Is the ECB's Target2 critical for the euro's future? A debate between Felix Salmond and Marshall Auerback

Following Marshall Auerback’s guest post on the problem with Target2, and how it can potentially lead the German Constitutional Court to throw a spanner in the works of the euro system, Felix Salmon published an interesting article arguing that all this fuss about Target2 is the result of a misunderstanding of what Central Banks do – and of the profound difference between a liability of a Central Bank and that of a private bank. Felix’s point is well taken. But Marshall Auerback is not unaware of these important differences. In this post, he replies to Felix. Read on…
Felix Salmon makes some very good points about Target 2 in his recent blog post. He is undoubtedly correct to Target 2 per se is NOT the problem. But he understates its significance, as it is the symptom of a much bigger problem to which I alluded yesterday – namely, the attempts by the German policy makers to frustrate the operation of Target 2.   Salmon also ignores the equally salient problems posed were Germany to frustrate the operation of the emergency lending assistance program (which is the sole thing now keeping the Greek banking system afloat), and the ECB’s repo activities by the LTRO (which in retrospect appears to be a clear attempt to forestall a deposit run in Spain and Italy).

Under Article 66 of the EU treaty there is complete capital mobility within the Eurozone. A citizen in any country can hold deposits in the common euro currency in banks domiciled in other countries. To meet this opportunity the banks in Europe’s northern core improved the banking facilities they offer to prospective deposit and loan clients on Europe’s periphery. Guaranteed freedom of capital movements and the introduction of the common currency opened the door for citizens in the periphery countries to move their deposits to banks domiciled in the northern core, and those northern core banks facilitated that transfer in every way. As a result it is virtually costless for a Spanish citizen to conduct all of his euro business with a German bank.

Given this ease of capital movements there had to be in the Euro area a quiet automatic payment system that would deal with transfers from banks in one country to banks in another. Initially the architects of the European monetary system thought that the private “markets” would accomplish all the needed financial transfers. If a Spanish bank lost deposits and a German bank received deposits, the interbank market would allow the German bank to immediately and profitably put the money to work and in doing so allow the Spanish bank to fund its deposit loss.

And apparently this is how things went in the early years of the euro. In 2007 German banks had direct claims on banks on the periphery of over 800 billion euros. However, when the Great Crisis occurred in 2008-2009 market confidence ebbed and private sector interbank lending dried up, especially to the European periphery. As a result German bank claims on banks in the periphery have since fallen in half.

What made up the difference? First, the payments transfer system through the system of European Central banks called Target 2. Target 2 refers to Trans-European Automated Real-time Gross Settlement Express Transfer. It is the euro system’s operational tool through which the national central banks of member states provide payment and settlement services for intra/euro area transactions. Target 2 claims can arise from trade and current account transactions as well as from purely financial transactions.

Recently financial transactions have become dominant. My understanding is that funds have been taken out of banks on Europe’s periphery and have been deposited in banks in the north of Europe, principally in Germany. The bank receiving the deposit places those funds with the Bundesbank (or other recipient national central banks); in doing so it has its funds delivered through the Bundesbank to the ECB (or other recipient national central banks) and then on to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction. It’s all allowed under the Treaty (although my blog post yesterday suggests that Germany’s constitutional court ruling on the EFSF and Greek bailout of 2010 might pose a threat to its existence going forward). The so-called Target 2 outstanding balance is the net position of such claims between two European countries. 

There are specific collateral requirements that must be met for Target 2 funding of banks to occur. Sometimes banks with deposit losses cannot meet those collateral requirements. However, there are other lender of last resort channels that can come into play.

When banks in some Eurozone countries – in this case the periphery – have funding problems and don’t meet Target 2 collateral requirements, they can borrow under the emergency liquidity assistance (ELA) program. Such assistance is extended by single national central banks to their banking systems. The risk is borne at the national level. The collateral requirements imposed upon a commercial bank for obtaining ELA funds is less than the collateral requirements needed for obtaining Target 2 funds. The national central bank in a country like Greece with commercial bank deposit runs ultimately funds its ELA financial assistance to its commercial banks from the ECB. That ECB funding for ELA is above and beyond Target 2 funding.

