JPM On Grexit, TARGET2, And The ECB

Unless Greece chooses to leave the Euro area, which JPMorgan doubts will happen, the rest of the region will have to push Greece out. The mechanism for this will be the ECB excluding the Greek central bank from Target2, the regional payments and settlement system. Although this might look like a technical decision about monetary plumbing, the ECB will elevate this to Euro area Heads of State. 

There is understandably a lot of interest in the mechanics of how a possible Greek exit from the Euro would play out in relation to the ECB. Reports of significant deposit withdrawal from Greek banks also direct attention toward the support for Greek banks coming from the Greek Central Bank and the Eurosystem. And yesterday’s announcement by the ECB of restricted access to regular repo Eurosystem financing for a number of Greek banks adds some more complication. Though we would not place a lot of emphasis on what the ECB announced yesterday as a signal of broader attitudes toward Greece, understanding the mechanics matters more broadly.


The view from the asset side…


Let’s start by considering the asset side of the Greek Central Bank’s Balance sheet (This is the less interesting part of the story, in our view).


If the Greek central bank makes loans to Greek banks under standard ECB repo terms, the credit risk on such loans is (under current law) shared across the Eurosystem. Regular repo operations against “extended collateral” see the credit risk transferred to the Greek central bank. And if the Greek central bank makes loans under ELA, the credit risk stays with the Greek central bank.


In the event that Greece were to leave the Euro area, any possible losses on ELA loans to banks and repos against extended collateral accrue to the Greek central bank.  What would happen to any losses on regular repo operations in the context of euro exit is much more hazy. Greece may claim legal  grounds that any losses should be shared. But since EMU exit would be a material breach of existing legal treaties, it is tough to argue that existing legal provisions would necessarily carry much weight. There would probably have to be some negotiation over any losses that accrue down the line.


The ECB’s decision yesterday to limit the access of Greek banks to regular repo financing, forcing more use of ELA, reflects the fact that the banks and the Greek authorities are still haggling over the terms on which they are recapitalised. The ECB’s position is that until the capital goes in, the banks are not fully solvent, hence lending to them goes via ELA, not regular repos. On the one hand, this puts pressure on the Greeks to stop haggling on the recap terms. On the other hand, some may argue that it demonstrates that the ECB is keen to limit the system’s exposure to Greece as a whole, pushing the loans to ELA where necessary, where Greece has no legal comeback at all for losses. We think the first of these is more important.


The view from the liability side….


If we now think about the liability side of the Greek central bank balance sheet: the story gets more interesting. The Greek central bank creates euros when it grants loans to Greek banks via either repos or ELA. In the first instance, these show up as reserve holdings by the Greek banks at the central bank when the euros are credited to their account. But with euros leaving the Greek banking system, Greek banks lose reserves as transactions are settled through the payments system. As Greek bank’s reserves  fall, this is replaced by a liability to the Target2 payments system for the Greek central bank. The Greek central bank’s liability to the rest of the Eurosystem via Target2 is currently near €130bn. As we move toward the Greek election next month, that is likely to climb given deposit flight. But we expect the ECB will do all within its power to keep the Greek banking system afloat until the election, even if some of the loans to Greek banks are redirected via ELA. The terms of ELA can be stretched so that Greek banks do not run out of collateral, while banks can issue bonds to themselves backed by a government guarantee to create more collateral.


How Greece could get cut off from Target2


But a much more challenging question is what happens after the election. Let’s imagine Syriza is able to form a government, declares a debt moratorium, and antagonizes the rest of the region by rejecting the Troika programme in its entirety. Even with no further disbursements of official loans, the region’s loans to Greece via the target 2 system will be continuing to grow. Loans from the Greek central bank to Greek banks would be almost completely forced into ELA.

The ECB can “shut off” the Target2 loans if it exercises its veto over ELA loans (requiring a two-thirds majority on the Governing Council), and if the Greek central bank respects that veto. But the Greek central bank would likely be faced with the need to impose very restrictive controls on Euro deposits to limit outflows if ELA loans to Greek banks cannot be made. If the Greek central bank is faced with the prospect of imposing capital controls, a collapse of the Greek banking system, or defying the ECB’s veto on ELA loans, what route would it take? If it chose the latter, the only way for the ECB to “shut off” the Target2 loans would be to prevent Greek access to the payments system itself, refusing to accept payments of euros to and from Greek banks. At that point, Greek created euros are no longer euros. That decision would not be made by the ECB alone, but would likely be deferred to European Heads of State.