How in the world did central banks miss this?

An interesting story has been developing over the past couple of weeks and has been flying under the radar somewhat, though Alex Barker over at the FT has covered this story very well, here, here and here.

The issue is that the Bank of England has found wording in the details of the EU’s Bank Recovery and Resolution Directive (the bank bail-in plans) which could prohibit governments from protecting central banks against losses when they  provide emergency lending to banks in a crisis. Quite a surprising find given that the final text has just been passed (the error was found with only weeks to spare).

This is the Emergency Liquidity Assistance (ELA), which we have covered here and here. As a recap, this is the lending which a central bank takes on in a crisis and offers to banks at less favourable rates if they have no other choice to avoid a liquidity crisis. As might be expected it was used heavily by the UK and many eurozone countries during the crisis.

Essentially, the concern is that it could expose the BoE to greater risk since it will not have the backing of the UK treasury when extending liquidity assistance, which is risky and can be very large when a financial sector the size of the UK’s is in crisis.

In fact the story now seems to have run through its full lifecycle:

• The BoE located the problem and alerted the European Parliament (EP) and other member states, while requesting to reopen the text of the legislation to amend the wording.
• The EP accepted and even published a revised text to take account of the concerns - see article 27 (2).
• In the end, however, the move was formally vetoed by the Netherlands, Finland and the Czech Republic due to concerns that reopening the text would lead to a raft of other demands, notably by France, Italy, Sweden and Portugal who were seeking further assurances that they could issue guarantees for bank bonds without requiring bank bail-ins first.

This may potentially be a very big deal - but there could also be ways around it. Ultimately, ELA can still be extended it just cannot have a blanket guarantee from the government. The central bank balance sheet should be strong enough to deal with this, although if losses were taken it could become an issue – would bail-ins be required, say, before the central bank was recapitalised? Furthermore, this doesn't just impact the UK, ELA was heavily used in the eurozone and is arguably more important for the eurozone than the UK since the ECB still struggles to act as a real lender of last resort.

However, this episode also speaks volumes about how EU rules are decided and assessed - and, in this instances, doesn't necessarily reflect well on the Treasury and the BoE:

• That the deal isn't now re-opened despite an obvious flaw in the legislation is symptomatic of EU law - the constant fear of  reopening deals or reassessing them due to uncertainty over what countries might begin to demand. This too often used as an argument against reform, when in fact it should be one in favour of reform. It highlights the need for a broader overhaul of the legislative approach and the need for a clearer structure and mechanism to reassess legislation. All too often this fear paralyses the process of improving or changing the EU.

• That said, looking at the revised EP text, there do seem to be a huge amount of changes (the text in bold and italics). This seems to highlight some severe concerns with the original agreement and again brings home concerns over the level of uncertainty - what is a precautionary recapitalisation? - that continues to dog the agreement.

• The alliances that built up on this issue are also interesting and somewhat unusual. The UK had the support of the European Parliament and even France and Italy, although they seemingly wanted to reopen the text for other reasons. However, Netherlands and the Czech Republic were firmly against, while Germany was very hesitant. The UK should take comfort in this. On this particular issue, the divide wasn't eurozone versus non-eurozone - that potential divide remains one of the biggest liabilities in the UK-EU relations, particularly in financial services. 

Most importantly though, how in the world did finance ministries and central banks - including the Treasury and BoE effectively - miss a provision which governs fundamental central bank actions? Admittedly, we didn't spot it either and it is a very technical clause but these are exactly the types of things that central banks should be on the look out for. It certainly raises some serious questions about the level of oversight and analysis of EU legislation both at the EU and national level. How did everyone miss this the first time around? If the central banks weren’t involved earlier, should they be on important financial legislation such as this?

Credit to the Bank of England for at least detecting it. Better late than never (well, sort of, in this case). 

Cypriot deposit developments

Update 31/05/13 09:40: As we noted below, it seems that the figures do include some of the write-downs of deposits under the bank restructuring (but not all). Apologies for the confusion. As the Central Bank of Cyprus notes the initial write down for Bank of Cyprus depositors is included. This totals around €3.2bn. This means the actual outflow was around €3bn, similar to the previous month.

This is still fairly significant, although we expect much of this may be domestic and due to people and businesses running down their cash reserves. This also likely reduces some of the concerns over the workings of the capital controls. The data does give some feeling for who might be losing from the bank restructuring - US Dollar depositors and foreign NFCs are probably a large share. The concerns over the bank deleveraging and increasing reliance on central bank financing also remain (since they were already well established).

