ECB head Jean-Claude Trichet. BORIS ROESSLER/AFP/Getty ImagesBORIS ROESSLER/AFP / Getty Images
As Europe's sovereign debt crisis intensifies, financial markets are worried about the continent's banks. But the strain is also falling in an unexpected direction - on the European Central Bank.
Like its privately owned counterparts, the euro zone's core financial institution carries large amounts of debt on its balance sheet from Greece and other risky borrowers. It wouldn't need much of a "haircut" - bond market jargon for a drop in the value of these debts - to seriously diminish the ECB's capital.
In a worst case, the ECB would have to seek new capital from the euro zone's member nations. This would push the ECB into uncharted territory for a central bank. Recapitalizing the bank would test the willingness of the richer members of the European Union and their taxpayers to pick up the tab for central bank losses, and could put additional political pressure on the fraying fabric of the monetary union.
"Ask yourself, why has [ECB president Jean-Claude]Trichet been so adamant that there be no haircuts taken [on Greek debt]" says Christopher Ragan, an economics professor at McGill University in Montreal and the David Dodge chair in monetary policy at the C.D. Howe Institute.
Prof. Ragan said one possible explanation is that if the reduction in the value of the bonds were large enough "then a whole bunch of your assets are going to decline in value, you become insolvent, potentially insolvent."
Last month, Open Europe, a think tank based in London, issued an analysis suggesting that a Greek default could erase most, if not all, of the ECB's capital.
"We think that the ECB's balance sheet is now incredibly exposed and that it's very weak," says Mats Persson, director of Open Europe.
The ECB said it had no comment on the think tank's evaluation of its financial status.
In its analysis, Open Europe estimated that the ECB has about €444-billion ($601-billion) in bonds issued by the struggling euro zone economies - Portugal, Ireland, Italy, Greece and Spain. The Greek exposure alone is probably around €190-billion. Meanwhile, the bank has only about €82-billion in capital and reserves.
If Greece restructures to bring its debts down to a level its economy can support, the ECB will probably face loan losses of up to €65.8-billion, which "comes close to wiping out the ECB's capital base. A loss of this magnitude would effectively leave the ECB insolvent and in need of recapitalization," Open Europe stated.
The ECB would find itself in this awkward situation because, like many central banks, it is highly leveraged. The ECB has only €1 of capital backing each €23.5 in assets, most of which consists of government bonds issued by various euro zone countries. A loss of about 4 per cent on its assets is enough to eliminate its entire capital base.
In normal times, central banks don't require much capital because they don't engage in risky lending. It's always been assumed that their prime asset - government bonds - have zero chance of loss. However, in the case of the ECB, that assumption is being called into question by Greek debt.
To be sure, central banks are not exactly like commercial banks, in that they have a handy way of papering over a troubled balance sheet because they can print money. Doing so, however, would be inflationary.
The most likely solution to any gap in the ECB's balance sheet is that taxpayers of the countries using the euro would have to come up with a capital infusion to replenish the bank's resources.
"The ECB is ultimately underwritten by taxpayers, which means that there is a hidden - and potentially huge - cost of the euro zone crisis to taxpayers," Open Europe concludes.
Since the burden would fall most heavily on the euro zone's richest members, any attempt to recapitalize the bank might run into resistance from countries such as Germany, where aid to countries such as Greece is already highly unpopular.
However, Prof. Ragan said such a replenishment "would happen in a flash" because "no government or set of governments … is going to want to sit around and say. 'Well, we own the central bank and it's insolvent, but that's okay.'"
The problem would be perception. If the financial system's rescuer were to need a bailout, investors might conclude the debt crisis is careening out of control. "I think there is an optical problem," Prof. Ragan said.
Even if a capital infusion isn't needed, the ECB could face a problems if too many of its assets - bonds from euro zone member countries - have to be written off. According to Nicholas Rowe, an economist at Carleton University, the bank might then have difficulty containing inflation because it wouldn't have assets to sell to drain money from the financial system.
But he said some inflation might actually help Europe. "In current circumstances, when the euro zone is in recession because everybody wants to hold money rather than spend it, a little bit of fear that their money might not be worth as much … wouldn't be such a bad thing."