European Central Bank turns up the heat on Greece

The European Central Bank has turned up the heat on Greece’s banks – at least a little – by tightening the rules under which it supplies them with liquidity. The ECB announced on Monday evening that it would maintain the supply of emergency lending to Greece’s banks at existing levels of around €89 billion.

However the ECB also said that it would demand a larger discount – or haircut – on the collateral which the Greek banks must supply it with, in return for emergency funding.

Banks typically pledge assets such as bonds as security when getting central bank funding and the change means Greek banks will have to supply more assets as security, though how much is not clear.Provided banks have spare collateral this may not have an immediate impact, but it is a clear warning shot from the ECB. Reports suggest the Greek banks will be able to renew their emergency loans for at least another short period.

The ECB said it took the action because the assets the banks used as security relied significantly on the Greek state, itself now facing significant financial uncertainties. Many of the assets used as collateral are likely to be Greek government bonds owned by the banks. However the ECB did not reveal how significantly it had changed the discount.

The collateral move, and the decision to hold emergency funding at existing levels, will mean pressure gradually increases on the Greek banks. This is why the Greek government has extended the “ bank holiday” – the period of bank closure – for a further period. The official announcement said they would remain shut until Wednesday, but to reopen they would now require a significant injection of new funds.

What is going on is quite straightforward. The banks simply do not have enough cash to meet all the demands they would face if the reopened. Deposits have been withdrawn and, given the fear of a Greek euro exit, more would disappear if the banks reopened.

The worry now is twofold. The first is how long things can go on as they are. Banks are still leaking cash and reports say at least some of them will run out of cash completely within days, unless additional ECB money if forthcoming. But to provide more cash the ECB will want to see political progress towards a new bailout, without which the solvency of the financial system will come into question. In the meantime, if progress falters, the ECB could tighten the rules on which it provides funding to the banks, further upping the pressure.

The second issue is the extraordinary difficulty of restarting the financial system. Things have now got so bad that a significant injection of cash would be needed. However it is not clear on what terms the ECB would provide the required amounts. There are also doubts about how much collateral the banks now have to pledge to the central banking system as security for further cash advance.

It is also quite possible that at least some of the banks may need more capital. Meanwhile the lack of a working financial system will take an increasing toll on the Greek people and their economy.

In short, the politics of this could still drag on, but from the outside the pressure on the banking system is clearly building and needs to be quickly addressed if bank collapses are to be avoided.