The FT is reporting (news article here, commentary here) that the ECB has “rejected” the Spanish government’s plan to recapitalise Bankia by providing them with €19bn of sovereign bonds.
In reading these stories, it is important to keep in mind Whelan Law’s of Financial Reporting: No concept is more mis-represented in financial reporting than bank capital.
I work hard to explain to my undergraduate students that bank capital is the gap between assets and liabilities and that’s it’s not a bank’s stock of cash or reserves or liquid assets. (e.g. here and here for my teaching notes and here for a video of Stanford’s Anat Admati and others discussing bank capital). By exam time, I’ve usually succeeded in pursuading about 60% of my students that this is the case. I think the other 40% go on to become financial journalists.
The FT comment story states
The floating of Madrid’s plan to recapitalise Bankia using ECB liquidity was seen by some observers as a high-stakes bet to put extra pressure on eurozone policy makers
By putting the onus on the ECB to turn Spanish government debt into cash through its repurchase, or repo, facility, Brussels and Berlin would get the message that Madrid means business.
There are several layers of nonsense here. First, banks are recapitalised by increasing the gap between their assets and their liabilities. The Spanish government bonds are the new assets that are recapitalising Bankia. It is possible that Bankia also has liquidity problems and needs to swap these government bonds with the ECB for cash. But this does not mean that the “ECB liquidity is recapitalising” the bank.
Second, the “onus\Madrid means businesses” sentence seems to ignore the fact that all Eurozone government debt is considered eligible collateral for ECB operations. The “high-stakes bet” is nothing of the sort. It simply asks the ECB to keep to its usual policies.
The news story tell us
The ECB told Madrid that a proper capital injection was needed for Bankia and its plans were in danger of breaching an EU ban on “monetary financing,” or central bank funding of governments, according to two European officials.
Again, the nonsense quotient is particularly high. First, there is nothing “improper” about the proposed Bankia capital injection. If the government gave Bankia €19 billion in cash and the bank then purchased government bonds with this case, the outcome would be the same: Is that a “proper” recap while the proposed one isn’t?
Second, it should be remembered that the ECB is already providing enormous amounts of liquidity against Eurozone government bonds as collateral, including government-backed bonds placed directly with banks such as the Irish NAMA bonds. If this isn’t “almost monetary financing” then why is lending money to Bankia?
So what is going on here? First, let’s note what is not going on. The ECB is not the Spanish bank regulator and it does not set EU’s rules for regulatory capital nor does it oversee government aid to banks (both of these are done by the European Commission job). So the ECB has no legal role that allows it to “reject” the proposed Bankia recap.
The “rejection” must instead mean that the ECB will refuse to sanction the provision of liquidity to Bankia under the proposed recapitalisation. There are two routes through which it could do this.
The first is through the ECB’s “risk-control framework” which allows it to cut off credit to individual banks or refuse to extend credit against certain collateral, if it feels it is taking too much risk. This framework was one of the tools the ECB used (and continues to use) when threatening to cut off credit to the Irish banks. Indeed, I discussed the framework here in a post written the month before the ECB shoved Ireland into an EU-IMF bailout. From the perspective of the Bankia deal, the key elements are
the Eurosystem may suspend or exclude counterparties’ access to monetary policy instruments on the grounds of prudence …
the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties …
The Eurosystem may exclude certain assets from use in its monetary policy operations. Such exclusion may also be applied to specific counterparties, in particular if the credit quality of the counterparties appears to exhibit a high correlation with the credit quality of the collateral submitted by the counterparty.
The last point is particularly relevant to Bankia.
A second route through which the ECB could reject the provision of capital is through preventing the Banco de Espana providing it with Emergency Liquidity Assistance (lots of material on ELA here.) I don’t know whether Bankia is receiving or may need to receive ELA but this is a separate track through which the ECB Governing Council could place Bankia in severe trouble if they choose to.
So there you have it. If the story is true, then the ECB has taken it upon itself to decide how Spanish banks are to meet their regulatory capital requirements and how the Spanish government must fund these requirements. All in the name of “risk control”. It will be interesting to see how controlled these risks will be once Spain is pushed into an EU bailout. Perhaps the ECB are interested in finding out.