The Unfortunate General Trichet...
When Greece came to the European Central Bank requesting emergency bailout funds its then president, Jean-Claude Trichet, found himself and his bank in a precarious position.
On one hand, markets wanted a prompt response to the sudden onset of Greek insolvency, especially with the billions of Euros on the line if Greece were to default on its debts. Investors had watched the ECB sit idly by, watching the Celtic Tiger succumb to the perils of market speculation and wanted to see a European version of the "quantitative easing" magic performed by Ben Bernanke, chairman of the US Federal Reserve. However, even if Trichet had wanted to pursue such a course of action, it was unclear whether or not he had the legal authority to do something similar.
On the other hand, the accounting problems in Athens were steep and extensive, as the Greeks had been misrepresenting their debts since entering the Euro in 2000. Deals with Goldman Sachs and other American financial institutions were uncovered that had exposed billions of Euros worth of off the book liabilities and it wasn't until November of 2009 that a reliable figure for Greece's debt surfaced. At some €299.7 billion, it was clear that Greece would need far more than the €45 billion that it had initially requested, so an audit over three years of financial data was conducted.
Once the audit had finished in November, the real situation was revealed to be much worse than anticipated. Greece had a budget deficit that was 15.6 percent of GDP, a debt-to-GDP ratio of around 130 percent, and was paying higher interest rates to continue selling its bonds on the open market; all of which far exceeded the EU established ceilings. Trichet and the European Central Bank needed to act promptly to provide additional liquidity to Greece's ailing financial sector in order to keep the nation from defaulting on its debts completely, an event that would have unimaginable consequences for the future of the Euro.
The European Central Bank isn't a "Federal Reserve of Europe," in the sense that it cannot lend to any financial firm, at any price and at its discretion, like the US Federal Reserve System. If the ECB wants to lend, it has to verify that the borrowing bank has collateral adequate to justify the size of the loan. In theory, the EU's internal controls on debt relative to GDP and government deficits should ensure that if one of the National Central Banks needs capital, its balance sheet will show collateral enough to justify the loan. Using an instrument called a repo contract, the ECB lends funds to the bank in need, expecting repayment at a given interest rate that it determines once the contract matures (normally a two to three week period).Trichet and the European Central Bank were faced with a difficult choice, knowing that Greece's ailing financial sector couldn't stand if the Bank of Greece contiued to issue bonds, but also knowing that Greece didn't have the collateral to justify a multi-billion Euro loan to rescue its banks. Unfortunately for Greece Trichet made the legally proper, but unquestionably poor choice. The European Central Bank would not act, until Greece could lower its debt enough to satisfy concerns (largely from Germany and France) that it could repay the funds the ECB would loan it.