I ‘ve been going through the detailed FAQ and legal documentation of ESM financial assistance procedures, available at the ESM website (see here and here) in order to determine how Greek banks will be recapitalized. What I have been able to determine so far is that the legal framework provides significant flexibility in managing the recapitalization exercise and can be used to justify both a (uninsured) depositor bail-in as well as capital injection through a loan to the Greek HFSF.

What is quite clear is that should the ESM be involved through the direct recapitalization instrument (DRI) a depositor bail-in is more or less certain since a contribution of 8% of total funds will be required. Bruegel does a very nice job in analyzing the various scenarios and probable scenarios. One should bear in mind though that these numbers are a moving target since the insured/uninsured deposits mix is not known, while any increase in central bank financing (through ELA) will lead to higher haircuts on deposits (since central bank exposure is fully collateralized and does not participate in bail-ins). As a result, every small cash redrawal (even from small insured deposit accounts) makes the required deposit haircut a bit higher.

What is not clear is whether Greece will be able to use the ESM loan to recapitalize its banks through the HFSF (as it did in 2012/2013) and avoid a depositor bail-in. In principle, the ESM legal guidelines allow an ESM loan for such purpose while the €25bn of the Greek privatization fund earmarked for use in the recapitalization exercise make such a loan easier (since it will be ‘collateralized’ by Greek assets). Yet in a strange twist of events, the fact that Greek debt is considered (by almost all parties involved) unsustainable makes granting a large loan instead of direct recapitalization a bit problematic. According to articles 2 and 3 of the relevant ESM guideline:

The aim of the financial assistance to institutions is to preserve the financial stability of the euro area as a whole and of its Member States by catering for those specific cases in which an ESM Member experiences acute difficulties with its financial sector that cannot be remedied without significantly endangering its fiscal sustainability due to a severe risk of contagion from the financial sector to the sovereign. The use of this instrument could also be considered if other alternatives would have the effect of endangering the continuous market access of an ESM Member. As far as the use of the instrument of an ESM loan for the recapitalisation of financial institutions is not possible, such financial assistance shall thus seek to help remove the risk of contagion from the financial sector to the sovereign by allowing the recapitalisation of institutions directly, thereby reducing the effect of a vicious circle between a fragile financial sector and a deteriorating creditworthiness of the sovereign.


The following criteria related to the requesting ESM Member shall be met in order for a request for financial assistance for the purpose of directly recapitalising institutions to be considered eligible:

  1. The requesting ESM Member is unable to provide financial assistance to the institutions in full without very adverse effects on its own fiscal sustainability, including via the instrument of an ESM loan for the recapitalisation of financial institutions. The use of the instrument can also be considered if it is established that other alternatives would have the effect of endangering the continuous market access of the requesting ESM Member and consequently require the financing of its sovereign needs via the ESM.

So it is clear that debt sustainability can be used as an excuse by creditors in order to push for the use of the direct recapitalization tool and increase the Greek ‘own contribution’ to the third financing package. The fact that the ESM envisions its contribution to be limited to €50bn – which are only enough the cover amortization of existing debt obligations and interest payments – makes the above scenario somewhat more probable given the IMF’s reluctance to continue its involvement in the Greek program.

On the other hand, since most retail uninsured deposits have already left the Greek banking system (and foreign deposits of significant amounts are almost non-existent), a depositor bail-in will mostly hit NFC working capital and create serious short-term problems on the economy (while also push a large percentage of these firms into insolvency). This is another reason to favor an ESM loan over the DRI although it requires that Greek and creditors motives to be .. aligned.

Overall I think that the ESM guidelines provide a great deal of flexibility for Greece and its creditors to use either instrument. Which one will eventually be used will be another indicator of whether creditors are determined to accept a larger part of ‘Greek risk’ or not. A possible large haircut in NFC deposits obviously makes a large part of the theoretical Grexit cost moot.

Update: Yiannis Koutsomitis mentioned on twitter that the ESM confirmed the availability of €10b in a segregated account to be used for future bank recapitalization (should the third package proceed as expected). That is definitely good news and hopefully makes things a bit clearer. I would like to take this opportunity to stress that, in this particular case, I am not trying to predict what course of action will be taken concerning Greek bank capital needs but rather to collect and analyze the available information and consider the political/economic implications of each option.

 Update2: The ECB published its opinion on the bank resolution draft law to be voted into effect on Wednesday 22/7. It seems that the bail-in tool will only be available after 1/1/2016. Here are the relevant interesting parts:

 ECB Opinion on Bank Resolution draft law

Frances Coppola also does a great job in analyzing the recap exercise.