Lastly, the ECB conducts repo operations with banks in the system. Recently these repo operations (e.g., LTRO’s) have also been funding banks in the periphery that have been experiencing deposit runs. It has been widely believed that LTRO funds received by Italian and Spanish banks went entirely into purchases of their government’s bonds. Some of these funds did go into purchases of national government bonds, but only in part; some of those LTRO funds financed deposit losses.

Through these many channels the European System of Central Banks closes the financial circuit created in the Eurozone when a citizen of one country chooses to move his deposit from a domestic bank to a bank domiciled in another euro area nation.

So far,so good. Unless there emerges a perceived risk that one country in the European monetary system may someday exit the euro. The consequences are obscured by a now extensive existing body of legal contracts written in euros. But euro exit by any nation opens the possibility that it may go back to its original currency. And that currency may somehow be worth less than the euro. There arises a risk of a currency devaluation loss for those holding euro deposits in a bank domiciled in an economy that could exit the euro. This poses problems – very severe problems.

In 1998 Professor Peter Garber recognized that the above created a fatal flaw in the euro system. As long as there was no perceived probability of euro exit by any euro nation, the established transfer system coupling private markets with European system of Central Bank support (Target 2, ELA, ECB repos) would function like any other monetary system in a single nation state. However, Garber recognized that if there arose the prospect of a euro exit and, therefore, a devaluation risk for holders of deposits in the banks domiciled in the country slated for exit (e.g. Greece or Spain), the European monetary system would be exposed to a bank run. Under the EU treaty capital mobility was guaranteed. Under the common currency deposit transfers from domestically domiciled banks in countries at risk of euro exit (e.g. Greece, Spain) to banks domiciled in other euro nation states (e.g. Germany, Netherlands) was costless. Faced with any non-negligible perceived risk of a euro exit and thereby a devaluation loss, rational market participants should move all their deposit funds from the banks domiciled in the country at risk of euro exit to banks domiciled in nations at the Eurozone’s unassailable core.

In the United States we have 50 states and one central bank. There are fund transfers across states. But there cannot be any prospect of a secession of a state that will bring with it its own devalued currency. Hence, there is no incentive for deposit flights from banks in one state or region to another. Therefore, private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers. The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did.

And that is why all of this discussion of Greece leaving the euro zone has been so destructive and exacerbated the deposit flight. Once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber argued that, given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.  That is where the problem lies.

In this regard, I find the comments the other day of Joerg Asmussen to be very enlightening. Asmussen discussed Target 2 and suggested that proposals to limit Target 2 balances are misguided. (perhaps he had Sinn in mind?)  To my mind this reveals that Target 2 lender of last resort financing on the periphery has become so large that some in the ECB and/or EU and/or Germany are arguing they should be limited, even though that could cut off needed funding by banks on the periphery and force them to suspend deposit withdrawals. That is pretty extreme stuff. It suggests that Target 2 balances have now become very, very large.

Asmussen also has conceded that non functioning of the interbank market is a real concern. Last week the Spanish finance minister revealed that Spanish banks were having difficulty rolling over their interbank and wholesale liabilities. This constitutes a bank run by the biggest players. Asmussen is apparently admitting that such an interbank and wholesale bank run may be severe.  So if operations such as Target 2, the ELA and the ECB’s repo operations are suspended, then banks on the periphery will have to close and suspend payment on requests for withdrawals and this will destroy the banking system of the Euro zone.


  • Yani:

    I am sorry man. I know I am leaving this blog in 2 days, but are you going mad?

    Are you featuring a punk-assed kid with no intellect whatsoever as a serious debater worthy of an entry in your blog?

    Don’t you do some rudimentary background checking of who these clowns are, or are you awed by the name Felix? It’s not helix and he does not have a propeller around his head. He just some moron Gen-Xer whose economic background is as substandard as his looks. And one that places bets with his friends on possible outcomes?

    What’s happening to you people? Are there no minimum standards? WOW!!!

