Wednesday, 7 September 2011

The Super-Sub in Frankfurt

I was challenged this afternoon to think of something that could yet buy time for the Eurozone – by definition something that didn't require Europe's politicians either to understand their catastrophic error, or to act with coordinated and effective purpose, but change market sentiment in the short and possibly even medium term.

And there is something.  Sometimes I hear fears that the European Central Bank is bust – that, put simply, it has bought far too many bonds from places that either aren't going to repay (Greece), or more banally would look ugly if they were ever marked to market (Portugal etc).

On the face of it, that's a reasonable worry: the ECB has capital and reserves of approximately Eu81.5 billion, upon the shoulders of which it carries Eu2.037 trillion of assets, of which Eu514 billion is lending to Eurozone banks, and Eu 523 billion are eurozone securities. It doesn't take an awful lot to go wrong with the underlying credits on those assets to wipe out the ECB's entire capital base – a 12% haircut would do it.

Looked at more closely, however, and it looks less worrisome. First, it is extremely hard to bankrupt a central bank. They go bust only if they carry huge net foreign liabilities which are suddenly withdraw. This isn't going to happen to the ECB, since it holds a net Eu 203 billion in foreign currency assets. About the only other way they could bankrupt would be if their licence to issue money or banking reserves was revoked by the governments of the jurisdiction in which they operate. And that's about it, really.

This has the following consequence: that, uniquely, the concept of marking-to-market the value of its domestic securities doesn't mean too much to a central bank, since in duration terms it can outlast any possible competitor. Just as you don't start a libel war with someone who buys ink by the barrel, so you don't play Bankruptcy Poker with a central bank. Even now, the ECB could stave off (the effects of) Greek sovereign bankruptcy by buying unqualified amounts of Greek sovereign debt in perpetuity.

Which leads directly to the question: we've established that the ECB has a financial leverage ratio of 25.4x (total assets/equity and capital). For a private company, that's way too much (even Goldman scrapes by with financial leverage of only 11.6x). But how does it compare with other central banks?

The answer is: extremely well. It turns out that among the world's central banks, the ECB is indeed the reincarnation of the Bundesbank. It's 25.4x leverage has to be compared with the US Fed's 45.8x (end 2010), or Bank of Japan's 52.6x (August 31, 2011).

What's more, as the chart shows, the ECB has tended to manage this ratio down when it can, taking it from a June 2010 crisis-peak of 27.6x to an April 2011 low of 23x (glad confident morning, that was).

Which leads to two conclusions and a suggestion. First, by international standards, the ECB is still on the sidelines in this crisis: it could buy about another Eu1,700 billion worth of dodgy Eurozone sovereign paper, and still be less leveraged than the Fed. And, excitingly, it wouldn't demand a raid on any particular European taxpayer's wallet to do it, and it could probably do so without exciting the outrage of Northern European electorates.

Second, it reminds us that a modest amount of new capital subscription for the ECB is a really great bargain for politicians  – every Eu 1billion subscribed buys possibly Eu 45 billion of new sovereign debt!

If I were a European politician unwilling/unable to face the electorate with a bill for bailing out Southern European governments, but keenly aware that current policies can lead only to disaster,  I'd be looking at the ECB's balance sheet with great interest. 

And the suggestion? Central banks don't just buy government debt – they can help recapitalize banking systems too.  In the aftermath of, say, a sovereign default? 

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