Why ELA is not Different from Bank Deposits

Truth is, when most of us hear about Emergency Liquidity Assistance (ELA), our minds go back to March 2013 when the Cyprus haircut was first announced; we think of ELA as a trouble indicator, one which signifies that a bank is desperate enough to obtain it from the Central Bank, and subsequently, that the bank which obtains it is about to collapse. Yet, even though some parts of this story are correct, both the conclusions usually reached as well as the consequences we think ELA funding has, are, most of the times, unreasonable.

First things first: banks operate with deposits and loans, with the available money in the economy. In addition, they also tend to create money themselves, by the power of credit. What basically happens is that banks, using liquidity (i.e. available money) from their deposits, loan out funds to people. This occurs until the regulatory capital requirement hits. What liquidity means though, is that banks cannot perform their day to day business without money. Imagine going to a bank only to find out that it has run out of money, just like what happened in the US during the Great Depression or in the UK during the 2008 crisis. In order to avoid panic, the Central Bank usually steps in when there is a large outflow of deposits providing liquidity to its banks.

Here's what should be noted though: running out of liquidity is nothing unusual for banks. That's why interbank loans and discount windows exist. In the first case, the bank obtains a short-term loan from another bank with more liquidity available in order to maintain a minimum until more money are returned (via deposits or through loan installments) while in the second case, the same occurs but the bank borrows from the Central Bank. In both cases, borrowing from either source actually has less cost for most banks, especially in the periphery (in countries like Germany and the UK, the interbank lending rate is usually very close to the deposits rate).

Thus, what liquidity needs mean is that there is a positive shortfall in the assets minus liabilities, and the bank has to cover it; whether this cover-up comes in the form of deposits or interbank/Discount window loans is irrelevant to the bank. Banks however, deal with other banks the way they deal with other customers: if they do not believe that they will repay, then they will not lend. Hence, when banks are not very stable (and this might just be a perception not reality), other banks might refuse to lend them forcing them to turn to the ECB discount window (the same might occur if a bank just thinks that it might need a large amount of funds, regardless of its state). The only issue here is that banks have to provide some collateral in order to receive the loan. This collateral is usually in the form of government bonds; when the bond has been rated as garbage, the bank cannot offer it for collateral.

At that time, the ELA comes in play: the National Central Bank (NCB), which usually operates in a strange dependent/independent relationship with the ECB, offers lending and accepts other forms of collateral (e.g. loans). The reason behind this lending is simply that the National Central Bank does not wish for the specific bank to bankrupt, as the costs will be much higher than the benefits (note: the decision of whether to offer ELA or not is 100% up to the NCB. Still, Central Banks do not enjoy making the decision of whether a bank will bankrupt or not so they just offer the funds. Nevertheless, this is not a bad policy in general). While this is a burden for the bank, it actually is much better than the alternative, i.e. deposits. Given the perception (either wrong or right) that the bank is in trouble, it will have to offer huge deposit rates to attract customers; in Greece and Cyprus rates often exceeded 4 or 5%. In contrast, the ELA is offered at Euribor plus 1-1.5%, a total of less than 2%.

We consider ELA to be troublesome because it is a loan, and because liquidity is something we usually do not understand. How can ELA lending be decreased? Simply by bonds moving from garbage to investment grade categories allowing banking institutions to access the ECB discount window (which is just cheaper, otherwise it is just as lending as the ELA), by regaining the market's trust and have more people trust their money to the bank or simply by increasing the money in the market thus increasing liquidity. The latter can only take place through increased bank lending, something which needs both willing lenders and willing borrowers.

If anything, ELA just signifies trust in the bank: if we believe that the bank is going to make it, then it will be able to repay ELA money with no trouble at all. If we do not and the bank does not receive any deposits or more so money are withdrawn, then the bank will not be able to repay. The same holds from the Central Bank side which is really out of options: it cannot really withheld ELA and allow the bank to fail (see Lehman Brother and the steps taken by the Fed afterwards).

Deposits and ELA are materially the same thing for the bank. It's trust which distinguishes between the two; market's on one hand and the Central Bank's on the other. If the latter is regained then the bank survives; if not then it fails. In any case, ELA has nothing to do on whether the bank is viable or not in the future.

The Irony behind NPLs and Lending

This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.

NPLs are loans for which "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. 

The correlation is obvious as can be seen in the case of Greece:

Source: CEIC Network

NPLs as a percentage of total gross loans. Source: Index Mundi

The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a higher risk weight than before. Thus, the higher the NPLs the lower the banks' ability to lend out more money.

The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without retracting money from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.

How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking  at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.

As said before, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the UK experience), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.

Is Europe Recovering?

At the time when the world's nations are wondering whether or not a military intervention in Syria is the way to go, the economy has managed to make it to the spotlight. It appears that good news are plummeting the market and judging from the table and graph above Europe is heading towards recovery. Or is it?

When the data are presented the way the are above, emphasis is given to the "X-month high" wording on the right. Yet, a more careful look in the manufacturing PMI shows something slightly different:

Even though the index appears to be increasing, this has not been because things are going better. It is because they are less terrible than before. In the words of Markit's Phil Smith (emphasis mine):

"The headline PMI continued its climb towards the 50.0 threshold as a slower decrease in new orders led manufacturers to moderate their reductions in output, employment and stocks of purchases compared to June. Although still some way off showing outright stabilisation in the sector, these latest data are at least a stark improvement from those observed at even the start of the year and bring hope that a recovery is on the horizon. “July’s decrease in factory employment was, as with new orders, the least marked since the start of 2010. This will have helped to relieve upward pressure on Greece’s unemployment rate which has already started to show signs of plateauing."