    • Apologies Dean. But no I do not look into anyone’s background. I lack the time and, to be honest, the interest too. As for your leaving in two days, I refuse to believe it. I am sure you will be back. There will be so much madness to talk about that you will not be able to resist.

    • Yani,

      Of course you already know that the one going mad is me not you.

      Thanks for you civil reply. I having be hot under the collar the entire week. I am beyond irritated even at the smallest things.

      Somehow I know my arguments are in vain. They only make me look as the odd man out. Be that as it may, at least I am creating entertainment if nothing else.

      You are doing a good job and I am loosing it.

    • @Dean

      Why such desperation?

      Won’t the possibility of a Samaras win make your day? We live on hope don’t we?

      Hang in there.

    • Estrangeiro:

      Couldn’t give a rat’s ass if Samaras wins.

      Greece is who should win. All the rest are expendable and play a small but useful part. And once they play their optimum part they are discarded without any emotion.

      If you think I am a Samaras supporter just like a football fan, you have grossly miscalculated.

      And if I think Tsipras is better on certain aspects affecting Greece, then Tsipras is my man.

      The only thing constant in my approach is this: Greece wins and everybody else loses. Starting with Germany that is.

    • Dear Dean
      I doubt you will really leave this blog so soon. Whatever the outcome of the elections in Greece – the times will remain challenging. Lots of hardship in any case:
      Either Greece leaves the Eurozone which will not be fun, neither for the others nor for Greece which will then potentially loose its financial lifeline from ECB and other supporting (though hated) EU countries.
      Or Greece remains in the Eurosystem which will make the continuation of the painful adjustment process inevitable.
      The good news is: In both scenarios, you will be able to blame Germany!
      So I am pretty sure you won’t miss that opportunity and continue to voice your opinion.

  • “then banks on the periphery will have to close and suspend payment on requests for withdrawals and this will destroy the banking system of the Euro zone.”

    Which would be good, because htey are bankrupt anyways.

  • It seems this Target2 debate from Sinn ,is just another way of trying to fit reality in Sinn-like people’s ideology.

  • Yanis you are an absolute legend. I wish we had more economic minds like yours here in Ireland. Instead we’re stuck with an incompetent media and corrupt politicians working hand in hand with their banker mates. God save us from these monsters.

  • This is the real issue: German profiteering at the expense of the rest of Europe.

    “Investor demand for German government bonds has pushed yields down to record lows. At an auction on Wednesday, Berlin issued 10-year bonds with an interest rate of just 1.52 percent. When adjusted for inflation, currently at 1.9 percent, the rate means that investors will actually lose money on their investment. In effect, they are paying Germany to keep their money safe.

    The figures are likely to provide critics of Germany with more ammunition. Already many economists and politicians outside the country are calling on Berlin to do more to solve the debt crisis. The perception that Germany is benefiting financially from the crisis while imposing strict austerity measures on countries in southern Europe is unlikely to win many friends for Chancellor Angela Merkel, who is already highly unpopular in countries such as Greece.

    According to calculations conducted for the Financial Times Deutschland by the private research company Kiel Economics, a spin-off of the respected Kiel Institute for the World Economy (IfW), Germany will save a total of around €15 billion ($19 billion) in 2011 and 2012 as a result of low interest rates on government bonds. Berlin will save at least €10 billion in 2012 alone, the economists calculate. “We are expecting a balanced budget in 2013,” the IfW’s Jens Boysen-Hogrefe told the Thursday edition of the newspaper. “

    • Dear Dean
      No, this is not the “real issue” in my eyes. It is a side effect of the disastrous situation Europe and to some extent the whole world economy is in due to the financial crisis and the Euro crisis in particular.
      If you get so excited about the savings that Germany makes by having to pay less interest on its government debt then consider this:
      Germany’s exposure to the Eurosystem is somewhere around EUR 1’000’000’000’000 (one thousand billion – I hope I got the noughts right).
      It Euroland disintegrates (which seems a real possibility) then all those nice “savings” of EUR 15 Billion or whatever will be nothing in comparison.
      So I don’t think the low interest rate of Germany is a major problem nor is it something anybody should get too excited about. Either the situation will come to some sort of “happy end” in which case the difference between the German interest rate level and that of, say Italy, Spain or Greece will decrease.
      Or the whole system will blow up in which case savings of EUR 15 billion are insignificant because Germany will loose many times that amount because assets lent to other countries will only partly be repaid, causing hundreds of billion Euros of damage.
      So either way, you don’t need to get too excited about the EUR 15 billion.

