Should We Worry About Target 2 Imbalances?
The Trans-European Automated Real-time Gross Settlement Express Transfer System (Target 2) is not something that normally captures the attention of financial markets and analysts, but the euro area debt crisis has changed this perception drastically. Since then several central banks from the euro area’s periphery have built up considerable liabilities vis-à-vis Target 2, while the German Bundesbank has acquired large claims on Target 2.
The build-up of Target 2 balances has led some observers to question whether the larger balances pose a risk to the Bundesbank or the European Central Bank (ECB). In our view, the build-up of Target 2 balances is mostly a reflection of the increasing reliance on central bank financing by banks in the peripheral Member States. As such, the risk to the euro system is mostly related to a situation where a government defaults on its bonds, in turn pushing the banking system into insolvency. Here the losses would be distributed to national central banks on the basis of their capital subscription to the ECB.
Only in the case of a break-up of the eurozone could the outstanding balances of Target 2 give rise to losses for the eurosystem. There is no clear legal guidance for how this situation should be handled. Most probably, the resolution would be based on a negotiation between the departing member state and the rest of the eurosystem.
Earlier this year, Hans Werner Sinn from the Ifo Institute pointed out that outstanding balances between central banks in Target 2 had increased dramatically since the credit crisis erupted in 2007. In an article entitled ‘The ECB’s Secret Bailout Strategy‘1, Sinn claimed that the net credit position of the German Bundesbank in Target 2 represented stealth financing of current account deficits in Ireland, Greece and other peripheral Member States, which had built up large net-liability positions.
Following this line of reasoning, Sinn argued that a major driver behind the bailout programmes for Greece, Portugal and Ireland was the ECB’s desire to reduce the Target 2 balances of national central banks.
Are Target 2 Balances a Risk for the ECB?
A question which has arisen on the back of this observation is whether the outstanding balances in Target 2 represent a risk to the ECB or the German Bundesbank?
This question has become particularly relevant after the risk of a disorderly Greek default increased dramatically with the Greek prime minister’s decision to call a referendum on the second bail-out package. Such a disorderly default could easily bankrupt the Greek banking sector, forcing the ECB to call the collateral posted by the Greek banks. To the extent that this collateral is in the form of Greek government bonds, this could impose losses on the Euro System of Central Banks (ESCB), even though the ESCB demands substantial haircuts on Greek government bonds.
However, it is important to underline that the losses to the ESCB would come from the Bank of Greece’s (BoG) lending operations to Greek banks and the direct exposure of the ESCB to Greek government bonds – not from the internal Target 2 balances of the ESCB. Here the latest available data indicate that the BoG had €93.2bn outstanding in regular liquidity operations. Here, the profits are distributed according to the capital subscription key of the National Central Banks, which use the euro as their currency, see Figure 3, and not related to the outstanding balances of Target 2.
Figure 3: Distribution of Losses Follow Capital Key
Source: Nordea Markets
Note: The adjusted capital shows the distribution among euro area members only. This would be the relevant key in case of distributing losses to the ESCB.
The potential for losses to BoG is actually slightly larger than for the eurosystem as a whole. Thus, the BoG is solely responsible for losses incurred on Emergency Liquidity Assistance (ELA) lending – ELA lending usually requires a government guarantee, but such a guarantee would obviously not be worth a lot in case of a disorderly Greek default. The latest data suggest, that BoG have extended €21bn in ELA to Greek banks, which do not have sufficient high quality collateral to obtain liquidity through the normal lending operations.2
If there is a risk associated with the Target 2 balances, it is only in relation to a break-up scenario. If, for example, Greece were to leave the eurozone, the BoG would in principle no longer be able to run a large liability balance vis-à-vis the Target 2.
However, it is important to underline that there is no legal guidance on how the exit of a Member State should be handled in relation to Target 2 or the ECB’s other operations. In the words of Mario Draghi, at his first press conference on 3 November 2011, the question cannot be answered because there are no provisions in the treaties on how to handle this situation.
As Draghi’s comments suggest there is no clear legal basis on how an exit from the euro area should be handled. However, in 1998 Charles Proctor and Gilles Thierry of the international law firm Norton Rose published the paper: Economic and Monetary Union: Thinking the Unthinkable, the Break Up of the Economic and Monetary Union. In this paper, the authors note that the departing member state would most likely seek a reimbursement for:
However, the authors note that: “in practice, of course, matters will not be so straightforward. The Maastricht Treaty does not allow for the withdrawal of contributed capital or reserves from the ECB, and financial terms would require a new negotiation. Such negotiations would be complicated by a number of factors; in particular, the withdrawal of a Member State would clearly shake market confidence in the euro and would be likely to lead to extreme volatility in its external value. This could only be mitigated by (i) a retention of a portion of the contribution of the withdrawing State; and/ or (ii) an additional financial contribution to the ECB by participating Member States in order to support the euro…..”
In our view, it seems obvious that the argument above could easily be extended to the question of settling outstanding balances in Target 2 in case of a Member State leaving the euro. In the case of a Greek exit, the Target 2 balance of €97bn (more or less the same as the outstanding liquidity operations from the BoG with Greek banks) should be netted out with the BoG’s claims on ECB capital of €10bn and gold and FX reserves totalling €646.5bn. This would most likely limit the loss to the ESCB in case of a Greek exit from the euro.
To understand how euro area central banks can build up liability or asset positions vis-à-vis Target 2, it may be worthwhile to give a brief run-down of what Target 2 actually does.
As indicated by the name behind the acronym Target 2, it is a system operated by the ECB for recording, clearing and settlement by both public and private market participants in the euro area. While the net balances of other members are settled at least daily, euro system central banks can build up gross and net claims and liabilities vis-à-vis Target 2 over time. In this fashion central banks from the euro area can borrow from or lend to each other.
As noted by the ECB, the main objectives of Target are:
By meeting these objectives, Target contributes to the integration and stability of the euro area money market.
More specifically we present two ways in which central banks may build up gross or net liabilities vis-à-vis Target 2.
A key point from both of the scenarios above is that the build of Target 2 balances occurs because the Irish banks do not have access to euro area money markets or funding through the bond markets. In this light, it is less relevant whether the country in question has a current account deficit or not. Of course, it is true that a country which is running a current account deficit needs funding from the rest of the world, including the rest of the euro area, but this only happens through Target 2, when other funding channels close.
If we assume, as Professor Sinn argues, that Target 2 balances were limited, the Central Bank of Ireland would not be able to extend unlimited liquidity to the Irish banking system. It is hard to see how the ESCB could then continue to offer the same interest rates to all banks across the euro area – in other words the monetary union would cease to exist.
Figure 4: Build-up of Target 2 Balances due to Current Account Deficits
Source: Nordea Markets
1Hans Werner Sinn, The ECBs secret bailout, Project Syndicate, April 2011.
2 The data on Emergency Liquidity Assistance (ELA) from the Bank of Greece (BoG) (or from the Bank of Ireland) are not released publicly. However, the balance sheet item ‘sundry assets’ of the BoG is generally thought to reveal outstanding ELA.