With the situation in Greece looking increasingly grim, the European Central Bank has been repeatedly raising its emergency lending to the country's shattered banks. But the one thing it wanted to avoid was allowing emergency liquidity assistance (ELA) to fund deposit flight from the ailing institutions. As negotiations drag on over Greece's bailout, however, that fear is increasingly becoming a reality. Here's what's been happening to Greek banks — deposits have dropped by 15% since August as savers pulled out their money from the country: Deposits fell by €7.7 billion ($8.17 billion) in February alone, meaning they have now fallen by €24.6 billion since December. Media reports suggest they could have fallen by a further €3 billion in March taking that total over €25 billion. Meanwhile Target 2 liabilities of Greece with the ECB (a gauge of how much the Greek banks are having to rely on Emergency Liquidity Assistance (ELA)) have increased by €44bn from August to February, according to Bank of America Merrill Lynch. In other words, Greece's banking system is increasingly on life support. And it's unclear how it's going to resolve the current situation as negotiations between the Syriza-led government in Athens and the institutions-formerly-known-as-the-Troika (the ECB, European Commission and the IMF) are making slow, if any, progress. Even though a temporary deal to release the next tranche of bailout funds would be a welcome result for the cash-strapped government, it may not be sufficient to lure savers to move their funds back into the banking system with so much uncertainty hanging over Greece's position within the monetary union. This leaves the ECB with a problem (albeit one partly of its own making). In February the ECB removed a waiver that had allowed Greek government-guaranteed bank debt to be used as collateral for funding from the central bank, despite being rated as "junk", in exchange for implementing the structural reforms agreed with the Troika. In other words, it cut the banks off from (cheaper) funding through its emergency loan programme and pushed them onto (more expensive) ELA, which is handled by the national central bank with the total amount capped at the ECB's discretion. ECB president Mario Draghi has repeatedly stressed that withdrawing the waiver did not signal an end to the support for Greek banks, but the discretionary move nevertheless signalled that such support was conditional on the outcome of the political discussions. Indeed, the way in which the decision was taken might suggest that the ECB was using the waiver as a bargaining chip to ensure Greek compliance with the Troika programme. At any rate, since that decision was taken the ECB has been forced to increase the ELA limit for Greece every week, but by much less than what the Bank of Greece has been requesting. Whether they will continue to do so if deposits keep flooding out of the system remains an open question. Focus now has switched to the balance sheets of the banks themselves. The protracted negotiations have begun to impact the real economy with a number of forecasters sharply downgrading their GDP growth forecasts for the country this year. This in turn is making it harder for Greek borrowers to keep up with payments on their loans, potentially worsening the problem of non-performing loans on bank balance sheets, and reducing demand for credit (credit growth in Greece dropped by 2.8% in January). The Greek government has floated the idea of creating a so-called bad bank that would allow it move problem loans into a separate state-managed entity, similar to Ireland's National Asset Management Agency (NAMA), to help reassure depositors and ease credit supply constraints on the banks. The hope will be that this would provide greater confidence in the system and allow deposits to trickle back as the banks estimate that as much as 75% of the deposits that have been withdrawn remain in Greece (presumably under mattresses) and could return if confidence improves. Even then, the financial sector is likely to have to tap equity markets if it is going to lower its reliance on ELA funding in the medium term. It remains unclear whether investors would be comfortable dipping their toes into a sector with so many question-marks hanging over it. So in the meantime will the ECB just keep increasing the ELA cap? Since its decisions are discretionary and subject to review on a bi-weekly basis, we simply don't know! If not it raises the prospect that Greece may have to implement capital controls if it fails to reach a deal by the end of the month. If that happens, the deposit outflow problem might be staunched but a whole new set of problems such as maintaining access to the eurosystem and a big negative impact on trade would emerge. The lesson of Iceland and Cyprus is you can impose capital controls, but it's very difficult to lift them. Here is a handy chart from Oxford Economics outlining the possible scenarios: A bad scenario that involves a disorderly Greek exit from the monetary union poses risks for the ECB too. As Oxford Economics points out (emphasis added): The only significant funds coming into Greece in recent months have been Emergency Lending Assistance (ELA) from the ECB. And if Greece redenominates, the Greek banking system would have insufficient funds to repay its €-denominated liabilities to the ECB and the European system of central banks. All in all, the next two weeks are likely to be crucial for the future of Greece's banks.Join the conversation about this story » NOW WATCH: What the Chinese saying 'The ugly wife is a treasure at home' actually means
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