Six months in a leaky boat.

OK Eighteen months in a leaky bank would be a more honest title, but …

Split Enz (not the Wiggles (this is a classic)) released their classic back in the days of the Argentine war – today Europe is in a war against time trying to fix the Euro Area but it has been going on for much more than 6 months. Last resort lending is a policy tool that is often talked about to resolve the problems Europe is facing. Lender of last resort loans (LOLR) can be effective, in resolving a run but not always. Sometimes they leak away from their desired targets. When that happens they cease to be LOLR loans, they become life support.

The idea behind LOLR loans is simple. Suppose a bank is faced with a run like the one in Mary Poppins (triggered when little Michael screams out the bank won’t give back his money). TH is also reminded of a story he heard of a run on a bank started when a breakfast radio show jokingly announced that a building society was going to fail (TH would love to find documented evidence of the details, the event is partially documented here  pg 53 — I believe the contagion to the Coop was due to the radio commentary).

Anyway, the bank only keeps a fraction of its deposits to meet its customers’ needs, so people knowing that there is only a limited amount of cash available, will rush to be first in line to get their money back.  The bank will soon exhaust all the cash in the vaults. To meet its depositors needs, the bank may have to liquidate some of its loans at a loss – the loss it takes may bankrupt the bank and result in exactly what depositors feared in the first place – losing their money.

This self fulfilling outcome can be avoided if the bank is backed by a pledge from the central bank to provide all the liquidity a solvent bank could need. It is as if the depositors believe that the vault will never be emptied, so there is no need to get on the line in the first place. Just the knowledge that the central bank will offer to stand ready to lend in unlimited quantities on good collateral is sufficient to alleviate the run.
In fact, generally speaking the mere presence of a central bank with a LOLR policy should rule out the possibility of a pure run (a la Mary Poppins). The problem is that bank runs are often caused by events more complicated than an innocent boy’s complaints and sometimes no amount of LOLR lending eliminates the run.

Greece is a case in point. Greek banks have been on LOLR life support for years. It is not that Greeks have momentarily lost confidence in their banks to meet depositors’ needs, it’s worse;  depositors don’t have confidence in their monetary and financial system. They worry that Greece might default or that Greece may leave the Eurozone, and if that happened, then what would euro deposits in Greek banks become?  So now 35 percent of Greek bank lending is financed by the Bank of Greece which in trun is financed by the ECB. Portugal is in much the same position 15% of credit to customers is being financed by the ECB via the Bankof Portugal.

Source: Bank of Greece
Source: Bank of Portugal

So here is Hume’s questions.  Where are those depositors funds going to?  Are they staying in Europe, or flowing out? And what happens when the ECB starts providing LOLR to major Italian banks over an extended period of time?

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