Goldman's Take On TARGET2 And How The Bundesbank Will Suffer Massive Losses If The Eurozone Fails
Two weeks ago in "Has The Imploding European Shadow Banking System Forced The Bundesbank To Prepare For Plan B?" we suggested that according to recent fund flow data, "the Bundesbank wants slowly and quietly out." Out of what? Why the European intertwined monetary mechanism of course, where surplus nations' central bank continue to fund deficit countries' accounts via an ECB intermediary. We speculated that according to the recent ECB proposal, the primary beneficiary of direct ECB intermediation in fund flows, as Draghi has been pushing for past month, would be to disentangle solvent entities like the Bundesbank, allowing it to prepare for D-Day without the shackles of trillions of Euros in deficit capital by virtually all of its counterparties. Today it is the turn of Goldman's Dirk Schumacher to pick up where our argument left off, and to suggest that it is indeed a possibility that the Buba would suffer irreparable consequences as a result of Eurozone implosion, and thus, implicitly, it is Jens Wiedmann's role to accelerate the plan of extracting the Buba from the continent's rapidly unwinding monetary (and fiscal) system.
"central banks in the core countries face one specific risk that can be traced back to the TARGET2 imbalances, and this refers to the possibility that a country might decide to leave the Euro area. In such a scenario, the net claims the remaining central banks have acquired vis-à-vis that country reflect a genuine risk that would not exist without these imbalances. This could in the extreme case of a total break-up of the Euro area, and assuming that the peripheral central banks could not repay their liabilities, mean that the losses would materialise on the Bundesbank’s balance sheet."
Adn the conclusion:
It is only if one or several countries were to decide to leave the Euro area that the imbalances would lead to potentially significant losses beyond the risk already reflected in the current generous liquidity provision through the ECB.
Needless to say, the possibility that a European country can leave at will, as the European Nash Equilibrium finally fails, is something the Bundesbank not only knows all too well, but is actively preparing for: here is what we said on December 6: "we may be experiencing the attempt by the last safe European central bank - Buba - to disintermediate itself from the slow motion trainwreck that is the European shadow banking (first) and then traditional banking collapse (second and last). Because as Lehman showed, it took the lock up of money markets - that stalwart of shadow liabilities - to push the system over the edge, and require a multi-trillion bailout from the true lender of last resort. The same thing is happening now in Europe. And the Bundesbank increasingly appears to want none of it."
After all, Germany has been sending the periphery enough messages to where only the most vacuous is not preparing to exit. The question is just how self-serving is Germany being, and whether once Buba is fully disintermediated, Germany will finally push the domino, letting the chips fall where they may?
In other words forget about printing: Europe will be lucky if it maintains the Bundesbank within the existing framework of the ECB. Which means the only European bailout rescue recourse continues to come from just one palce - that of the subbasement deep under the Marriner Eccles in Washington, DC.
From Goldman Sachs' Dirk Schumacher
TARGET2 balances: A shock absorber for the Euro area, not an amplifier
The so-called TARGET2 balances between Euro area national central banks have, by acting as a safety valve, prevented a disorderly correction of the imbalances in the region. By moderating the adjustment, they have bought policymakers time to address the underlying causes of these imbalances. Thus, the rising net claims of ‘core’ vis-à-vis ‘peripheral’ central banks in the Euro area should be seen as symptoms—rather than a cause— of the crisis.
TARGET2 imbalances reflect peripheral countries’ continuing need for external financing and are therefore complementary to the persistent large current account deficits seen in the periphery. However, these imbalances do not per se represent an additional risk for national central banks beyond that already stemming from the ECB’s very generous liquidity provision. Only if one or several countries were to decide to leave the Euro area would these imbalances reflect a genuine new risk for those central banks that have acquired net claims vis-à-vis other central banks.
Another ECB mandate: Smooth operations of payment systems
The ECB’s main role in the eyes of the general public is to set the interest rate level at which banks can borrow reserves at the ECB. Determining the appropriate stance of monetary policy is indeed the main task of the ECB in order to fulfil its “primary objective”, which the EU treaty defines as “to maintain price stability”.
