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

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

The ECB does not want to be pushed into a position where it is making decisions on the future of the Greek banking system—and the country's membership in the Eurozone—without political cover from European capitals. If talks on a “bridge” financing deal for Greece break down again, ECB President Mario Draghi will have to weigh whether to ration funds further or threaten a veto, just as he did in Cyprus two years ago.

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

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

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

'Pretty Strong'

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

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

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

“They will go through this crisis like they went through the previous 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. 25 election. Depositors have taken out around 3 billion euros so far in 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 the Brussels-based Bruegel research group. “There's a circularity about it all. If the banks become illiquid, then solvency becomes a concern very quickly.”

When solvency in fact depends on the continued provision of liquidity, the ECB holds the fate of the banking system in its hands. In 2013, as politicians failed to secure a deal to bail out neighboring Cyprus, the ECB presented an ultimatum.

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

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

The ECB is concerned that the liquidity support is in fact being used to keep the government itself in cash, through the recycling of short-term bonds, or T-Bills. That borders on direct monetary financing, banned under European Union law.

Funding Gap

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

With a funding gap estimated at around 90 billion euros by Oxford Economics Ltd., Greek banks are close to the edge of their available 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 by the end of this month, Greece will be without funding for the first time in almost five years, and the ECB will be forced to consider its ELA position at a meeting—in Cyprus—on March 5. A reminder of the seriousness of the situation could be made before then.

Without political progress and continued funding, accelerated deposit flight and capital controls loom, according to Gabriel Sterne, head of global macro research at Oxford Economics in London.

“Cyprus has written a script, Greece's could be similar,” he said in a note to clients. “Closing a nation's banking system is probably the most economically destructive act that could be wrought in peacetime.”

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

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