TARGET2 – Window on Eurozone Risk

* This paper can also be downloaded in PDF format here.  



About a year ago, a blogosphere debate erupted over TARGET2, the inter-central bank payment system for the Eurozone. Ground zero for that discussion was a blog post by Hans-Werner Sinn, followed by a more comprehensive paper:

Sinn’s argument was that the TARGET2 payment system constituted a “stealth bailout” mechanism for the financially weaker countries of the Eurozone. This view was questioned by those who maintained that TARGET2 was a straightforward operational feature of the Eurosystem, and not a factor in the structural challenges facing the Eurozone. Although the debate has evolved since then, the two sides remain generally committed to their opposing interpretations.

This essay intends to examine the relationship of TARGET2 to the strategic risks currently facing the Eurozone. While this will not be a dissection of the earlier debate, our conclusion is that Sinn was largely correct in his analysis, particularly in the context of strategic risks affecting longer term Eurozone viability, where existing risk and loss sharing mechanisms are not necessarily guaranteed as certain. His lengthier paper above includes several relevant rebuttal arguments in response to initial blogosphere criticisms of his shorter post. Nevertheless, we point out several aspects of his analysis that suggest additional qualification. Links to several early blogosphere responses to Sinn’s arguments are included in Appendix III.

Meanwhile, the prevailing Eurozone TARGET2 asset-liability configuration and imbalance that was the focus of the debate has deteriorated further over the past year, increasing its potential relevance as an indicator of Eurozone risk. For example, the German Bundesbank provided net funding of 727 billion euros to the rest of the Eurosystem via TARGET2 as at July 31, 2012. The Spanish Central Bank required net funding of 423 billion euros at the same date. Both of these positions have increased substantially over the past year. Aggregate TARGET2 balances held by four countries (Germany, Netherlands, Luxembourg, and Finland) provided net funding to the system exceeding 1 trillion euros. A more complete accounting of the distribution of TARGET2 imbalances is included further below.

This essay is more descriptive than prescriptive. An answer to the question of how to “fix” the Eurozone “problem” is not offered. Prescriptions flourish elsewhere, although the dynamics of the evolving economic landscape and political process mean that the probability is quite low that any one of them is an accurate forecast of the eventual solution to the problem. Conversely, certain elements of a required response are common, cutting across the spectrum from those emphasizing stimulus to those putting weight on austerity. A wide range of debate exists, along with forecasts of what is needed and what the outcomes might be. A section further below extracts a sampling of these solutions, including representative opinions from those with views as diverse as Paul Krugman and Robert Mundell, but which point to common threads, and which connect directly to TARGET2 operational evidence. The situation continues to be dynamic. Ideologies in the approach to the Eurozone challenge are well distributed. Policy muddles through. We will examine some of the foundation risks, as reflected in TARGET2 evidence, rather than recommend policy.

The reader may find the explanation of TARGET2 operations and accounting somewhat complex and perhaps tedious, although we’ve attempted to summarize this at the conceptual level. More clinical expositions of operational function are available at some of the links provided in Appendix III. But one can’t avoid encountering this subject in some form in the analysis of Eurozone risk. The monetary system is a construction of institutional arrangements, accounting, and related risk distribution. And the TARGET2 operating system is a foundation piece of the Eurozone central banking system.

TARGET2 is a payment and clearing system for multiple central banks that are in effect operational issuers of the same currency.  This system feature is unusual, because a multiple central bank system is unusual. Central banks are usually singular. They don’t normally make home currency payments that settle as liabilities of central banks in other countries. A currency issuer in such a system faces an open rather than closed home currency payment environment. The currency it issues either as bank reserves or banknotes can disappear from its balance sheet due to international flows. Such flows become analogous to commercial bank payment clearing patterns in a single central bank system. This adds to complexity in monetary operations, but is an essential feature of a multi-national currency union.

These particular operational characteristics may be of interest to those who are curious in general about operational issues around commercial and central banking – such as the idea that “loans create deposits”, an operational fact of banking that still seems to cause controversy in some corners of monetary economics; or the idea that commercial banks “don’t lend reserves” to non-bank customers, another fundamental operational aspect that seems to elude many monetary economists and analysts even today.

