Goldman Pops The "Deus GrEx Machina" Balloon
While hard information is scarce, concerns about deposit flight from Greek banks have increased since the 6 May elections. To the extent that such flight arises from liquidity concerns, the ECB can contain it (or its impact) via its various monetary policy and ELA operations. But, as Goldman Sachs notes in its Focus today, the ECB cannot deal with concerns about bank solvency and/or deposit currency redenomination. That requires a pan-Euro area guarantee of the Euro value of bank deposits by the fiscal authorities. However, attractive in principle, even Goldman agrees with our skeptical perspective that it is unlikely that such a guarantee can be implemented credibly in short order. And thus pops the latest straw being clutched at by failing Deus GrEx baloons, to butcher a countless number of metaphors...
Goldman Sachs Focus: Meeting deposit runs in the Euro area
Are we experiencing a run on bank deposits in the Euro area? Hard information is scarce. We will not get the May official data on the evolution of bank deposits by country until towards the end of June. Bank balance sheets are only reported for accounting purposes on a quarterly basis. But the authorities have expressed concerns, particularly in Greece.
Is deposit flight something new?
As illustrated in a series of Global Market Dailies by Robin Brooks, we have seen evidence of deposit flight from some countries throughout the ongoing financial crisis, even if this is hard to distinguish from other processes such as deleveraging which have also served to shrink the size of bank balance sheets. On the basis of developments in household deposits relative to nominal GDP (shown in Chart 1), falls in household deposits have been particularly acute in Greece, with more modest falls or stagnation in Ireland, Spain and Italy. Portuguese deposits have shown a higher degree of resilience.
How much further can deposit flight go?
Chart 2 shows the remaining stock of household deposits in peripheral countries’ banking systems. These total almost EUR 2 trillion. By nature of their size, Spain and Italy stand out, accounting for approximately EUR 1.5 trillion of household deposits between them. Were deposit flight to infect these countries, the magnitude of the issue would be a quantum bigger than what we have seen thus far.
What policy measures can contain a deposit run?
Where deposit flight is triggered by liquidity concerns – that is, the bank may not be able to generate cash quickly enough to meet withdrawals – then the central bank has a role to play in following Bagehot’s rule for lenders of last resort: lend freely against good collateral at a penalty rate. Such an approach can ensure that banks never run short of liquidity. Banks thus don’t fall victim to a ‘self-fulfilling prophecy,’ where the perception of liquidity concerns leads to a withdrawal of deposits that validates the original perception and causes an acceleration of withdrawal. The ECB already provides unlimited liquidity to banks via its full allotment monetary policy operations against a very broad set of eligible collateral. And the ECB has shown willingness to expand the definition of eligible collateral and/or shift banks with collateral shortages to emergency liquidity assistance (ELA) so as to maintain the flow of liquidity. Such actions are ongoing: as long as the ECB is prepared to keep them in place, they should ensure that banks undergoing bank runs do not face liquidity shortages.
But where banks are suffering deposit withdrawals owing to concerns about the solvency of the bank, a central bank lender of last resort may not be sufficient. While the ECB can offer a liquidity guarantee, it cannot guarantee the solvency of deposits: that is a fiscal responsibility, which lies outside the mandate of the central bank. Should the ECB offer to guarantee deposits in the face of bank insolvency, it would be taking over the role of the fiscal authorities and, as such, violate the Treaty’s prohibition of monetary financing. This would be likely to lead to a legal challenge to the ECB’s actions in the European Court of Justice.
Of course, the distinction between liquidity and solvency problems is not easy to draw in practice, especially in real time. And any willingness of the ECB to extend ELA to banks against collateral of questionable quality would entail the assumption of some fiscal risks. Nevertheless, in our view, to be credible a deposit guarantee must be underwritten by the fiscal authorities.
What are the characteristics of a credible deposit guarantee?
In current circumstances, a deposit guarantee would need to be pan-Euro area in nature. While depositors believe that the fiscal backing offered by the deposit guarantee is worth more in some jurisdictions than in others (owing to variation in the underlying fiscal strength of the countries concerned), then depositors will have an incentive to switch deposits to the fiscally stronger country. A pan-Euro area guarantee would eliminate this incentive: the fiscal backing for the deposit is the same regardless of the bank’s location.
Moreover, deposit flight may be triggered by the perceived threat of capital loss should the deposit be redenominated in a different currency as one country exited the Euro area. In this context, a credible mechanism to halt deposit flight would need to guarantee the Euro value of the deposit. But the willingness of other countries to honour a guarantee to make deposits good in Euro terms at banks in a country that has exited the Euro area (possibly in acrimonious circumstances) is, at best, open to question. As a result, the credibility of such a guarantee may be low. This is one example of how admitting the possibility of Euro area exit opens up a Pandora’s Box that makes maintaining the integrity of the Euro area and its financial system more challenging.
How close are we to a pan-Euro area deposit insurance scheme?
Proposals for the introduction of a pan-Euro area deposit insurance scheme were apparently discussed at the G8 summit over the weekend and may resurface at this evening's informal EU summit. But the challenges to the introduction of such a scheme are formidable.
Politically, it will not be domestically popular in Germany (inter alia) to extend such guarantees, however much Germany may benefit from arresting the financial instability deposit runs may cause. Legally, the German constitutional court has limited the scope for the German authorities to widen its financial obligations towards the rest of the Europe: a pan-Euro area deposit guarantee would be a significant extension of such liability and therefore may require further legal consideration. And institutionally, in order to contain the threat of free-riding on the guarantee of others, entering into a pan-Euro area deposit guarantee would need to be associated with a deepening of the pan-Euro area system of financial supervision and regulation. This would involve substantial loss of sovereignty relative to the status quo and require significant institutional innovation.
For all these reasons, we doubt that a credible pan-Euro area deposit insurance scheme can be introduced in short order. To be credible, legally sound and institutionally robust -- in other words, to work -- such a scheme will need to be developed over a longer period.
Source: Goldman Sachs