How a splintering euro could wreak havoc on German banks

The euro marriage is on the rocks. The Greeks are barricading themselves in their room; the Germans are raging; while the Dutch are talking about packing their bags.

However, as any divorce lawyer will tell you, breaking up is only the first and the easiest step. The real problems start when the fight over the assets begins.

In this case, the dispute would be over who has to pick up the tab for the losses on the Greek assets that the European central banking system owns.

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Indeed, some experts believe that the German financial system could end up needing a large amount of government support. Why? It all comes down to a slightly obscure system called TARGET' the Trans-European Automated Real-Time Gross Settlement Express Transfer...

The silent run on Greek banks

It's not terribly controversial to argue that keeping money in a Greek bank account is pretty risky. Their exposure to their own national debt means the 'haircuts' will force a bailout.

More importantly, if Greece leaves the euro, you can also bet that all bank accounts will be changed to drachmas overnight. So, many Greeks have taken their money out of the banks. According to reports, deposits have fallen by €70bn in the last three years.

Some of this money has been spent. And some of it has ended up in safety deposit boxes, or stuffed in mattresses. However, a significant chunk has been put in overseas banks. The most popular destination has been Germany, with its reputation for stability.

This has created a problem. On the one hand, Greek banks need to replace those funds. On the other, German banks need to find new ways to put the deposits to work.

In most cases German banks have left money in accounts at the central bank, which is where the TARGET clearing system puts them. In turn, the Bundesbank has lent these funds out to Greek banks, either directly or via the ECB, accepting Greek assets as collateral.

The problem arises if Greece defaults (which has already partly happened), and the banks are unable to repay the loans, which in turn means that the central bank is forced to take losses on the assets.

Who pays?

The key question in this scenario is "who pays up?" The Germans will argue that the Bundesbank was acting as a branch of the ECB, and so the losses should be split equally among all member states.

Other members will argue that since all central banks are technically able to choose the assets they lend against, it's a German problem. Even though all eurozone central banks have to follow the ECB's guidelines, the latter argument is likely to prevail.

It will clearly be even more difficult for Germany to force the other central banks to take losses if the euro completely splinters. One option would be for the Bundesbank to simply print money to make up the losses. However, fears about inflation make this unlikely. In the end the German government may have to end up bailing out its central bank and/or its financial system.

The Germans are getting worried

You can see why this state of affairs might be getting the Germans hot under the collar. Bundesbank officials are starting to complain in public. A letter from Jens Weidmann attacking the head of the ECB appeared in several German newspapers. It claimed that allowing banks to borrow against low quality assets was a bad idea.

Of course, Germany has only one vote on the ECB, so it isn't able to force a change. However, central bankers tend to shun the spotlight especially in Frankfurt. If senior officials are willing to leak their views to a newspaper, then it's clear that they are worried.

It also raises the question of what they are going to do. One view is that the problems make a breakdown of the euro less likely. After all, if an exit will mean an injection of capital into German banks, the Germans may think it better to muddle through.

However, that's quite an optimistic view of things, which may not happen. There is a chance that the Bundesbank could be joined by other European countries, who could then force the ECB to increase the quality of the collateral required. It could also refuse to clear any more money through TARGET, and invest the balances in alternative assets.

This would sharply increase the pressure on Greek banks and make a Greek exit more likely.

Either way, this dispute shows the extent to which attempts to delay the inevitable are creating more problems. Looser collateral standards only ensure that the cost will be higher when Greece exits.

Had Greece been forced to exit in 2010, when it first needed support, the German taxpayer would not now be in so much potential trouble. Indeed, the best solution would have been not to bend the fiscal rules in the first place, to help Greece get in.

Given where we are now, it's too late for that. The only choices to be made now are bad ones. It's yet another reason to believe that the eurozone crisis won't be resolved without a lot more pain and a much weaker euro.