It is the economic analog of banging your head on the wall and then switching to banging it on plastic; you feel less pain and you are losing less blood than before, yet, you are still bleeding and you are still in pain. As Smith puts it, there are signs of plateauing. Nevertheless, this plateau has not been reached yet and we cannot be certain of when it will be.

In the optimistic analyses, it appears that we give too much emphasis on a single indicator. Consider for example, the unemployment rate: it has been rather stable during the summer, which means that either all EU countries have not witnessed a change in the unemployment rate (which is not true) or that it has fallen in some and increased in others. During the crisis, the drivers of unemployment have been the countries of South Europe, where it seems that, with the exception of Cyprus, unemployment was either stable or decreasing (by 0.1% at most) in July. Good news right? It depends. It may be that recovery is on its way, yet it may also be that we have had a surge in tourists in the highly seasonal South economies. The reader may object that the unemployment rate is seasonally adjusted; even so, a small deviation of 0.1% is something which no statistician would claim as possibly unaffected by seasonal effects no matter how good the adjustment is. The Greek statistical authority actually reports higher income from tourism in the second quarter of 2013 and thus revised its GDP growth to -3.8% from 4.6%. And just as any person who lives or has been to the South of Europe will tell you, the busiest months are always July and August.

On the other end of the spectrum, Cassandras are, as always, abundant: Ambrose Evans-Pritchard comments that the future may not be as bright as we think it will be, given that even if Europe recovers Germany will require a rates rise in order to stop overheating its own economy. Yet, the overheating of the German economy is not bound to happen even if Europe recovers. A rise in investment in the South would most likely equal a rise in exports in the North which would help boost the German economy. What the Germans should worry about is not overheating their economy but over-dependence on exports; a Eurozone recovery is something they should be looking forward to. What is more, Central Banks do not really influence policy that much: lending rates have already started increasing in Germany as discussed later.

Yet, Evans-Pritchard is definitely right on one thing though: oil prices have been increasing over the recent Syria turmoil and this is not a good sign in times of recession. High inflation in addition to extremely high unemployment could escalate to a situation much worse than the 1970's stagflation. Although the probability of an oil shock more than 100% is very low, it is still existent. As usual, political and military action in Middle East will define the price Western countries have to pay for their growth. In the same article, there is mention of M3 money slowing down to a 1.3% annualized rate of growth and the euro appreciating against the Japanese yen, the Brazilian real and US dollar. What is missing here is that these are the unavoidable consequences of non-EU policy: the extended QE policies in Japan and the US have forced their currencies to depreciate and the Brazilian real has actually been depreciating in general since 2012. Neither of those really means anything when it comes to recovery.

The most interesting topic Evans-Pritchard presents is "the rise in borrowing costs by 70 basis points (or 0.7%) across Europe". Although I wonder where he got the data (the FT's Michael Steen comments that lending rates have reached a two-year low in Spain and Italy whereas it the same appears to hold in France as well) the issue is the location of this increase in borrowing costs, as aggregate and averaged data are more often than not misleading. If countries like Germany and Finland are witnessing increased lending rate (just as the graph to the right indicates) then this is more good news than bad ones since the spread between EU countries is actually decreasing and it is the natural consequence of prosperous economies beginning to slow their growth rate. The decrease in of more than a percentage point in lending rates since 2012 is of tremendous importance both for SME's facing trouble as well as for future investment.

Unfortunately, after all this analysis and deconstructing of both the positives and the negatives, the question still remains: is the EU moving to greener pastures or will it remain in the land of austerity-driven recession for quite a while? The answer is that unfortunately we cannot know for sure until 2013 has gone by. PMI indices, euro appreciation and lower costs of lending are all signs of better days ahead, yet their effect is yet uncertain. If borrowing costs continue their fall and if the PMI continues to rise we may witness more growth than expected by the end of the year, and this is what most analysts expect.

Probably the most important issue here is that uncertainty has been lifted from the Eurozone. Although there are still fears of Italy and Spain defaulting, the probability is much lower than before; even in Cyprus, the bail-in has marked the end of uncertainty despite all the terrible consequences it has brought with it. Markets prefer bad news to uncertainty and this is what we are currently observing in the Eurozone. It is not that "Europe, it seems, has become anaesthetised to bad news," as Simon Tilford from the Centre for European Reform says. It is just that finance and economics are, by construction, optimistic fields. There is no point in planning for the future if you do not really hope, deep down, that it will be better than the present. And as already said, less bad news equals good news for some and they are right up to a point.

Personally, although I believe that the results of Q3 will further enlighten us on whether a recovery is on its way,  the situation is like a fire which is about to be put out in the near future; yet one for which the probability of rekindling is extremely high. The rekindling can come in various forms: oil shocks, bank failures, state defaults and even additional bail-outs. Yet, with the possible exception of a 3rd bail-out for Greece, everything else has very little probability; which does not really mean that we should rest assured that recovery is on its way.