ECB and Bankia: Liquidity Solvency Confusion in the Eurotower

My earlier post about the FT’s story on ECB “rejecting” the plan to recapitalise Bankia by providing them with €19bn of sovereign bonds was critical of both the substance of any such ECB intervention, if it existed. It was also critical of the reporting of the story by the FT on the grounds that it confused solvency and liquidity issues, something I try hard to explain to my undergraduate students.

Now it appears that the confusion of solvency and liquidity isn’t confined to the FT reporters but includes ECB officials as well.

The ECB this morning tweeted a denial of sorts of the FT story:

Contrary to media reports published today, the European Central Bank (ECB) has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank. The ECB stands ready to give advice on the development of such plans.

I say “denial of sorts” because the “blunt rejection” of the plan from the ECB reported by the FT may have occurred in an unofficial way e.g. the ECB explaining what there response to the plan would be if it they were to be officially consulted on it. This allows room for a statement that ECB hasn’t been consulted.

Then an emailed statement was sent out. Then, things get more interesting. A second email statement was sent out. Here it is. If you’re too lazy to click, here’s the full text.

Contrary to media reports published today, the European Central Bank (ECB) has not been consulted and has not expressed a position on plans by the Spanish authorities to recapitalise a major Spanish bank. The ECB stands ready to give advice on the development of such plans.

It should be noted, however, that the funds needed to ensure banks’ compliance with capital requirements, can not be provided by the Eurosystem.

Now why should this be noted? Does the ECB official who wrote this paragraph actually believe that the Spanish plan involves providing funds from the Eurosystem to meet capital requirements? If so, they need to go back to Money and Banking 101.

Bank capital is the gap between assets and liabilities.Taking on a loan increases both assets and liabilities and so has no effect on capital. The Bankia proposal only affects capital because the provision of new government bonds to the bank raises its assets without raising its liabilities. Whether it then pledges these bonds to the ECB in return for a loan affects the bank’s liquidity but has no influence on its capital\solvency ratios.

Next up, the ECB issues a statement saying this additional sentence had been “published erroneously”.  Well perhaps, but it didn’t write itself.

Since it seems highly unlikely that the ECB press office makes up these statements on its own, one can only assume that the sentence was written by a senior official. Moreover, this senior official apparently believed, at some point today, that it was necessary to make a point about Bankia’s capital requirements that was based on a complete misunderstanding of how the Spanish plan affects the bank’s capital ratios.

And these are the people we’re relying on to save the world! Now I’m scared.

The ECB and Bankia

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.