We are creeping towards another bailout in Spain but the capacity of the fractured single currency to sustain another round of assistance is diminishing

Like Greece before it, Spain is going through a slow-motion bank run. Spanish depositors, fearful for the safety of their cash, withdrew €74bn in the last month – a euro-era record, with deposits in Spanish banks falling by nearly 11% over the last year.

Deposits to German banks, meanwhile, have increased by 4.4%. It’s not too hard to see what’s going on – this is capital flight, driven by the prospect of a Spanish banking collapse. Spanish savers no long entirely trust their own banking system to be able to look after their cash, and nor do they trust the promises of their (increasingly indebted) government to support stricken banks. They are, instead, looking for safer havens in northern Europe.

Of course, in the way of these things, it is exactly the march out of Spanish banks that will make a collapse more likely, since banks starved of deposits cannot sustain themselves. Bank runs – even comparatively slow ones – can become self-fulfilling prophecies. That’s why confidence matters so much to banking systems. If depositors believe banks to be secure, the banks will (probably) remain secure. If not, the bank collapses. And if depositors see one bank crumbling, they can start to believe the whole system is at risk – thereby threatening the whole system.

It is because banking systems are so prone to ephemeral shifts in confidence that governments have developed the means to support them. Deposit insurance and offers of emergency assistance are all intended to reassure depositors that their money remains in safe hands.

Largely, these measures work. In more normal circumstances, the state’s promises are believed and banks remain upright. For the eurozone, depositors could have some faith that not only would their own state act to support banks, but that they would be backed up by the joint support of the whole European system.

Interbank lending

One important element of that support is through the interbank lending market. Banks continually borrow and loan to each other, allowing them to meet differences in demand for money: one bank facing a rush of depositors seeking to withdraw cash could borrow from another experiencing a glut of savings. The central bank in each national banking system acts as the lynchpin of the whole, running accounts for each of the private banks and allowing them to clear balances held against each other.

The eurozone ties together what were 17 separate national banking systems, all of them operating with their own currencies, into a single currency area that allowed the free movement of money across member states. Some means had to be found, then, to allow banks in different states to make transfer payments to each other, balancing out the different demands they face. This was done through the “Target2” system: each national central bank oversees interbank transfers amongst its national banks, and then – to balance the whole system – makes or receives payments from the rest of the eurozone through Target2.

Target2, in other words, should act to balance the whole system. For most of the euro’s existence, it has. Depositors treated money placed in (say) a Spanish or a Greek bank as safe as money deposited in a German bank. Transfers amongst the national central banks would therefore not be particularly large, and there would be no obvious biases in the system. Peripheral eurozone countries, like Spain and Greece, ran large current account deficits throughout the period, buying more from abroad than they sold. These deficits required financing, but that financing came through capital markets, leaving a limited impact on the Target2 balances.

Hidden support

But since the crisis broke, the system has started to function quite differently. The graph below shows the patterns of net claims made through Transfer2 since 2007. A positive balance indicates positive net claims against the rest of the eurozone – in other words, receiving money. A negative is the opposite – an outflow. Germany has swung strongly into a positive balance. Spain, sharply negative.

When the debt crisis broke, capital began flowing out of the peripheral eurozone countries. That began to force open the Target2 system, as banks in peripheral countries began to request greater and greater volumes of money to meet both their current account deficits – and, increasingly, the flight of depoists. Germany’s Bundesbank, in particular, began to loan greater and greater amounts into the system to meet this demand. What should have acted as a neutral accounting measure, facilitating payments amongst banks, has become one means by which the chronic imbalances of the eurozone are papered over.

But borrowing through Target2 requires collateral. If banks in need of funding do not have collateral, they cannot borrow. As the eurozone crisis drags on, high-quality collateral becomes harder to find – not least because the obvious contenders, national government bonds, have been downgraded across the eurozone. Peripheral banking systems are coming to rely instead on Emergency Liquidity Assistance (ELA), provided directly by the European Central Bank (ECB) itself. Details of loans are not disclosed, but by November last year Greece had already borrowed €55bn. A figure of €100bn would not, by now, be implausible. Spain has yet to activate an ELA facility, but with collateral running scarce and the banking crisis showing no sign of slowing, it could be forced onto the programme soon.

Political economy

This is where the political economy of the eurozone comes into play. The great advantage of the Target2 payments is that – whatever the debate over whether it is “stealth bailout” or otherwise – the system appears automatic, and outside of direct EU-wide support. It is the national central banks that are financing the system; they bear the liabilities alone. But if those loans start to dry up, the turn has to be made to ECB support for banking systems – most likely through the ELA in the first instance. That, however, raises the spectre of European bailouts, and the vexed question of where liabilities for EU institutions – including the ECB – ultimately lie. The fatal weakness at the heart of the euro project – that it is a single currency without a single state, able to back up a single central bank – is once more exposed.

The Spanish bank run shows no signs of slowing. Capital flight continues. Collateral becomes harder to obtain. We are creeping towards a further bailout. But the capacity of the fractured single currency to sustain another round of assistance is diminishing.