With reference to the live policy situation at present, Mario Draghi in his press conference of August 2, 2012 provided an analytic framework for future policy direction from the European Central Bank (ECB):

Draghi is operating in effect from a menu of institutional options that include both ECB and non-ECB funding programs for the Eurozone financial system. One can interpret the potential for such monetary interventions and adjustments as part of an overall portfolio management approach to the intermediate solution for the Eurozone structural problem, combining elements of monetary adjustment with elements of fiscal discipline. This ongoing process tracks an evolving ideological mix of monetary stimulus and fiscal austerity prescription. It will determine a dynamic policy path that navigates Eurozone risks and emerging TARGET2 asset-liability patterns as a reflection of those risks. The market continues to be impatient, as the upcoming ECB meeting of September 6, 2012 approaches, with the German court scheduled to rule on the constitutionality of the ESM bailout fund shortly after that.


Risk Management

The general subject here is banking, including central banks, commercial banks, and government treasury functions that relate to those central banks. TARGET2 is the payment system that connects the 18 central banks in the Eurosystem (17 national central banks (NCBs) and the European Central Bank (ECB)).

The important core risks facing commercial banks include liquidity, interest rate, credit, and foreign exchange risk. These are sometimes also collectively and roughly classified across intra-institutional lines as structural (commercial banking), market (investment banking), and operational (infrastructure) risks. Commercial banks hold capital (mostly equity) as an insurance buffer against these risks. The functional role of capital is to absorb actual losses that may result from risk. Shareholders require a reasonable risk-adjusted return on capital in order to compensate for assuming such risk. Pricing of bank assets and liabilities must take this into account.

Central banks interface with their respective commercial banking systems along these same risk dimensions. Interventions in liquidity and interest rate conditions are normal; interventions in credit risk conditions less so. The complexity of this risk interface has been evident in central bank responses to the global financial crisis, which have included zero bound or near zero bound interest rate management and significant elements of credit and quantitative easing. Eurozone central banking has a special relationship with foreign exchange risk, due to the contingency that constituent nations might exit the currency union and convert and devalue under a new domestic currency.

The overarching systemic risk now facing the Eurozone is a form of operational risk – the risk that the intended functioning of the system and its structure will break down in some fundamental way. The ECB has referred to this potential state as “reversibility” or “convertibility” risk, in the sense that individual members may choose to exit the Eurozone and revert to their own reconstituted currencies. Even short of extreme reversibility outcomes, individual members may still default and/or be “bailed out” from credit risk while maintaining their Eurozone membership status. Lately, some ECB spokespersons have even hinted that the policy mandate of the ECB might implicitly include heretofore non-standard measures to combat reversibility risk, such as capped bond yields supported by bond purchases. This remains to be seen.

The banking risks listed above form a continuum of sorts. The core liquidity characteristic of central banking is the capacity to issue banknotes to the public and reserve balances held by banks. (Also, central banks issue deposit balances to government Treasury functions as a feature of regular payment and clearing system operations.) A central bank normally faces no liquidity risk, as it has the operational capacity to issue unlimited “medium of exchange” liabilities, simply by acquiring assets at will. It responds to the liquidity risk management inclinations of the private sector as a matter of monetary policy. Nevertheless, the Eurozone incorporates an interesting wrinkle on this arrangement, in the sense that national central banks can face outflows of either banknotes or reserve balances that are essentially beyond their control. This is a basic liquidity risk feature, and it is core to the story of TARGET2 operations.

Central banks also issue capital. And it is a common error to assume away the relevance of central bank capital simply due to the capacity of central banks to “print money”. Central banking is an institutional form of choice, and capital matters in that institutional structure. Central bank profit and loss pass through the capital account. This has a direct financial impact on the surplus or deficit position of the sponsoring fiscal authority. To suggest this impact doesn’t matter is equivalent to suggesting that fiscal deficits don’t matter, which is nonsense. Moreover, the notion that governments can easily recapitalize their central banks or run them with negative equity is not a relevant argument in the context of this institutional choice – the important issue is the tracking of central bank risk and return in an institutional framework that connects monetary and fiscal operations through such capitalization channels. Also, one should not confuse views on “fiscal sustainability” with the separate importance of coherent accounting for net deficit or surplus fiscal contributions from central bank monetary operations in such a bifurcated institutional structure.

