What happens if a Eurozone NCB goes rogue?

I have a question.

But first, here is a good round-up from the NYT:

After a hastily convened evening meeting to assess the situation, the group of 17 finance ministers whose countries use the euro issued a statement declaring themselves “conditionally satisfied” with most of the new proposal, which the so-called troika of lenders — the International Monetary Fund, the European Central Bank and the European Commission — is to assess on Friday after the Parliament vote.

The plan sent to Parliament on Thursday would nationalize pension funds from state-run companies and conduct an emergency bond sale to help raise the 5.8 billion euros Cyprus needs to secure a 10 billion euro bailout. Gone was any reference to a deposit tax, which Parliament had roundly rejected in a vote two nights earlier.

Meanwhile, the WSJ reports:

Europeans in Dark Over Cypriot Plans, Officials Say

By evening, European officials in Brussels had received no detailed information on two of three key bills that were being discussed in the Cypriot parliament and that Nicosia said represent an alternative to a controversial tax on bank deposits, according to three officials involved in the talks.

Cypriot Finance Minister Michalis Sarris, who was in Moscow trying to get support from Russia, didn’t join an emergency telephone conference with his euro-zone counterparts Thursday night, according to a senior European official on the call. Instead, Cypriot Labor Minister Haris Georgiadis dialed into the conference, but presented only a vague outline of the government’s plans, promising to deliver a written proposal soon, the official said.

Mr. Sarris’s absence from the telephone conference with other euro-zone finance ministers came a day after Cyprus skipped a previous call with high-level finance-ministry officials from the currency bloc, according to a Cypriot official.

If your plan is to get the €10 billion bail-out from the EU/IMF, why would you keep your European friends “in the dark” and skip two emergency conference calls on the topic?

Now for my real question. My understanding is that Emergency Liquidity Assistance (ELA) is extended by national central banks — in this case, the Central Bank of Cyprus — not by the ECB directly. See, for example, this comment by Alea, who usually knows what he is talking about.

So what would happen — what physically would happen — should the ECB governing council vote to terminate ELA to Cypriot banks, but the Central Bank of Cyprus provided it anyway?

Put another way, what would happen if Cyprus decided to make G series Euro notes the new Cyprus pound?

Presumably, there are mechanisms in place to prevent this. What are they?

4 comments to What happens if a Eurozone NCB goes rogue?

  • dsquared

    Basically (I looked this up in the case of Greece):

    1) Per Article 14.3, the national central banks are an integral part of the ESCB and are obliged to obey the ECB Governing Council. So this would be an illegal thing to do.

    2) CBC could credit Laiki’s CBC account in Euro, but this would mean that the CBC was insolvent in Euro – it would have no Euro asset to correspond to the Euro liability it had created via the ELA (this does not happen in the normal ELA case as the counterpart is a newly created Euro at ECB-Frankfurt.

    3) If CBC decided to literally print Euro banknotes, then these would be valid Euro credits and could be used to provide ELA to banks. However, this would come out of CBC’s allowance for printing notes and therefore the amount of notes and coin available to the Cyprus economy.

    4) In any case, it would not be physically possible for CBC to carry out a meaningful amount of monetary finance by printing physical banknotes. Euro notes require special paper and ink and none of the nine mills in the world which produce Euro banknote stock are located in Cyprus. There are only three ink producers, also none of which are in Cyprus. NCBs do not keep a particularly large inventory of paper and ink.

    5) In the event of Euro exit, of course, CBC would lose the right to print Euro notes, and would have to hand the plates back and/or arrange for their destruction. Any G series bank notes printed after Euro exit would be, literally, forgeries.

  • Nemo

    Hi, Dan, and thank you for your reply! You are probably the heaviest hitter to have commented here.

    Laws are ink on a page, not a “mechanism”. When push comes to shove, policymakers find a way.

    My question is as much about electronic transfers as physical currency (the “G series Euro notes” was rhetorical flair, mostly). You say “same answer; their payments would be rejected in TARGET2 and you’d have a different currency”. But my question is, how would TARGET2 know to reject them? Is it not an automated system? How would a computer distinguish ELA transactions with the Cyprus Central Bank from any other transactions? Would they have to block all TARGET2 transactions involving the CBC? Who would actually do that, and how? Do they even have a procedure for it? etc.

    Obviously, I am ignorant of TARGET2 mechanics, but I am curious whether they are actually designed to prevent this occurrence.

  • dsquared

    Basically, T2 would know to reject them because they’d come via the Central Bank of Cyprus; that’s the hub for all Cypriot banks, and Cypriot banks don’t (except via their subsidiaries which are now being taken over by their local banking systems) have Target accounts with anyone other than CBC.

    The logistics would be that they would freeze the CBC T2 payment account at the ECB-Frankfurt, so that further TARGET2 credit was not extended. This would mean that CBC could make (facilitate) payments across the Eurozone, but only so long as they did so on an in-credit basis (ie, every day, they would have to wait for someone to send them some Euros before they could make payments out in Euro). If that happened, pumping Euro into the Cypriot banks via ELA would increase the “pseudo-Euro” money supply but the newly created pseudo-Euro couldn’t find their way into the rest of the Euro area.

    (In actual fact, if the CBC had proved itself to be so totally unwilling to abide by its obligations under the Treaty and Statute of the ESCB, I think they would be more likely to just cut them loose from TARGET2 altogether and let them do their banking by SWIFT via a Euroland correspondent bank, if they could find one).

    The operational “actually doing it” bit would be done in Frankfurt, via a bit of computer programming by the team responsible for TARGET2. Any payment system has a load of rules defining the kinds of messages that can and can’t be sent, and this would just be a matter of adding a few more.

  • Nemo

    I guess I do not understand how the rest of the system would distinguish “pseudo-Euros” from Euros. Seems to me they would be indistinguishable electronic credits… But clearly I need to read more about TARGET2.

    And “pseudo-Euros” would work fine inside Cyprus itself, for a while (?)

    Anyway, thanks again for your answers.

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