The real test of the deposit flight will come, firstly once the bank restructuring is complete (by end of July) and secondly once the capital controls are removed (who knows when).

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Yesterday saw the release of the latest data on the state of bank deposits in Cyprus – which always makes for interesting reading.

The headline figures are pretty terrible. Overall deposits declined by €6.346bn (10%) in April, almost double the level seen in March (when the crisis was in full swing) - despite stringent capital controls being in place for the entire month. However, given their importance, these figures deserve delving beyond the headlines.

The charts above (click to enlarge) raise some interesting points:

• First, it’s clear that the deposit flight is continuing despite the strict capital controls. This is concerning, since it shows the Cypriot government’s inability to enforce the rules, particularly on the financial sector. It also means that capital controls continue to hamper the functioning of the Cypriot economy, but are failing to stop an outflow of money (though admittedly it could have been much larger without them).
• Second, the outflows are split between domestic residents and those in the rest of the world (ROW). ROW deposits are unlikely to return for some time. Cyprus could hold out hope that domestic residents are just stashing cash due to concerns over the economy and banks, meaning this money may eventually return. Unfortunately, given the bleak outlook this is unlikely to happen anytime soon.
• Third, a surprisingly large amount of the withdrawal (€3.2bn) has come from deposits held in US dollars. This money might also have moved abroad and is unlikely to return, suggesting both domestic and foreign investors are moving money away from Cyprus.
• Lastly, much of the withdrawal has been by non-financial corporations (NFCs) and households. This was perhaps more predictable, but again raises concerns about the future of investment and consumption in the economy. The underlying data shows especially strong withdrawals from ROW households and NFCs which have been a big source of economic growth for Cyprus in recent years. It could also peak concerns over the impact the capital controls are having, as firms and households are forced to eat into their cash reserves (although they still remain at a decent headline level).

One important point to keep in mind concerns the losses for some uninsured depositors under the bank restructurings. It is not clear from the Central Bank of Cyprus figures whether this has already been accounted for in the data above, although this looks unlikely since the process is still continuing. That said, if it has been, then the actual withdrawals are smaller - though still high. The overall economic impact also remains similar.

What does all this mean for Cyprus and the eurozone?

• Much of it confirms what many people feared in the aftermath of the crisis. In particular, it paints a bleak picture for future growth in Cyprus as money flows out of the economy. It also raises questions over whether such outflows were accounted for in the overly optimistic assumptions about Cypriot growth.
• Another problem will be bank financing. Cypriot banks are locked out of the markets and may well be for some time. With deposits falling they will be forced to access more ECB liquidity and possibly the Emergency Liquidity Assistance (ELA). This is something which the ECB has notoriously been trying to avoid in Cyprus, and more generally. Not least because under any future restructuring/default/euro exit scenario the ECB would face larger losses.
• But it’s also important to remember that there is a limit to how much Cypriot banks can access through these facilities since they require assets to be posted as collateral. Even if they are able to, it is clearly possible that this pressure could force them to increase the already rapid pace of deleveraging. This would undoubtedly further hamper lending to the real economy and in turn economic growth.
• As noted above, from a wider perspective it will increase already pressing concerns over the enforcement of the controls and more generally over regulation of the financial sector in Cyprus.

Let the guessing game continue: The Eurogroup's mixed messages on capital controls

As we have noted at length, the capital controls are a key part of the Cypriot deal and could have a huge bearing on how and when Cyprus recovers from this crisis. Unfortunately, as with almost all important eurozone decisions, this one lacks clarity.

The body of the Eurogroup statement said:

“The Eurogroup takes note of the authorities' decision to introduce administrative measures, appropriate in view of the present unique and exceptional situation of Cyprus' financial sector and to allow for a swift reopening of the banks. The Eurogroup stresses that these administrative measures will be temporary, proportionate and non-discriminatory, and subject to strict monitoring in terms of scope and duration in line with the Treaty.”

However, the Annex noted:

“Only uninsured deposits in BoC will remain frozen until recapitalisation has been effected, and may subsequently be subject to appropriate conditions.”

EU Internal Market Commissioner Michel Barnier added earlier today:

“Any measures to restrict or limit freedom of movement may only be enacted exceptionally and temporarily and that is what has been requested by the Cypriot authorities.”

