A recent news story gives us a sobering anecdote about the Greek crisis: a merchant who must conduct all his business in cash because he can neither receive credit card payments nor pay vendors with electronic transfers. This means that the Greek banking system is failing to provide a payment system, a core function. At first blush, this looks like another piece of the same crisis story we’ve heard for some time. But it is important to distinguish the banking system and its woes from the refusal of the “Troika” to extend a bailout program for the Greek government over disputes about austerity, pensions, and taxes. The latter is a largely political choice, with a geostrategic component. But the Greek banking crisis in itself is one where the EU institutions could help easily and should do so.
Popular accounts have collapsed two crises into one. The first crisis is that the Greek government may run out of cash, at least Euros, and thus be unable to pay its obligations as they come due, whether debt repayments to sovereign creditors or, eventually, pension payments and other government payouts. The second crisis, potentially the source of much more enduring damage, is that the Greek banking system may collapse, or be saved only by inflicting massive losses on private savers. The cash-strapped merchant gives us the glimmer of a banking system collapse: transactions must take place in cash, cash is difficult to obtain, and so the private sector greatly contracts because it becomes so much harder to transact. Such a broken financial sector will put the Greek economy in free fall and, incidentally, exacerbate the political crisis.
Regardless of what you think about the negotiations between the Greek government and the “Troika” over the repayment terms of Greek sovereign debt – self-indulgent, over-spending Greeks or heedlessly hard northern Europeans, or both — the European Central Bank and other relevant European authorities must save the Greek banking system.
Here’s the technical “how to do it”: the European Stability Mechanism, a bail-out fund created in the wake of the global financial crisis, should provide first loss protection to the ECB for collateral taken in exchange for continued loans to the Greek banks. This will permit the ECB to continue to serve as lender of last resort to the Greek banks while protecting the ECB against loss-making lending. Since last year, the ESM is now also formally allowed to engage in such private sector rescue operations.
More important is the “why.” For that, turn back to the European chapter of the global financial crisis, 2010-2013, that began with concerns about Greece’s sovereign solvency but that spread to many other European countries and threatened to engulf the European banking system. Why so? Because many European banks were doubly exposed to sovereign creditworthiness: because they held sovereign debt on their balance sheet and because sovereigns had backstopped shaky bank balance sheets overladen with dubious real estate-related assets. As the crisis-triggered recession deepened, plunging tax revenues put national budgets under stress. This increased sovereign default risk, which both reduced the value of sovereign debt held by the banks and undercut the credibility of government banking sector guarantees.
The crisis produced a fierce recognition of the importance of separating Eurozone sovereigns from Eurozone banks and led to the creation of the European Banking Union, which federalizes the supervision and the resolution of significant banks in the Eurozone. One of the major objectives of EBU was to assure that the failure of a major bank would not lead to unsupportable sovereign guarantees and, similarly, to assure that shaky sovereign creditworthiness would not engulf a major bank.
Greek banks are in trouble because they have been caught in the transition period between the prior regime and the fully-implemented Banking Union. Had EBU been fully implemented, EU-level supervision (by the ECB) would have limited the Greek banks’ exposure to Greek sovereign debt and an EU-supervised resolution regime would protect Greek banks against catastrophic failure.
Greek banks suffer from a legacy problem: they hold a disproportionate amount of Greek sovereign debt. As the state’s finances deteriorate, banks have insufficient high quality collateral to justify further emergency funding by the ECB. A properly run supervisory mechanism would not have permitted a Greek bank to concentrate assets in risky sovereign debt, so that the deterioration in a single sovereign’s credit rating would not create the liquidity issues that the Greek banks now face. Moreover, a functioning Banking Union would have provided some disciplining of sovereign borrowing because local banks would not have been a captive buyers of domestic sovereign debt. A Banking Union would, in other words, separate the (business) operation of banking from the (political) calamities of the country.
Moreover, under the Banking Union regime the major Greek banks would have issued a significant tranche of unsecured term debt that would be available to convert to equity should the bank fail and thus require resolution. This requirement of the Banking Union regime would shield depositors from the risk of loss and thus reduce the risk of devastating bank runs.
In short, the EU authorities can justifiably think they should protect the Greek banks as part of the emergent European Banking Union, quite independent of the negotiation with the Greek government over its sovereign debt burden. To repeat, the Eurozone parties have already agreed to federalize the most important elements of prudential bank regulation; “Banking Union” has preceded “Fiscal Union.” During the financial crisis the EU cobbled together a series of emergency bank rescue facilities; the formal replacement is the European Stability Mechanism, which has ample capacity to rescue the Greek banks.
Rescuing the Greek banks may be more important to the long run health of the Greek economy and the stability of the Eurozone than avoiding a Greek sovereign default. Sovereign default restricts the capacity of the Greek government to pay all its obligations in Euros, a shock to the economy, to be sure, but not a catastrophe. By contrast, failure of the Greek banking system would disrupt the payment system, both within Greece and between Greece and its trading partners, and would disrupt the banks’ capacity to provide credit support, even trade credit, to the real domestic economy. This would be a catastrophe. It’s the difference between a blow to the stomach and a knockout punch.
Look at the Puerto Rican situation for an instructive contrast. If Puerto Rico defaults, it will not bring down the local banking system (despite Puerto Rico being stuck in a monetary union with the US without much fiscal union). The Puerto Rican economy may contract but it will not collapse. Because the banking system is unimpaired, tourists (and citizens) can use the ATMs, their credit cards, and their transaction accounts.
Moreover, from a self-interested European perspective, the risk of contagion from the Greek crisis is not so much for the sovereign debt market as for the banks in the respective southern European states, which, like the Greek banks, remain exposed to sovereign risk because the European Banking Union is not fully operational. Separating the Greece crisis into its two components helps the relevant decision-makers appreciate what needs to be done to protect the Eurozone.
Protecting the Greek banks also reduces the pressure on the Greek government to give up the Euro. The Greek banks need a lender of last resort to survive. If the ECB stands aside, the Greek central bank probably takes over that role. Since it can’t create Euros, the fallback is drachmas. Whatever the economic case for/against Greece remaining in the Eurozone, the decision should not be driven by the need to protect the Greek banking system.
The point is this: the Eurozone has opted for a currency union with member state fiscal autonomy but also with a federal banking union, in which member states have surrendered supervisory and regulatory authority. Even if the “Troika” decides to let Greece default on its sovereign debt, the ECB with the support of other Eurozone partners should protect the Greek banking system.
Jeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School and Co-Director of the Millstein Center for Global Markets and Corporate Ownership. Wolf-Georg Ringe is Professor of International Commercial Law at Copenhagen Business School and the University of Oxford.