    • Martin:

      The 15 Bil. is only one year’s interest savings. Since the start of the crisis Germany has profited and pocketed 65 Bil euro and counting on interest savings alone.

      This has been a cash cow for Germany at the expense of the rest of Europe. And only one small aspect of total exclusive benefits to Germany.

      How about the unending crises engineered by the Bundes Taliban lower the euro value and thus on a cumulative basis have resulted in more than 200 Bil. euro worth of extra German exports which you would otherwise be unable to raise?

      Have you ever looked at graphs showing the relationship of euro value to the timing of German exports? Every time the euro drops there is a concurrent flood of German exports fueled by lower euro values. The Chinese have already raised it as an issue. They refuse to buy at such artificially fabricated euro crisis prices and insist on a weighted average instead. Why don’t you find those graphs and post them here. Every time the euro drops below $1.30, Germany sells massive amounts and the kitchen sink. And the whole world knows about it.

      How else do you think Germany provides its share of “European” contributions ? First it steals the money through trickery and manipulation from all other European governments.It then pretends to offer part of the profit money resulting from unfair practices to the same Europeans it stole it from. This is such a ponzi scheme of first fleecing Europe and then returning back something equivalent to 10 cents on the euro stolen.

      This is not trivial. These are serious financial abuses.

  • TARGET2 balances have real economic value (in external debt derailing countries) and explain in a way possible losses that eg Deutsche Bundesbank would have to absorb in its balance sheet.
    TARGET2 imbalance shows better that there is capital flight out of the periphery to the core, and this is dangerous. Also, periphery trade deficits and overall thesis of banks growing the dependence on the inputs threw TARGET2.
    The point however is not the ekthesis on GR POR IRL or SPAIN debt.
    The real point is how banks perform.
    Banks (especially Greeks that i know of) for 3 years are unable to perform independently. The financing TARGET2 and MRO, LTRO, liquidity is for recycling balance sheets and stay almost unchanged.
    But is like being in a gypsum.
    Why? Because the nature of banking is associated with maturation. Deposits of customers can be readily available for commitment but also the banks lend to businesses and households and are committed for many years. The result is that banks often face significant liquidity risks.
    The GR banks during this crisis lost more than 70 b € in deposits.
    The ratio L/D for every euro in most was around 0.9-1.2 which is from the best ratios in most western countries.
    But here comes the dynamics of unchanged maintenance which in some cases make things more difficult.
    We witnessed a massive rescheduling in loans with cost for banks, a great increase in NPL but also the inability to finance companies, new business schemes and i m talking even for export based companies.
    The banks policy was: we try to restructure loans in order to make many customers able to pay but to new loans, we say NO.
    Because if they contract new loans more to those eg of 2010-11 the CAR would be in huge deterioration. So less loans than 2010 a not so substantially worst CAR for 2011 even after huge losses with PSI +!
    The problem here? By reducing corporations funding especially those many thousands small family led companies -in case of Greece- we made them dissfunctional.
    The most important is that a reduction in loans at 10% practically has a huge impact in GDP and reduce it at least 3-4%.
    So the TARGET2 impalances might be the one side of the coin, the potentially difficult to assess, the other is the functioning lately of the Spanish banks.
    Real issue for europe is to recapitalise effectively banks facing problems with the best possible terms, in order to improve the funding in real economy and gain trust.
    Trust is the issue, a practical one. The mechanics of TARGET2 could be a multiexplaining tool for observation and analysis, but not a base for change especially now its structure.

    • You are talking about the bulk of deposits going to Germany from certain countries.

      He is talking about the deposits of the periphery going to Germany and other northern countries.

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