Some pretty mixed messages. The first suggests that “administrative measures” (which is widely being taken as capital controls or related measures) will be generally applied. Bruegel suggests that this may not even need to take the form of full capital controls and could be limited to measures slowing down the movement of capital. This is contradicted by the second point which suggests they will only apply to the Bank of Cyprus uninsured depositors. Barnier’s point is closer to the first point but suggests actual controls will be needed.

FT Alphaville has an interesting run-down of the different type of capital controls and their implications. Paul Krugman makes the valid point that, if the trade-off of the single currency is reduced transaction costs in exchange for an overvalued currency, once capital controls are introduced, what is the motivation to stay inside? As he notes, wider points on the EU and access to ECB liquidity apply but it gets to the crux of the choice facing Cyprus.

As we have suggested, we find it hard to imagine that the banks could survive long without capital controls, while the economy would likely take an even bigger hit. As we have mentioned, it would fall on the ECB to continue to sanction ELA to keep banks afloat during deposit outflows, but this would amount to a large transfer of risk towards the Cypriot Central Bank (and therefore the Cypriot state, and therefore the eurozone). Meanwhile, access to the ELA is limited by the ECB’s view of bank solvency (one they have shown they may not stretch indefinitely) and assets which can be posted as collateral.

One thing that is for sure: this lack of clarity is certainly not helping an already messy situation.

Cyprus update – halfway to a deal, but the biggest obstacle remains

It’s looking as if there will be a deal in Cyprus, although there are some big obstacles to be crossed to get there and it is likely to go down to the wire.

Last night the Cypriot parliament voted to approve a few bills which will make a significant bank restructuring possible and allow the government to install capital controls if it sees necessary, here are the key points of what was approved (and what was not):

• Plan to wind down Laiki bank – good assets and insured deposits below €100,000 will be shifted into a good bank which will be merged with the Bank of Cyprus. Bad assets along with uninsured depositors above €100,000 will be put into a bad bank – these depositors could lose as much as 40% of their money.
• Ability to enforce capital controls – these are wide ranging from limiting non cash transfers to turning standard current account deposits into time fixed ones, and pretty much anything else the government deems as necessary for ‘public order and safety’.
• The creation of a solidarity fund – this will not play a large role in the bailout deal, since it was already rejected by the EU/IMF/ECB Troika as an alternative to the deposit levy.
• No deal on the bank deposit levy – Eurozone finance ministers will meet on Sunday in Brussels with the Cypriot parliament only likely to vote on a deal after it has been cleared at this meeting.
• Bank of Cyprus has survived being ‘resolved’ for now.
• The Greek bank Piraeus will take control of the Greek parts of Laiki and Bank of Cyprus.

These measures are expected to raise just over €2bn (maybe more, we’re waiting on firmed details on the solidarity fund). That still leaves €3.5bn+ to be raised to meet the €5.8bn target set by the Troika – although reports yesterday suggested this may have been raised by €0.9bn due to worsening forecasts for Cyprus. Below we outline our key takeaways from the deal.

The largest obstacle to a deal remains: Clearly, this will once again come down to the deposit levy. With a smaller amount needing to be raised, it is likely to fall only on €100,000+ deposits. As we noted yesterday a levy of between 12% - 15% looks likely, although given the bank bailout plan it could hit some big Laiki depositors especially hard. Kathimerini reports that the levy could be pushed higher and focused on a smaller group of depositors. Ultimately, though, with few alternatives left now a levy on largest depositors seems the least destructive option (but still far from ideal).

This will go down to the wire: The ECB has set a Monday deadline for a bailout deal or it will cut of liquidity to Cypriot banks. The banks are due to open on Tuesday but this could be extended if no deal is found. As long as the banks stay shut (and with use of the capital controls, see below) they may be able to buy a few days to reach a deal, allowing the ECB to reverse its decision. Still, it will be a messy few days with the Cypriot parliament unlikely to vote on the deal until the it is approved by the Eurozone and assured of passing. If the deposit levy is only on large deposits, it should gain support from DIKO (the junior coalition partner), while reports suggest some opposition members could abstain or be absent from the vote to allow it to pass.

Still, this has been left very late and the decision to approve the above measures first seems to be putting the cart before the horse. This is not too surprising though (since clearly these were easier options to push through) and reminds us of other parts of the crisis – such as the decision to approve the ESM before the EFSF was revised to be fit for purpose.

