March 20, 2013 4:20 pm

Q&A: The ECB and Cyprus’s banks

The rejection by the Cypriot parliament of a controversial bailout plan has left the island’s banks in limbo.

Wolfgang Schäuble, Germany’s finance minister, has said the two biggest banks are being kept in business solely thanks to “emergency liquidity” from the Central Bank of Cyprus, and that the European Central Bank has told Nicosia that this will be cut off if no rescue plan is agreed.

For its part, the ECB said on Tuesday that it “reaffirms its commitment to provide liquidity as needed within the existing rules”.

So what’s happening?

The Emergency Liquidity Assistance (ELA) said to be propping up the two biggest Cypriot banks – Bank of Cyprus and Laiki (also known as Cyprus Popular Bank) – is liquidity provided to a eurozone commercial bank in a financial crisis by its national central bank.

Does it come directly from the ECB?

No, it is money provided by national central banks. ELA is a measure that allows the eurozone’s 17 national central banks to act as lenders of last resort, once the assets held by commercial banks no longer qualify under ECB rules as suitable collateral in return for funding. The ECB has defined ELA as “support given by central banks in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions and markets”.

Does this mean the local central banks effectively bail out their local commercial banks?

ELA is meant to be used to overcome a temporary liquidity crisis, where a bank has assets but cannot access them quickly enough to meet liabilities, such as cash withdrawals. It has been used extensively in Greece and Ireland.

The ECB stresses that ELA is “exceptional”, that the national central banks have to ensure they receive “adequate collateral” before offering it, and that they must not engage in “monetary financing” – that is, printing money to prop up their banks. They must also report back to the ECB, which can choose to step in and terminate ELA with a two-thirds majority vote at its 23-member governing council.

And what are the “existing rules” that the ECB has alluded to?

You will struggle to find much in the way of ELA documentation, let alone hard-and-fast rules. Among the available ECB documents that refer to ELA, a key phrase is: “Flexibility and discretion are . . . essential in order to guard against the risk of moral hazard.” Like Fight Club, the first rule of ELA is you do not talk about ELA.

Surely it cannot be used to help an institution that is actually insolvent?

In a financial crisis the line between liquidity and solvency can become very blurred. Speaking in 2003 and looking back at the Asian financial crisis of 1998, the late Tommaso Padoa-Schioppa, a former ECB executive board member, said: “In theory, we all agree that emergency liquidity support should be provided only to illiquid but solvent institutions. But the distinction between these two concepts is particularly difficult to make in periods of financial distress, which is exactly when central banks may have to use this tool. Consequently, careful judgment is necessary in providing emergency liquidity assistance.”

So there is lot of wiggle room before the ECB would be obliged to tell the Central Bank of Cyprus to cut off ELA to Cypriot banks?

Yes. Which is exactly why it remained in place for years in Ireland and is still being used in Greece, albeit at much reduced levels.

Does the ECB publish statistics on ELA?

ELA is revealed, if at all, only in comments from policy-makers or individual disclosures by national central banks. However, the total figure for eurozone ELA is included within the heading “other claims on euro area credit institutions denominated in euro” published in weekly ECB eurosystem financial statements. Last week that stood at €70bn, down €3bn on the week. Less than half of that is understood to be ELA, which remains at considerably lower levels than last year.

Didn’t the ECB negotiator at last weekend’s eurozone finance ministers’ meeting threaten to cut off ELA to Cyprus?

Jörg Asmussen, the ECB executive board member at the talks, has said no threats were made. But it was pointed out to Nicos Anastasiades, the Cypriot president, that ELA could not be given to insolvent banks and, without a rescue plan, Cypriot bank solvency was not assured. Make of that what you will, but it does not follow that an imminent termination of ELA is likely.

The argument for cutting off ELA is that Cyprus’s banks are indeed insolvent and need to go into bankruptcy. The argument against it is that the absolute amount of liquidity support they receive is relatively small, and that cutting it off would be a nuclear option with potentially unpredictable consequences – it could well set in train Cyprus’s departure from the euro area with all the attendant risks that brings.

Mario Draghi, ECB president, said last July that the bank would do “whatever it takes” within its mandate to keep the eurozone together. Maintaining ELA for the time being would appear to be within that mandate.

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