A central bank has the operational capability to combine forces with its sponsoring fiscal authority, directly or indirectly, in acquiring Treasury debt in exchange for bank reserves. When this capacity is combined with an effective fiscal authority, it becomes fundamental to the argument that a particular class of fiat currency issuers faces no effective insolvency risk. And such a fiscal authority even has the capacity in theory if it so chooses to instruct the central bank to accept government cheques and other forms of government payment, without necessarily clearing those credits through Treasury bond issuance. Recognizing the importance of this type of authority structure becomes important in assessing the nature of risk facing the Eurozone. Due to the inherently restrictive nature of the currency union, the Eurozone as currently constituted does not fall into this class of currency issuers.

The core interest rate characteristic of central banking is the capacity to set a policy rate of interest based on the chosen supply of bank reserve balances and/or the pricing of bank reserve balances. Notwithstanding the existence of academic theory that may suggest an invisible hand that somehow guides the central bank toward a “natural” rate of interest, it is indisputable that the modern central bank has the operational capacity to set the short term rate at any desired operating level. This becomes very important in assessing a range of institutional options that is available in the joint operation of a central bank and its sponsoring fiscal authority. And it is important to the analysis of Eurozone risk.

Liquidity risk is at the heart of banking, and payment systems are at the center of the heart. TARGET2 is the epicentre for Eurozone liquidity operations. The Sinn thesis roughly was that the evolving asset-liability configuration of the TARGET2 system reflected a comprehensive risk in Eurosystem structure, one in which the system liquidity profile was inextricably linked to emerging credit and foreign exchange risks. This is true in several ways. First, the imbalances that have shown up in TARGET2 are symptomatic of underlying interest rate, credit and foreign exchange risks. Second, as Eurozone risks deteriorate, the prospective distribution for the absorption of risk and losses may evolve into something that was not intended by the designers of the system, because they did not build into their plans the contingency of structural degradation or collapse, including the possibility of the currency union’s disintegration. The ultimate risk and loss distribution in such extreme situations may be contingent on the severity of such an outcome. And such gathering risk may be revealed by the evolving TARGET2 asset-liability configuration. Some of Sinn’s critics seem to have only roughly acknowledged the first point above, and appeared not to have considered the second (see relevant links in Appendix III).


The Contingent Institutional Approach – Eurozone Version

In a previous post, we developed a “contingent institutional approach” to the integrated analysis of fiscal and monetary operations, in the context of the usual single central bank operating structure:

This approach defined operational and strategic issuers of a sovereign fiat currency. For example, the US Federal Reserve is the operational issuer of the dollar, in the sense that it issues monetary liabilities in the form of banknotes, bank reserves, and deposits held by the US Treasury. The US Treasury is an operational user of the currency within such an institutional framework.

The USA, using the institutional authority of the US Congress, may be considered as the strategic issuer of the dollar, since Congress has the power of choice to ensure that the US central bank becomes the direct lender of last resort to the government, should that become necessary. Or, in a more radical institutional adjustment, the central bank might become “currency issuer of last resort” for government – by allowing Treasury expenditures to be credited directly to bank reserve accounts, without imposing bond financing requirements. Such ultimate congressional power means that operational insolvency for the US government is virtually unthinkable, so long as it operates with the dollar as a fiat currency. Congress has the ability to empower the central bank and/or Treasury with as much operational authority as required in order to establish such lender/issuer of last resort features in connecting fiscal and monetary operations more directly.

This distinction between operational and strategic currency issuance allows for the analysis of potential scenarios involving alternative institutional structures. For example, as described in the post noted above, one such contingent institutional framework includes a “Central Treasury Bank” (CTRB), which formally absorbs the existing central bank currency issuing function into an overarching Treasury institution that becomes the integrated authority for fiscal and monetary operations. CTRB would have more direct latitude and flexibility in regular deficit financing methods than is currently in place. It can be considered as an institutional formalization of what is now only an implicit central bank function as lender of last resort (LLR) to government.