The capital controls are severe: The government has significant leeway to limit the flows of capital. People have rightly been asking questions of whether this, de facto, moves Cyprus out of the single currency. Ultimately, money is no longer fungible between Cyprus and the rest of the Eurozone and, at this point in time, it’s hard to argue that a euro in Cyprus is worth the same as a euro elsewhere. The real problem though may not be imposing the controls but removing them, as WSJ Heard on the Street points out. It is hard to see how the Cypriot economy will be able to function properly with these strict controls on and at some point questions will surely begin to be asked if it would not be better off with a devalued currency outside the euro.

Why is Bank of Cyprus not being ‘resolved’? Reports suggest the Cypriot government has fought hard to stop the bank having the same fate as Laiki. This may be because it is the largest bank and a large employer in Cyprus, but it is could also be because it remains very close to the government and is the home for some of the largest Russian depositors. In any case, avoiding the tough decision to fully restructure the banking sector is likely to make things more difficult in the future.

Greek banks are getting a very good deal: The branches of Cypriot banks in Greece have around €22bn in assets and account for 8% of all deposits in Greece and 10% of loans. Clearly they are sizeable and hiving them off helps reduce the size of the Cypriot banking sector relative to GDP and reduces the cost of the bailout. It also protects the rest of Greece from contagion. That said, Piraeus is picking up a very good deal, not least because Cypriot exposure to the Greek crisis was a key driver of the current problems Cyprus faces. The purchase was done at a symbolic €1 but the cost of recap is €1.5bn. Funding will come from the Hellenic Financial Stability Fund (the Greek bank recap fund) and the Cypriot bailout programme – €950m from the former and €550m from the latter. So these banks, investors and depositors avoid any losses despite many being entangled in the Greek crisis. The fact that Piraeus bank shares were rocketing yesterday is a clear enough sign of who did better out of this deal.

The deal has come full circle and has been very poorly managed: as we noted yesterday, we are basically back to a mix of the deal proposed by the IMF (bank restructuring) and the Eurozone (deposit levy) last Friday. The impact the events of this week will have on Cyprus should not be underestimated – there will be a huge outflow of capital (or will be whenever the controls are removed) and significant political upheaval. This has been poorly handled by both sides – the Eurozone failed to listen to the Cypriot government and was complacent about the impact of Cyprus on the wider Eurozone economy. The Cypriot government has fought to hang onto an impossible business model, focused on big finance funded by foreign deposits, and has looked to play a risky geopolitical game. Unfortunately, the ones that lose from all this are the 800,000 people who live in Cyprus.

Why is the ECB threatening to pull the plug on Cyprus? And how would it work?

The ECB - which holds the key to Cyprus' future inside the euro by virtue of funding the country's banks - this morning issued a statement which essentially set Monday as the deadline for a Cypriot bailout deal. It said:

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.

So, extending the ELA without a clear deal could lead to a significant transfer of risk towards the ECB and questions over its credibility. This would be a particularly poisonous debate in Germany, something which neither the ECB nor the German government would want ahead of the German elections in September.

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.

All at sea – What does the 'No' vote mean for Cyprus and the eurozone?

Following the dramatic vote by the Cypriot parliament tonight to reject the bailout deal, here is our flash analysis of the situation:

The Cypriot parliament tonight voted against a bill to introduce a tax on bank deposits, in return for a €10bn bailout offered to the country by Germany and other eurozone governments. Not a single Cypriot MP voted for the deal. The structure of the tax in the bill is shown in the table below. The vote leaves Cyprus’ place in the eurozone hanging in the balance and threatens the escalation of the crisis to a new level, though the most likely outcome is that the Cypriot parliament votes a second time, on a revised deal.

Results of the vote (click to enlarge)

The governing party (DISY) abstained (with one member absent), while the junior coalition partner (DIKO) voted against – this signifies the huge political divisions at work in Cyprus. Even if a bailout deal is eventually approved the government’s position continues to look untenable.

What does the vote against the deposit levy mean?

As we have noted before, this has the potential to be a very serious twist in the eurozone crisis. Previously, Germany and the eurozone have stressed that Cyprus has no alternatives to the deposit levy. Now, all eurozone partners are forced back into difficult negotiations.

What timeline are Cyprus and the eurozone working on?

Cyprus will run out of cash on 3 June, when it has to repay a €1.4bn international bond. However, the decision will need to be taken long before that. Cypriot banks cannot stay closed for long but they cannot be reopened until a decision is taken, otherwise there will almost certainly be a deposit run. While people can reportedly withdraw up to €700 per day from ATMs, businesses, large and small, cannot function without banks being open. We would expect some decision would need to be taken by early next week before the lack of liquidity and lack of economic activity begins to severely harm the Cypriot economy.

