The ECB and Loss-Sharing

The ECB has released its annual accounts for end of year, 2011.  Expect to read lots of excitable commentary that focuses on the small size of the ECB’s “Capital and Reserves” of €6.5 billion relative to over €1 trillion that has been loaned out in long-term refinancing operations and the €284 billion in sovereign bonds purchased under the Securities Market Programme .

This kind of commentary misses a number of important points.

First, the ECB also has revaluation accounts and provisions, both of which can cover losses, worth €30 billion.

Second, and most important, the ECB does not actually do any direct lending to banks. As I discuss on page 7 to 9 of this paper, monetary policy operations in the Euro area are done on a decentralised basis and the ECB Governing Council interprets Article 32.4 of the ECB statute as implying the losses on these operations should be shared among Eurosystem central banks according to their capital share.

So what matters when thinking about whether there is loss-bearing capacity in relation to the LTROs is the size of the Eurosystem’s capital resources. A Eurosystem financial statement is released every week. It shows capital and reserves of €83 billion and revaluation reserves of €394 billion.  LTRO losses would need to be enormous to wipe €477 billion off the Eurosystem balance sheet.

Finally, while internet banter about poor quality Eurosystem collateral is a popular sport, the Eurosystem applies haircuts when lending, meaning the value of the underlying collateral is larger than the value of the loan. And the haircuts applied to the newly-eligible “credit claims” (i.e. bank loans) are huge.

All told, the prospect of recapitalising the Eurosystem should be very low down anyone’s list of worries about the European economy.