Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 26 January 2012

Another look at ECB's capacity to take haircuts

A debate has arisen regarding loss absorption capacity after Lagarde's call (See yesterday's post: Eurozone Snap Comment 25-Jan-12). The argument being made is that the relevant balance sheet to look at for loss absorption capacity is the Eurosystem balance sheet and not the ECB balance sheet. For the Eurosystem, general reserves are huge (~70bn) and dwarf the Greek bond holding through SMP.

Prima facie it appears to be a valid argument but to reach the correct conclusion, some facts need to be established.

The first is to understand how losses will be allocated. From Article 33.2 from the Statute of the ESCB:
"In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5."

Therefore the general reserve fund of the ECB absorbs any loss first. This is capped at 100% of the capital based on Article 33.1:
"The net profit of the ECB shall be transferred in the following order:
(a) an amount to be determined by the Governing Council, which may not exceed 20 % of the net profit, shall be transferred to the general reserve fund subject to a limit equal to 100 % of the capital;
(b) the remaining net profit shall be distributed to the shareholders of the ECB in proportion to their paid-up shares."

Losses over and above this are then offset against the monetary income for the year (yield on assets funded by currency in circulation and bank deposits minus interest paid on the deposits).

If this does not prove sufficient then it becomes important to ascertain how the additional losses will be absorbed to determine whether one has to look at the Eurosystem balance sheet as a whole or purely the ECB's balance sheet.

Again going back to the Statute, Article 32.4 states that:
"The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB. Indemnification shall be in a form deemed appropriate in the judgment of the Governing Council; these amounts may be offset against the national central banks' monetary income."

As far as I can check, no such indemnification has been provided. Although FT Alphaville seems to think that ECB bears the credit risk of SMP holdings.

Therefore if NCBs are next in line to take losses then there are 70bn of Eurosystem reserves to run through. This comfortably allows for haircuts on both Greek and Portuguese debt before losses flow through to ECB's paid-in capital.

However, if FT Alphaville is correct then it is the ECB balance sheet which has to be considered in isolation (as per yesterday's post).

The other interesting issue which comes to the fore when considering the Eurosystem as a whole is implicit and unchallenged assumption that no country or bloc leaves the Eurozone. This is the only way that reserves can be used and losses apportioned according to the paid-in capital of the ECB. However, if a country/bloc does leave then it leads to a loss distribution based on the actual distribution of SMP holdings and whether the leaving country/bloc has a TARGET surplus or deficit. It means that the ultimate credit risk rests with the countries which have TARGET surpluses.

Whichever way one looks, the buck as usual stops with the Bundesbank.

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