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. It is to some extent the vital difference between option 2 and 4, while keeping liquidity on could help facilitate option 1. 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.

Click here to read our analysis in full, including four potential scenarios.

Greek banks and the Greek bond buyback

Yesterday we put out a flash analysis looking at the latest Greek deal and the prospect of Greek bond buyback. One of the many issues with the deal (and the buyback in particular) which we raised was that Greek banks will find it difficult to participate without needing extra capital.

However, Greek Finance Mininster Yannis Stournaras also said yesterday (in a timely statement):

The debt buyback "doesn't mean new capital for banks, given that they have recorded these bonds at lower prices than those that will be offered."

His suggestion then, is that the Greek banks have already marked their bonds to market prices on their books, meaning that they can sell them at the low prices involved in the bond buyback without needing new capital. This may make their participation more likely, but there are plenty of other reasons why we still see it as difficult and unpredictable. (We also still question why foreign holders will be involved, particularly previous hold outs and those who are holding to maturity, see our full analysis here).

Firstly, as Kathimerini reported today, the banks themselves are not keen to be involved in the buy back. Many feel that they have already done their part in terms of taking part almost ubiquitously in the first debt restructuring. If they were to take part in the buyback, they could seek adjustments in the terms of the recapitalisation and reform – something which the EU/IMF/ECB troika is unlikely to accept.

Secondly, taking part in such a scheme would need significant approval within the banks and other financial firms. This means board level and possibly wider shareholder approval. As the restructuring earlier this year showed, this takes time, with the process dragging for months. Given the 13 December deadline to have a bond buyback plan in place (i.e. to have a firm idea of who will take part, to make sure it is worthwhile) it is not clear how many bondholders will be in place to participate.

Thirdly, and possibly most importantly, is that the banks need their holdings of bonds (around €22bn) to gain liquidity from the Emergency Liquidity Assistance (ELA) through the Greek Central Bank (GCB). Looking at the GCB balance sheet, it seems broadly that Greek banks posted €247bn in collateral to gain €123bn in liquidity, an average haircut of 50%. Given that many of these assets will be loans or securities, sovereign debt (even Greek) is unlikely to be judged any more harshly than the average. So, if the banks sold these assets for a 65% write down (as suggested) they could purchase new assets (maybe other sovereign debt) but would be able to buy less of it (as not many other assets priced at a 65% discount) meaning they would not be able to gain as much liquidity under the ELA as with current Greek bonds.

Essentially, this could harm the Greek banks liquidity position which would further constrain their lending ability and possibly prompt further deposit flight – both of which would hurt the fragile Greek economy.

All in all then, this process could still be counterproductive for Greek banks even if they do not book new losses directly and they still could be hesitant to take part voluntarily. However, that is not to say that the political pressure applied behind the scenes will not be enough to force them to voluntarily join. Ultimately, it simply highlights that this policy may deliver a small benefit with some negative side effects but is at best a way of skirting the real issue of whether the eurozone can stomach permanent fiscal transfers to Greece. This will come to the fore again soon.

A summit plus for Greece?

Given that Greece lacked any real political presence at last week’s EU summit, discussions on the crisis in Athens were fairly minimal and it was largely overlooked during the ensuing press coverage.

However, Kathimerini has an interesting report today suggesting that Greece could attempt to get the cost of its bank recapitalisation removed from its sovereign debt levels – in the same way that Spain is hoping to do. This could well be seen by eurozone leaders as a way to quickly reduce Greece’s debt burden – although we don’t think it will change any of the fundamental problems which it faces.

A large amount of the second Greek bailout – around €50bn – is actually going to Greek banks to help them absorb the large losses they faced from the Greek debt restructuring. With Greek debt currently standing at around €327bn or 160% of GDP, removing €50bn from this figure could provide a significant boost to Greek debt sustainability – bringing the figure down to 136% of GDP.

There are, however, a few important caveats to note here:

• Firstly, 136% is still an unsustainable debt level, even with this reduction the Greek debt burden is still huge and the need and demands for austerity are not likely to waiver . 
• Secondly, and possibly more importantly, is that this will only be an adjustment on paper for all intents and purposes. Greek banks are dead on their feet, living off liquidity from the ECB and the Greek Central Bank. They will never be able to repay this money and it will still ultimately be underwritten by the Greek state. So, even if this debt is shifted off the official figures it will still be a burden of the state – in reality little will have changed. 
• Lastly, this process will not happen anytime soon. The bailout funds cannot lend directly to banks until the ECB is in place as the eurozone’s financial supervisor, and as we have noted, this will be at the earliest the start of next year. This also happens to be the period by which we have suggested that leaving the euro may become more attractive from a Greek perspective. 