This operational/strategic institutional spectrum can also be used to analyze Eurozone monetary operations. The 17 national central banks (NCBs) that, along with the ECB, constitute the European System of Central Banks may be considered as operational issuers of the Euro. The ECB provides integrated leadership on monetary policy. But the ECB is not a “strategic” currency issuer, because it is not directly responsible for integrated fiscal policy as a connecting force, and has not been endowed (or endowed itself) with any implicit or explicit lender of last resort function as far as multiple Eurozone national treasury functions are concerned. Moreover, none of the 17 Eurozone countries has the sovereign power to invoke its own brand of contingent operational or institutional change empowering strategic control over combined national monetary and fiscal operations. They have all surrendered that power under the currency union. These countries are strategic issuers of the Euro neither collectively nor individually in the sense of our analytical framework. In fact, there is no strategic issuer of the Euro by this meaning. And that is a major problem for monetary policy flexibility. The required institutional trigger for the exercise of a contingent LLR function, a multi-national Eurozone fiscal authority, does not even exist. Many feel that this is a structural failure of the Eurozone design.

The 17 Eurozone countries and their respective government treasury functions are respectively strategic and operational users of the euro in the context of our contingent institutional framework. And there is no implicit LLR function embedded behind these 17 Treasury functions, individually or collectively, unlike the cases of US, Canada, or Japan at the federal level. These Eurozone countries have surrendered their monetary and fiscal sovereignty to a currency union. Without either an implied or explicit government LLR function, the possibility of member government insolvency becomes a thinkable contingency. And unlike the case of a strategic issuer like the US, Canada or Japan, solvency risk becomes a true factor in bond market pricing, a consequence which in itself feedbacks to and compounds the mathematical risks that underpin the core insolvency threat. The flaw in the design of the Euro system arguably is that there is no strategic issuer of the Euro (in the definitional context of our framework). The system was designed under the premise that it would not fail and not require such a monetary backstop.

Policy prescriptions currently offered for the Eurozone crisis can be analyzed in the context of this contingent institutional framework. Prior to turning to the conceptual mechanics of the underlying TARGET2 operating system, we sample a range of such prescriptions offered by several prominent commentators. Notwithstanding different ideological inclinations, their recommendations intersect to some degree in their tendency to recommend a much greater degree of monetary system flexibility than currently exists, using a wider range of available instruments and institutions, while at the same time promoting wider fiscal integration. Important institutional elements include strengthening banking systems with capital and Euro-wide deposit insurance, and expanding the ECB function to a lender of last resort (LLR) for governments as well as banks. This LLR extension is in effect the activation of what is implicitly understood in our contingent institutional approach. The problem for the Eurozone is that such activation is urgently required in some form now, before an overarching and enabling strategic framework has been established as a matter of permanent Eurozone fiscal and monetary structure. This is a time-reversed engineering of the contingent institutional approach. It builds the required strategic framework by working through in real time the formulation and implementation of emergency measures that should ideally have been built into the upfront design of the monetary and fiscal system.


Eurozone Risk Analyses

The purpose of this section is to provide a sampling of risk analyses from several prominent commentators, illustrating the connection between the strategic view (fiscal and monetary policy analysis) and the operational view (emerging TARGET2 evidence of structural stress in the Eurozone) of risk. TARGET2 is noted as an explicit risk component in several of them. Notwithstanding diverse ideological inclines, these analyses intersect meaningfully in their proposals for dealing with the crisis at this stage. Common themes include banking, fiscal, and political union, and the development of a more entrenched ECB lender of last resort facility for Eurozone Treasury functions. While the last two analyses emphasize fiscal discipline more than the first four, a common theme of desirable monetary flexibility is noteworthy. All of these analyses offer excellent summaries of Eurozone strategic risks. They are extracted here as a way of fleshing out some of the overarching risk considerations under which TARGET2 and Eurozone central banking now operate:


Paul Krugman:

“Then there’s the lender of last resort issue, which turns out to be broader than even those who knew their Bagehot realized. Credit for focusing on this issue goes to Paul De Grauwe who pointed out that national central banks are potentially crucial lenders of last resort to governments as well as private financial institutions. The British government basically can’t face a “rollover” crisis in which bond buyers refuse to purchase its debt, because the Bank of England can always step in as financier of last resort. The government of Spain, however, can face such a crisis – and there is always the risk that fears of such a crisis, leading to default, could become a self-fulfilling prophecy…

1)     Europe-wide backing of banks. This would involve both some kind of federalized deposit insurance and a willingness to do TARP-type rescues at a European level – that is, if, say, a Spanish bank is in trouble in a way that threatens systemic stability, there should be an injection of capital in return for equity stakes by all European governments, rather than a loan to the Spanish government for the purpose of providing the capital injection. The point is that the bank rescues have to be severed from the question of sovereign solvency.

