidity as needed within the existing rules”. The crisis has shown so far that the rules of the ECB are incredibly malleable, so what exactly that statement means is unclear, but the vote could certainly go either way.
But why has the ECB taken such a tough line with Cyprus? Below we outline a few potential reasons behind its thinking (some of which were touched upon by @KarlWhelan on twitter yesterday):
- ECB rules clearly state that ELA must be provided only to solvent but illiquid banks - without recapitalisation (under a bailout deal) Cypriot banks would certainly be insolvent.
- Continuing to provide liquidity to Cypriot banks could also amount to a huge transfer of risk from depositors and investors to the ECB.
- Even if a deal is reached there are likely to be huge deposit outflows particularly from foreign depositors (even more so if the banks open without a clear deal).
- Cypriot bank ELA is currently around €9bn. Russian deposits total between €15bn and €20bn. If Russian depositors are hit hard, much of these deposits could be withdrawn.
- At almost 30% of all deposits, this would bring the solvency of Cypriot banks into question. The ECB would have to extend ELA massively to keep banks afloat – possibly by another €10bn to €15bn.
- This liquidity would therefore indirectly help fund outflows of deposits.
- Even increasing the ELA would not be sufficient if this turns into a full deposit run. This means the banks could still collapse and Cyprus could leave the eurozone. In this scenario, the Cypriot Central bank would default on its Target 2 imbalance with the Eurosystem (currently €7.5bn but it could double if the outflows are significant) leaving the ECB with a loss.
- Financially this loss would be bearable but it would hit ECB credibility hard and break the taboo of the ECB not suffering losses in the eurozone crisis, a No-No for Germany.
- If the banks collapsed but Cyprus stayed within the eurozone, the eurozone would likely have to stump up further funds to keep the country afloat.
- Any losses from the ELA are the responsibility of the Cypriot Central Bank (and the Cypriot state which backs it), so they would not become a Eurosystem/ECB issue directly. That said, with Cyprus under a bailout programme the burden will likely fall on the eurozone since the Cypriot state would be unable to backstop the central bank alone.
With this in mind, it is possible to see why the ECB has taken such a strict line here. That said, it certainly ramps up the pressure over the next few days.
Lastly, although the ECB is taking the decision based on technical considerations, it's clear the good folks in Frankfurt are now deeply embroiled in a highly political debate - precisely what the ECB wants to avoid at all costs.