An interesting development which seems to have mostly slipped under the radar then. We wouldn’t be surprised to see the eurozone and Greek leaders take advantage of this opportunity to gain a large reduction in the superficial figures on Greek debt – it would make for an effective headline figure and would likely buy them some more time in terms of making Greek debt look sustainable in their and the IMF's models. Ultimately, though, it would only be window dressing, further shifting of funds around to try to make the situation seem better than it is. In the end, as we have always said, there are no easy answers to the Greek or eurozone crisis.

Despite a mundane EU summit, plenty of challenges remain in Greece

Just a quick post on the developments at what must be seen as the most mundane (if not pointless) EU summit on eurozone issues for some time. Reports today suggest that the eurozone will withhold part of the bailout funds for Greece, only paying out the part required to ensure that the voluntary Greek restructuring can go ahead.

This was mostly expected and as we have noted previously, as well as in our report released yesterday, the amount that needs to be paid out is sizeable. The eurozone estimates it at €58.5bn, while we have suggested it could be closer to €86bn.

The main reason for this difference arises from the expected level of recapitalisation for Greek banks. The eurozone returns to previous estimates of around €23bn to aid the banks, despite widespread reports that this could reach €40bn - €50bn as admitted by the leaked EU/IMF/ECB debt sustainability analysis. For our part, we estimate that the bank capital needs could fall between €36bn - €46bn (depending on how they incorporated the write downs onto their balance sheets) to meet the European Banking Authority’s 9% capital requirements.

It is likely that Greek banks will need at least €50bn in the longer term, so it may be that the eurozone is keen to limit the immediate capital pay-out to the minimum necessary to stabilise the banks. This may be prudent on one hand, since it reduces the amount which needs to be raised to push the restructuring through and is less politically divisive. However, running the banks so close to the edge in an economy as uncertain as Greece’s could be asking for trouble.

The final point worth considering on the Greek banks is the issue of collective action clauses (CACs – see here for background). It looks increasingly likely that they will need to be used to get the necessary participation in the Greek restructuring (notice at this point we finally drop the ‘voluntary’ qualifier, as in no way could that still be claimed to be the case). This would leave Greek banks in a tricky situation. Under this scenario the rating agencies would likely leave Greece in a ‘default’ rating longer than expected, meaning that Greek banks will be locked out of borrowing from the ECB for some time (funds which they need to survive). The main way to keep Greek banks alive would be to transfer their funding to the Greek Central Banks Emergency Liquidity Assistance (ELA) as we discussed here.

This is far from ideal, since the ELA is opaque and secretive, but ultimately it may be necessary and unavoidable. Triggering CACs at this stage may be one of the few ways to actually deliver the debt relief which Greece needs. It presents many challenges and unknowns but it still seems better than pursuing a path which seems to be fundamentally flawed.

A 'selective' Greek default and some emergency liquidity

A few interesting developments overnight and this morning in the eurozone. Specifically, S&P’s decision to put Greece into ‘selective default’ and the ECB’s reaction.

‘Selective default’ is essentially a partial default rating (in this case validly applied due to the current restructuring which Greece is undergoing and the fact that some bonds held by the ECB have been exempted). Under the ECB’s rules, when a country (and therefore its debt/bonds) is classified in any form of default its bonds cannot be used as collateral for the ECB’s lending operations. The ECB released a statement confirming as much this morning.

The kicker here is that Greek banks are completely reliant on ECB lending for their liquidity needs – they could not survive without it. Unfortunately, a huge majority of the assets which Greek banks use as collateral with the ECB are tied up with the Greek state (Greek government bonds or bonds backed by a Greek state guarantee). The plan to deal with this issue is for the majority of lending to Greek banks which currently takes place under the ECB to move to the Greek Central Bank’s Emergency Liquidity Assistance (ELA) programme. The ELA has lower collateral requirements and therefore will presumably continue to accept the 'defaulted' Greek bonds as collateral.

This is an unprecedented move and should stop Greek banks collapsing. That said the opacity and secrecy of the ELA means it will be even harder to figure out what is going on within the massive sovereign banking loop in Greece.

As a refresher, we present an article we wrote last September on the ELA for the World Commerce Review. It provides a comprehensive run down of how the ELA works and what implications its use could have for eurozone.

To read the article see here.