WORRIES MOUNT ON E.C.B.´S ABILITY TO STEM A PANIC / THE NEW YORK TIMES ( VERY HIGHLY RECOMMENDED READING )

May 25, 2010

Worries Mount on E.C.B.’s Ability to Stem a Panic

By LANDON THOMAS Jr.

LONDON — The euro stops with the European Central Bank — or does it?

Amid signs that some fretful deposit holders on Europe’s troubled periphery are moving their money to presumably safer German banks, the fear that Europe’s central bank and the 16 sometimes fractious nations that back it might not be able to stem a classic bank panic is being voiced on trading floors from Hong Kong to Frankfurt to New York.

By Tuesday afternoon in New York, the euro had lost another 0.5 percent on continued worries about the debt problems that plague Europe, in part sparked by news that four troubled savings banks in Spain were forced to merge because of their mounting real estate losses. That gave further credence to a growing view that Spanish banks had not reserved sufficient capital to counter their real estate loans.

There is no conclusive evidence that money is fleeing Europe in any significant amounts. And the E.C.B. retains several crucial tools that should serve to backstop vulnerable banks, including the ability to buy more of their bonds and even, if pressed, to raise interest rates to attract capital from elsewhere.

But the continued erosion of the euro against other major currencies and the dark mood reflected in nervous financial markets highlight perhaps the most crucial question facing Europe today: Who ultimately stands behind the banks if the loans they and the E.C.B. have extended directly and indirectly to Greece, Portugal, Spain and a few other sovereign debtors need to be written down?

“If it was one country and one central bank, this would work,” said Timothy Congdon, an economist and self-confessed euro-skeptic in London, whose biting dissections of the E.C.B. are now becoming more widely read. “But here you have one currency and 16 governments — which one is going to guarantee Spanish and Greek debt?”

Mr. Congdon argues that concerns that one of the weaker nations may be forced to abandon the euro have already sparked a deposit shift from peripheral economies to the core. He points to a spike of €46 billion, or $56 billion, in credit afforded to “euro area credit institutions,” which can be seen in an E.C.B. balance sheet released on May 18. (On Tuesday, the E.C.B. released data showing a lower, €5 billion increase in this form of credit.)

The growth is proof that the E.C.B. is ramping up credit to banks suffering deposit withdrawals, Mr. Congdon says, a trend that is also made clear by the big increase in the bank’s refinancing facilities for euro-zone banks — worth more than €60 billion since April 30.

“People in Spain and Portugal and Greece are afraid they will lose their deposits,” Mr. Congdon said, “so they are moving them to banks in Germany.”

A spokeswoman for the E.C.B. declined to comment.

This recent intra-zone shift highlights a longer-term trend of waning deposits within the euro zone that began in the days after the collapse of Lehman Brothers in September 2008. It has picked up in earnest since then, forcing banks to rely on the E.C.B. and riskier forms of interbank lending to bolster their weakened capital positions.

Indeed, the most desperate banks in Greece can no longer borrow from these markets at all; they are wholly dependent on the E.C.B. for financing beyond their deposits.

Meanwhile, according to research by BNP Paribas, retail deposits among euro-zone banks dropped €8.8 billion in March compared with the month before, the most recent data available, and were €50 billion below the level in March 2009.

Deposit shifts can be driven by many things other than a flight to safety, including a move by savers into alternative financial instruments like stocks. But even though it is too early to say for sure, such a development during such an uncertain time — especially if it continues this year — suggests that the E.C.B. may need to do even more to shore up confidence in Europe’s complex and varied banking system.

So far, the E.C.B.’s reluctance to do anything that might seem to compromise its independence has been interpreted by many investors as a sign of indecision. That view has been bolstered as evidence mounts that the central bank’s bond-buying program may not replicate the dramatic stabilizing infusions by the U.S. Federal Reserve, the Bank of England and the E.C.B. itself in 2008 and 2009.

Still the notion now gaining ground among impatient traders — that the E.C.B. has become a toothless symbol of Euro-stasis too fixated on inflation — may also be overdone.

In fact, it was the E.C.B., much more than the Bank of England, that was an aggressive lender of last resort during the banking crisis in 2008, making more than €700 billion available to liquidity-starved banks in the euro zone.

Moreover, the announcements in late 2008 from Germany, France and other countries that they would not allow their major banks to fail remain in place.

Paul De Grauwe, an economist based in Brussels who advises the president of the European Commission, José Manuel Barroso, disputes the view that the divergent euro-zone system prevents governments from acting on their own as a guarantor of last resort.

Mr. De Grauwe cites the example in 2008 when the Belgian National Bank — and, by extension, the E.C.B. — accepted highly questionable collateral from the collapsing Fortis Bank for new credit, with any losses being taken by the Belgian government.

“This was the condition imposed by the euro system on the lender of last resort function exerted by the national bank,” he said. “This technique has been used in other countries in the euro zone, and it ended the bank run.”

But the big question now is whether the amount of dubious euro-zone sovereign debt being held by European banks is so large — perhaps as high as €1 trillion — that it threatens the ability of even a country as financially sound as Germany to make good on such promises.

Greece has already made clear that it is not in a position to stand behind its own debts. And questions are growing about Spain being able to do the same — especially as it is now becoming evident that banks may be on the hook for billions in busted real estate loans on the books of the country’s regional savings banks.

Sooner, rather than later, the E.C.B. may be forced to show its hand.