The European Central Bank may be telling the world it has virtually unlimited liquidity, but except for the extremely unpalatable approach of just printing more money, this promise is not as sturdy as it seems.
In an investor note out this morning, Morgan Stanley explains how exactly the ECB works:
– The Eurosystem’s — and not the ECB’s — balance sheet is the important piece of the lending mechanism here, because it is the consolidated balance sheet of the national central banks (NCBs) and the ECB.
– If the Eurosystem incurred balance sheet losses — for instance, through the Securities Markets Program (SMP) — they would eat into the reserves of the NCBs as well as those of the ECB.
– Revaluation accounts, general reserves ($94 billion), risk revisions, and paid-in capital ($13 billion) would all serve as a backstop against loss absorption. After all of this, the Eurosystem could decide to mark losses against income of the NCBs
– Of note: NCBs’ balance sheets are of two parts: one that remains national and consists of assets not transferred to the ECB and one part where it acts as custodian to the ECB.
If all else fails, the ECB could run from a negative equity position, but this would create problems of its own. From the report:
The ECB’s paid-in capital would act as the final buffer. Once that is used up, a recapitalisation might be required or the ECB is forced to operate with negative capital. While central banks can and do operate with negative capital, it is nothing that a central bank governor would aim for. In a multinational central bank like the ECB, such a negative equity position could create fresh concerns. This is why the Eurosystem should increase provisioning for potential losses that the system could incur from its OMOs [open market operations]. This would send a clear message that the ECB’s risk-taking is not a free lunch.
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