The European Central Bank (ECB) is sending a message to the euroarea's leaders: Don't make us pull the trigger on Greece'sbanks.

After the Frankfurt-based ECB blessed the expansion of so-calledEmergency Liquidity Assistance (ELA) to the debt-stricken country'slenders by about 5 billion euros (US$5.7 billion) on Thursday,officials are insisting that continued support is contingent onpolitical talks over Greece's bailout. Greek stocks and bondsrallied Friday, after Prime Minister Alexis Tsipras hinted atprogress.

The ECB does not want to be pushed into a position where it ismaking decisions on the future of the Greek banking system—and thecountry's membership in the Eurozone—without political cover fromEuropean capitals. If talks on a “bridge” financing deal for Greecebreak down again, ECB President Mario Draghi will have to weighwhether to ration funds further or threaten a veto, just as he didin Cyprus two years ago.

“Ending ELA would be a very last-resort type of intervention,paramount to a nuclear option,” said Henrik Enderlein, professor ofpolitical economy at the Hertie School of Governance in Berlin.“The ECB would never really want to use it, as it is basically thesame as pushing Greece out of the euro area.”

ELA is funding provided by national central banks at their ownrisk, and is extended against lower-quality collateral than the ECBitself will accept. Greece's lenders now have access to about 65billion euros in such funds, according to a euro-area central bankofficial. The expansion from 60 billion euros was reported Thursdayby German newspaper FAZ. An ECB official declined to comment, as isthe policy on all ELA operations.

Greek stocks and bonds surged as the talks proceeded, with thebenchmark Athens Stock Exchange up 7.84 percent by 2:00 p.m. localtime. Yields on three-year bonds fell 309 basis points to 14.6percent. Tsipras said yesterday that his government aims to reach asix-month bridge agreement leading to a “new contract” withinternational creditors.

'Pretty Strong'

In 2012, as Greece stumbled toward its second internationalrescue and a debt writedown, banks ran up a tab of as much as 158billion euros in local central bank and ECB funding. That suggeststhe ECB will allow a much greater extension of the emergency line,as long as politicians are seen as being on the path toagreement.

“The flexibility that the ECB has shown in this crisis is alsorelated to the fundamentals,” ECB Executive Board member PeterPraet said in London on Thursday. “ELA can be provided to thebanking system for a longer period of time than a very short time,but on the condition of the solvency of the banks. But if theproblems are linked to the sovereigns, then it's also veryimportant that the balances, in this case public finances, are onthe right track.”

As the ECB is now the direct supervisor of Greece's four largestlenders, it knows in detail how solvent the banks are. ECBSupervisory Board Chair Daniele Nouy said on Jan. 28 that they are“pretty strong.”

“They will go through this crisis like they went through theprevious ones,” she said in an interview.

At the same time, capital flight is continuing rapidly.Withdrawals exceeded 14 billion euros in the runup to the Jan. 25election. Depositors have taken out around 3 billion euros so farin February, Kathimerini newspaper reported on Friday.

“Deposit flight doesn't, per se, change the solvency assessment,as long as ELA is forthcoming,” said Nicolas Veron, a fellow at theBrussels-based Bruegel research group. “There's a circularity aboutit all. If the banks become illiquid, then solvency becomes aconcern very quickly.”

When solvency in fact depends on the continued provision ofliquidity, the ECB holds the fate of the banking system in itshands. In 2013, as politicians failed to secure a deal to bail outneighboring Cyprus, the ECB presented an ultimatum.

On March 21, the Governing Council said it would agree tocontinued funding for another four days.

“Thereafter, Emergency Liquidity Assistance (ELA) could only beconsidered if an EU/IMF programme is in place that would ensure thesolvency of the concerned banks,” it said in a statement. A dealwas reached just before the ECB deadline expired.

The ECB is concerned that the liquidity support is in fact beingused to keep the government itself in cash, through the recyclingof short-term bonds, or T-Bills. That borders on direct monetaryfinancing, banned under European Union law.

Funding Gap

“Emergency funding isn't there to finance the state,” ECBGoverning Council member Christian Noyer said on French radio onThursday. “We're ensuring that emergency liquidity is there at alltimes to finance people and companies.”

With a funding gap estimated at around 90 billion euros byOxford Economics Ltd., Greek banks are close to the edge of theiravailable funding at both ELA and standard ECB operations.

The ECB's Governing Council meets again on Feb. 18. To veto ELA,a two-thirds majority would be required. If a deal isn't found bythe end of this month, Greece will be without funding for the firsttime in almost five years, and the ECB will be forced to considerits ELA position at a meeting—in Cyprus—on March 5. A reminder ofthe seriousness of the situation could be made before then.

Without political progress and continued funding, accelerateddeposit flight and capital controls loom, according to GabrielSterne, head of global macro research at Oxford Economics inLondon.

“Cyprus has written a script, Greece's could be similar,” hesaid in a note to clients. “Closing a nation's banking system isprobably the most economically destructive act that could bewrought in peacetime.”

–With assistance from Nikos Chrysoloras, Christos Ziotis, andMarcus Bensasson in Athens and Eleni Chrepa in Brussels.

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