But the EU treaty also obliges the ECB “to promote the smooth operation of payment systems”, which implies “facilitating the circulation of money in a country or currency area”.1 The ECB plays a crucial role in the Euro-zone’s payments system through the so-called TARGET2 system2, which allows banks to settle payments between each other. Around 866 credit institutions currently participate directly in TARGET2 and some 3,585 participate indirectly through subsidiaries. The daily average turnover of the system in 2010 was 343,380 payments, representing a total average value of €2.3trn.
Strong increase in imbalances One characteristic of the ECB’s TARGET system is that payments from one bank to another bank in a different Euro-zone country are processed through the respective national central banks. If, for example, money is
transferred from country A to country B, this payment will involve the central bank of country A as well as the central bank of country B.
An important feature of the TARGET2 system is that claims among national central banks resulting from crossborder payments are not necessarily balanced. The payment from country A to country B therefore leaves, all else equal, central bank B with a claim vis-à-vis the central bank of country A. If the payments predominantly flow in one direction—always from A to B, without any offsetting flows—the receiving central banks’ claims will continue to rise, creating ever-growing imbalances in the TARGET2 system.
Chart 2 shows the imbalances that exist among Eurozone central banks, as reflected in the net claims of some central banks against others. As can be seen, these imbalances have increased dramatically since the outbreak of the crisis: the Bundesbank—and to some extent the Banque de France and the Nederlandsche Bank—have acquired significant net claims against the central banks in the periphery.
But while there are now substantial imbalances in the TARGET2 system at the level of central banks’ accounts, it is less obvious how these imbalances should be interpreted.
The macro view of TARGET2 imbalances
Before we explain in more detail the mechanics of the TARGET2 system, and how cross-border flows between core and periphery are processed in the system, it is worth looking at the macroeconomic story underlying the imbalances. This should make it easier to follow the economics behind the accounting that we present below. Countries in the periphery ran partly very sizable current account deficits, which were financed through borrowing from core countries, mainly through the banking system. These loans were privately funded and, although processed through the TARGET2 system, did not lead to imbalances.
As banks in the core economies were no longer willing to extend credit to peripheral banks, central banks in the periphery stepped in and refinanced peripheral banks. Consequently they financed the current account deficits of peripheral countries. It is this replacement of privately lent money through central bank funding that led to the rise in net claims of central banks in the core against peripheral central banks.
The mechanics of TARGET2
We now explain the mechanics of TARGET2, starting with a simple example showing the money flow of a payment between banks within a single country. If a client of bank A transfers money from her account to another account at bank B to pay a bill, her account at bank A is debited with that amount in the first step of that transaction. The settlement between bank A and bank B then takes place through the exchange of central bank money. For this, the account of bank A at the central bank is debited with the respective Euro amount, while the account of bank B is credited with that same amount.
Note, that the balance sheet of the central bank has not changed in this transaction, as it simply transferred central bank reserves from one account to another, without any change to the overall liabilities or claims to the commercial bank sector.
We now look at the same transaction but assume that bank A and bank B are located in different countries, with bank A (‘bank periphery’ henceforth) domiciled in the Euro-zone periphery and bank B (‘bank core’) sitting in the core Euro-zone.
Table 1 shows the stylised balance sheets of all four institutions involved in the transaction. We assume that bank periphery and bank core have made loans to corporates in their respective countries worth €100, and that these loans are financed through deposits and the issuance of bank debt; we abstract from any equity capital. Each bank also has deposits at the central bank and liabilities of that same amount. The central banks in turn have claims against the commercial banks and
We now assume that a corporate in the periphery wants to buy a machine worth €10 from a producer based in the core. For this, the corporate borrows €10 from bank periphery and asks the bank to transfer the €10 to the account of the producer of the machine at bank core. Again the settlement of the payment takes place via the central bank. But, given that the banks are located in two different countries, the central banks of periphery and core are involved in this transaction.
At the first stage of the transaction, the claims of central bank periphery against bank periphery will increase by €10. The liabilities of central bank periphery will increase by the same amount as the money is passed on to central bank core; implicitly the claims of central bank core against central bank periphery increase by €10. Furthermore, central bank core credits the account of the producer of the machine with €10.
