Analysis: Europe, not just Greece, is waking up to a nightmare

People line up at an ATM outside a Piraeus bank branch in Athens. Photo / AP

With the ECB freezing the level of emergency liquidity assistance (ELA) it is providing to Greek banks, the nightmare scenario for Greece is already beginning to unfold. Capital controls are on the way, with all the disruptions to everyday economic activity that they entail - and Greek banks will stay closed for a week.

The ECB's decision sends a clear signal that ELA support beyond June 30, when the current bailout programme comes to an end, cannot be taken for granted. Indeed the BBC reported that ELA support by the ECB had already been cut off.

Pictures of Greek depositors queuing up at ATMs resemble the situation in Cyprus in March 2013, when again the euro area came very close to unravelling. Although there are key differences between Cyprus in March 2013 and Greece now, there are also enough similarities that can not only help explain the rationale behind ECB decisions but can also help Greece draw the correct lessons from Cyprus.

At the time the ECB made its decision to withdraw ELA support to Cypriot banks, there was an angry reaction within Cyprus, partly fuelled by the inability of politicians to understand the rules that govern ELA provision. Many, including the Cypriot government itself, blamed the ECB for an unprecedented blackmail that eventually forced the government to accept harsh bailout terms in order to remain in the euro area.

This type of action by the ECB is not without precedent. In 2010 the ECB behaved in similar fashion in the case of Ireland when ECB president at the time, Jean-Claude Trichet, wrote a letter to the Irish finance minister advising him that ELA support to Irish banks would cease if the Irish government didn't apply for an EU/IMF adjustment programme.

All that the ECB was doing in the cases of Cyprus and Ireland - and now in the case of Greece is - simply applying its ELA procedures, which adhere to strict rules that reflect its legal set-up. If anything, the ECB has shown remarkable patience and flexibility in applying these rules in order not to be seen to be interfering in the political process.

People line up at an ATM outside a Piraeus bank branch in Athens. Photo / AP

Playing by the rules

These rules can, in fact, justify withdrawal of ELA support to banks at such critical times. The first and perhaps the most important rule - that most central banks in the world adhere to - is that ELA can only be provided to solvent banks that are facing temporary liquidity difficulties.

Central banks are not there to bail out failing commercial banks. That is a decision that should be made by democratically elected governments that are accountable to taxpayers.

In the case of the ECB, there is also Article 123 of the Lisbon Treaty, which prohibits the monetary financing of government deficits, because such financing is considered inflationary. This is in fact the cornerstone of the design of the monetary union, which is based on the successful anti-inflation record of the German Bundesbank.

Question of solvency

So, the key question that needs to be answered is whether Greek banks are solvent. They clearly must have been considered solvent up to now, otherwise ELA support would not have been forthcoming. ELA support to Greek banks is reported to have reached nearly €90 billion, as a result of massive deposit withdrawals in the past few weeks and months, that in recent days have escalated to a bank run. During the past week or so, ELA ceilings have been increased on a daily basis.

The Greek government, however, runs the risk of becoming insolvent if it defaults on its June 30 IMF debt repayment. The country's current bailout programme (which expires on June 30) is key to keeping Greece's public finances sustainable. With no political agreement to extend it, Greek banks, which hold a lot of the Greek government debt, would almost certainly fail to meet regulatory minimum capital rules that apply to all banks in the EU. This means that unless the Greek government is able to recapitalise them - unlikely without an IMF/EU programme - they will almost certainly be deemed insolvent by the ECB on July 1.

Elderly people, who usually get their pensions at the end of the month, wait outside a closed bank in Athens. Photo / AP

Patience and flexibility

The cases of Cyprus and Ireland were somewhat different. Both countries needed to borrow large sums of money from international creditors in order to recapitalise their banks, that suffered losses from a collapsing property market and (in the case of Cyprus) the Greek debt restructuring that took place in 2011. There is, nonetheless, a key similarity: without an adjustment programme to make their public finances sustainable, all three countries' banking systems could not be considered solvent by the ECB.

If anything, the ECB has shown remarkable patience and flexibility with Greece in the last few months. It knew there was always a risk that an agreement between Greece and its international creditors would not be reached. It therefore knew that Greek banks could not be deemed solvent beyond June 30 2015, without an agreement between Greece and its international creditors, yet it chose to continue supplying increasing amounts of liquidity to Greek banks, because it did not want to interfere in the political process.

In a similar vein, the ECB continued to supply ELA to Cypriot banks for several months until an agreement was reached that made the country's public finances sustainable. In the case of Cyprus - and previously Ireland - the risks did not materialise because both governments proceeded with their bailout agreements. But Greece now looks very different indeed.

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Panicos O. Demetriades is Professor of Financial Economics at University of Leicester.

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