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By providing cheap credit to near insolvent banks and struggling eurozone governments, the European Central Bank has a hidden and potentially huge cost to the taxpayer on its balance sheets.
22 June 2011
The role of the European Central Bank (ECB) in the ongoing Eurozone and banking crisis has been significantly understated. In parallel with the IMF’s and EU’s multi-billion euro interventions, the ECB has engaged in its own bail-out operation, providing cheap credit to insolvent banks and propping up struggling Eurozone governments, despite this being against its own rules. The ECB is ultimately underwritten by taxpayers, which means that there is a hidden – and potentially huge – cost of the Eurozone crisis to taxpayers buried in the ECB’s books.
The ECB’s balance sheet is now looking increasingly vulnerable. We estimate that the Eurosystem which underpins the ECB has exposure to struggling Eurozone economies of around €444bn – an amount roughly equivalent to the GDP of Finland and Austria combined. Although not all these assets and loans are ‘bad’, many of them could result in serious losses for the ECB should the Eurozone crisis continue to deteriorate.
Critically, through national central banks, struggling banks have been allowed to shift risky assets away from their own balance sheets and onto the ECB’s (all the while receiving ECB loans in return). Many of these assets are extremely difficult to value. Overall, the ECB is now leveraged around 23 to 24 times, with only €82bn in capital and reserves. In contrast, the Swedish central bank is leveraged just under five times, while the average hedge fund is leveraged four to five times. This means that should the ECB see its assets fall by just 4.25% in value, from booking losses on its loans or purchases of government debt, its entire capital base would be wiped out.
Hefty losses for the ECB are no longer a remote risk, with Greece likely to default within the next few years – even if it gets a fresh bail-out package from the EU and IMF – which would also bring down the country’s banks. We estimate that the ECB has taken on around €190bn in Greek assets by propping up the Greek state and Greek banks. Should Greece restructure half of its debt – which is needed to bring down the country’s debt to sustainable levels – the ECB is set to face losses of between €44.5bn and €65.8bn on the government bonds it has purchased and the collateral it is holding from Greek banks. This is equal to between 2.35% and 3.47% of assets, meaning it comes close to wiping out the ECB’s capital base.
A loss of this magnitude would effectively leave the ECB insolvent and in need of recapitalisation. Worryingly, it is not entirely clear how the ECB would cover such heavy losses in practice. A recapitalisation can take various forms with the losses more or less shared out between national central banks. Irrespective of the mechanism that is used, ultimately the bill will be passed on to taxpayers in one form or another. Absent a recapitalisation, the ECB would have to start printing money to cover the losses. This would trigger inflation, which is unacceptable in Germany and elsewhere.
The ECB’s actions during the financial crisis have not only weighed heavily on its balance sheet, but also its credibility. Firstly, as a paper published by the ECB last year noted, “The perceptions of a central bank’s financial strength have an impact on the credibility of the central bank and its policy”. Secondly, by financing states, the ECB has effectively engaged in fiscal policy – and therefore politics – something which electorates were told would never happen.
Worried about the risk of these potential losses being realised, the ECB is vehemently opposed to debt restructuring for Greece and other weaker economies. However, continuing the ECB’s existing policy of propping up insolvent banks – and intermittently governments – would be even worse for the eurozone as a whole.
The ECB’s cheap credit has served as a disincentive to struggling banks to recapitalise and limit their exposure to toxic assets in weak Eurozone economies. This creates moral hazard for banks and governments alike, at times even fuelling the sovereign debt crisis, while transferring more of the ultimate risk to taxpayers across Europe. Therefore, in its attempt to soften the immediate impact of the financial crisis, the ECB may in fact have exacerbated the situation in the long-term, increasing the cost of keeping the eurozone together for taxpayers and governments.
Moving forward, the ECB must return to its original mission of promoting price stability and a way has to be found to get ailing banks off the ECB’s life support. This should include a winding-down mechanism for insolvent banks.
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