However, the question remains of how bank periphery has funded the loan to the corporate. One possibility is that bank periphery issues debt worth €10 in order to fund this loan. Bank core would be, in our little model economy, the natural buyer. As its deposits have now increased by €10, it may want to invest somewhere. Thus, bank core buys the bond issued by bank periphery by wiring €10 back through the central bank system. As a consequence of the reversal of the payment, the claims of central bank core against central bank periphery are reduced to zero again, as are the liabilities of central bank periphery against central bank core.
- When periphery borrows from core, a current account deficit opens up. The periphery has bought the machine from the producer in the core by borrowing €10 from bank periphery, which has been funded ultimately through the savings of the machine producer (the deposits in the machine producer’s bank account have increased by €10). The macroeconomic equivalent of this is that the periphery records a current account deficit against the core.
- Credit risk of core extends through the banking sector. Although the machine producer in the core is the ultimate bearer of the underlying credit risk, that risk would only materialise if bank periphery and bank core were unable to make their obligations, i.e., bank periphery was unable to repay the bond issued and bank core unable to guarantee the deposit of the machine producer. Note that we have abstracted in our stylised model from any equity on the side of banks that could be used to absorb any losses.
- Central banks bear no risk in this transaction. The trans-border payments have not led to any change in the exposure of central banks vis-à-vis the private banking sector, as the claims against the banking sector in the periphery and core have not changed on the back of the transaction. Central banks have simply facilitated the flow of money, and thus the lending from core to periphery.
- No TARGET2 imbalances. Neither central bank ultimately saw a change in its liability or claim against the other central bank once all payments had been made, and there are consequently no net claims— TARGET2 imbalances—of one central bank against the other, despite a current account deficit of periphery against core.
Core stops lending to bank
We now assume that the funding situation of bank periphery deteriorates and that bank periphery finds it increasingly difficult to finance the loans on its balance sheet. These difficulties could stem from the fact that bank core is unwilling to roll the bond issued from bank periphery, for example.
The sequencing of the flows starts with bank periphery shifting €50 to its account at central bank periphery as bank core is unwilling to re-finance the debt that is maturing, and is demanding that its money be wired back.
Central bank periphery then transfers the money to central bank core, which results in the liabilities of central bank periphery against central bank core increasing by €50. Finally, central bank core credits the account of bank periphery with €50 and bank core credits the account of the depositors from the periphery—who have now opened an account with bank core in order to shift their deposits from periphery to core—with €50.
The crucial question is how bank periphery is financing its loans, as the asset side of bank periphery is now longer than the liability side (€110 in loans plus €10 in central bank reserves against €60 in deposits/debt). Assuming that bank periphery is not able to issue any new debt or increase its deposits, there are only three possible scenarios at this stage. First, the bank could try to reduce its asset side as well by pulling credit lines or selling off loans. If this is not possible, bank periphery could try to refinance its loan book at central bank periphery. If this is not possible either, the only option left for bank periphery is a default. The scenario depicted in Table 3 assumes that bank periphery refinances its loans after the withdrawal of deposits by pledging its loan as collateral to central bank periphery.
Another possible scenario leading to funding strains for bank periphery is if deposits are withdrawn and transferred to bank core as depositors question the solvency of bank periphery. The underlying flows in this ‘capital flight’ scenario are identical to what is displayed in Table 3, and central bank core again acquires in that scenario a claim on central bank periphery, i.e., aTARGET2 imbalance opens up.
No change in the current account deficit, but the deficit is funded differently now
There are similarities—but also meaningfully differences—between the balance sheets as displayed in Tables 2 and 3. For one, the current account deficit of the periphery vis-à-vis the core is the same. What is different, though, is how the loans on the balance sheets at bank periphery are funded: central bank core has replaced bank core and/or private depositors from the periphery who have shifted their money to the core. It is this replacement that has led to the rise of TARGET2 imbalances. Because there is no money flowing back from the core private sector to the periphery, central bank core has now a net claim against central bank periphery of €50. But these net claims are not a result of higher lending activity in the periphery or of a bigger current account deficit.
Note in that respect that there is no limit to the claims/liabilities between central banks created through the TARGET2 system. The only real binding limit is the amount of eligible collateral that peripheral commercial banks can pledge to their national central banks.
