ECBanker of Last Resort

Watching the weekly balance sheet of the ECB has become a thing of horrified fascination: the statements as presented are reasonably opaque, and don't directly answer the questions we all have in mind, such as to what extent the continuing functioning of banking markets in the Euro-periphery are now underpinned by the central bank. Nevertheless, watch closely and the patterns begin to reveal themselves.

Consider first, the build-up of deposits held by the ECB which are surplus to regulatory requirements. Since the beginning of the year, these have risen from a January average of Eu 135.6 bn to Eu 425 bn as of November 18^th. That rise of Eu290 bn in deposits voluntarily placed in ECB is absolutely startling in the context of European banks, which in the year to end-September saw a rise in total deposits of only Eu 255 bn. Put it this way: on a net basis, the only thing European banks have been doing with the deposits they have collected this year has been to hand them over for safe keeping to the ECB. Isn't that astounding?

Then consider what ECB has been doing with this flood of deposits: roughly half has been re-lent back to the Eurozone's financial institutions (Eu139.3 bn worth), and a similar amount has gone to buy eurozone bonds (Eu128.57 bn). In other words, the ECB is simply taking the financial risks that Europe's banks are no longer willing/capable of taking. Instead of the market, we have the ECB.

Well, one might argue (though perhaps not if one were German) that in times of great risk-aversion, that's precisely what a central bank should do – after all, if it loses its equity, it can have resort to the taxpayer's purse, can it not?

But there's a second, and contingent danger here. For the tide of deposits being banked in ECB means that they now effectively fund approximately 70% of the lending ECB is doing back into the banking system itself – a proportion which used to be fairly static at around 20%.  

It seems a neat arrangement: banks daren't do anything with deposits – and certainly not intra-Eurozone interbank lending - so they give them to the ECB, which in turn recycles the deposits back to those banking systems that really need them (Euro-periphery, presumably). But the neatness is purely contingent: the balance need not continue like this. In particular, banks may find they have use for those liabilities – for example, to offset a drain in foreign liabilities (which is happening – gross foreign liabilities of Eurozone's banks contracted by Eu 162 bn between January and September). If there is any significant acceleration in the drain of those foreign liabilities, banks may find, and urgently, that they no longer wish to retain those assets in the ECB.

At which point, the ECB will face the choice of cutting their Eu 625 bn in lending to those Eurozone banks which need it, or finding some other way to fund their position. And frankly, the choices at that point are rather limited: the only other liability which could be expanded so quickly would be . . . . the amount of currency in circulation.