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.