ECB funding of peripheral banks has increased sharply, while German banks show little interest
The previous section showed that TARGET2 imbalances can arise simply by a tightening of funding conditions for banks that led to a stronger reliance on the central bank as a funding source. We now look at the extent to which the scenario described in Table 3 is consistent with the rise in TARGET2 imbalances. For this, we first look at the funding of banks in peripheral and core countries through the ECB (Chart 2). The dependence on the ECB as a funding source has increased significantly over the last two years—particularly in the case of Greece, Ireland, and Portugal—and the rising share of banking system assets are re-financed at the ECB.
Note that these numbers under-represent the actual reliance on the ECB as they do not include lending under the so-called Emergency Liquidity Assistance (ELA), which in the case of Ireland, for example, reflects around 15% of outstanding loans of Irish credit institutions.
Chart 3 shows another development that is consistent with the shift of funding from peripheral countries to the core, and in particular Germany. While German banks represented around of 50% of the ECB’s refinancing operations before the crisis, this share has declined to almost zero. The decline in the share of German banks at the ECB’s refinancing operations also reflects the tendency of German banks to play an intermediary role, which they ceased doing after the crisis led to a mutual loss of confidence among banks. At the same time, deposits as a share of loans to the private sector have continued to increase over the past couple of years in Germany (see Chart 4).
As far as the drying up of private funding sources for peripheral banks is concerned, there is evidence that German banks have significantly reduced their lending to peripheral banks. Given that it is the Bundesbank that has seen its net claims rising strongly against peripheral central banks, the reduced funding of German banks is simply the counterpart to the TARGET2 imbalances. Finally, we can also observe that deposits in Greece have declined sharply over the last two years, although deposits in the other peripheral countries have remained broadly stable so far (Chart 6).
TARGET2 smoothes the adjustment in current account deficits, but does not prevent it
Some commentators have argued that the existence of the TARGET2 imbalances would prevent an adjustment of the current account deficit. As Chart 7 shows, this is not necessarily the case as the current account deficits in the periphery are declining. Moreover, private-sector deleveraging also remains strong (Chart 8) and bank lending has generally declined (Chart 9).
A genuine TARGET2 risk only in the event of a Euro area break-up
By increasing its liquidity provision to Euro-zone banks, the European System of Central Banks (ECB plus national central banks) also inevitably increased the credit risk it faces, despite the various haircuts the ESCB applies to the collateral that is pledged. As the ECB has increased its funding to peripheral banks in particular, the risks the ESCB faces is also more concentrated in that region.
The losses the ESCB might face, however, are distributed among the national central banks regardless of where they materialise. This is the case whether there are significant TARGET2 imbalances or not. The rise in TARGET2 imbalances has increased the risk for core central banks only to the extent that without these imbalances the liquidity provision of peripheral banks would have been smaller. But it is not clear to what extent the liquidity provision to peripheral banks would have been any smaller without the TARGET2 imbalances. After all, it is the repo operations (whether full allotment or not) and the collateral regime that decide on the size of the liquidity provision.
Put differently, it was the decision to replace private funding through central bank liquidity that increased the risk the ESCB faces and not the fact that TARGET2 facilitated transfers from peripheral countries to the core. As long as peripheral central banks are able to replace private funding—and the limiting factor here is the amount of collateral that can be pledged—there is no additional risk due to TARGET2 imbalances.
However, central banks in the core countries face one specific risk that can be traced back to the TARGET2 imbalances, and this refers to the possibility that a country might decide to leave the Euro area. In such a scenario, the net claims the remaining central banks have acquired vis-à-vis that country reflect a genuine risk that would not exist without these imbalances. This could in the extreme case of a total break-up of the Euro area, and assuming that the peripheral central banks could not repay their liabilities, mean that the losses would materialise on the Bundesbank’s balance sheet.
Overall, barring any collapse of the Euro-zone, TARGET2 imbalances do not reflect an additional risk for core central banks. It is only if one or several countries were to decide to leave the Euro area that the imbalances would lead to potentially significant losses beyond the risk already reflected in the current generous liquidity provision through the ECB.