2)     The ECB as a lender of last resort to governments, in the same way that national central banks already are. Yes, there will be complaints about moral hazard, which will have to be addressed somehow. But it’s now painfully obvious that removing the option of emergency liquidity provision from the central bank just makes the system too vulnerable to self-fulfilling panic.

3)     Finally, a higher inflation target … euro experience strongly suggests that downward nominal wage rigidity is a big issue. This means that “internal devaluation” via deflation is extremely difficult, and likely to fail politically if not economically. But it also means that the burden of adjustment might be substantially less if the overall Eurozone inflation rate were higher, so that Spain and other peripheral nations could restore competitiveness simply by lagging inflation in the core countries.”


Paul De Grauwe:

“It is useful to start by describing the weakness of government bond markets in a monetary union.

Eurozone governments issue debt in a “foreign” currency; i.e. one which they do not control by fiat.

Thus governments cannot guarantee to the bondholders that they will always have the necessary liquidity to pay off the bond at maturity.

This contrasts with “stand-alone” countries that issue sovereign bonds in their own currencies. This feature allows these countries to guarantee that the cash will always be available to pay out the bondholders. This is why a stand-alone country can provide an implicit guarantee—the central bank is a lender of last resort in the government bond market.

The absence of such a guarantee makes the sovereign bond markets in a monetary union prone to liquidity crises and contagion—very much like banking systems were before central banks backstopped them as lenders of last resort…

This loss of confidence can trigger a liquidity crisis in these other markets because there is no buyer of last resort. Without such a backstop, fears can grow until the liquidity problem degenerates into a solvency problem. In the case of bonds, the cycle starts as the loss of confidence increases the interest rates governments must pay to rollover bonds. But the higher interest harms governments’ solvency. Since there is always an interest rate high enough to make any country insolvent, the cycle of fear and rising interest rates may lead to a self-fulfilling default…

In fact, most central banks have been created to solve an endemic problem of instability of financial systems. With their unlimited firing power, central banks are the only institutions capable of stabilising the financial system in times of crisis…

While the ECB’s lender of last resort support in the sovereign bond markets is a necessary feature of the governance of the Eurozone it is not sufficient. In order to prevent future crises in the Eurozone, significant steps towards further political unification will be necessary. Some steps in that direction were taken recently when the European Council decided to strengthen the control on national budgetary processes and on national macroeconomic policies. These decisions, however, are insufficient and more fundamental changes in the governance of the Eurozone are called for. These should be such that the central bank can trust that its lender of last resort responsibilities in the government bond markets will not lead to a never-ending dynamic of debt creation.”


George Soros:

“It is now clear that the main cause of the euro crisis is the member states’ surrender of their right to print money to the European Central Bank. They did not understand just what that surrender entailed – and neither did the European authorities…

At the onset of the crisis, a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But, as the crisis has progressed, the financial system has become increasingly reordered along national lines. This trend has gathered momentum in recent months. The ECB’s long-term refinancing operation enabled Spanish and Italian banks to buy their own countries’ bonds and earn a large spread. Simultaneously, banks gave preference to shedding assets outside their national borders, and risk managers try to match assets and liabilities at home, rather than within the Eurozone as a whole.

If this continued for a few years, a euro breakup would become possible without a meltdown, but it would leave the creditor countries with large claims against debtor countries, which would be difficult to collect. In addition to intergovernmental transfers and guarantees, the Bundesbank’s claims against peripheral countries’ central banks within the Target2 clearing system totaled €644 billion ($804 billion) on April 30, and the amount is growing exponentially, owing to capital flight.

So the crisis keeps growing. Tensions in financial markets have hit new highs. Most telling is that Britain, which retained control of its currency, enjoys the lowest yields in its history, while the risk premium on Spanish bonds is at a new high…

The Eurozone needs a banking union: a European deposit-insurance scheme in order to stem capital flight, a European source for financing bank recapitalization, and Eurozone-wide supervision and regulation. The heavily indebted countries need relief on their financing costs. There are various ways to provide it, but they all require Germany’s active support.

It is clear what is needed: a European fiscal authority that is able and willing to reduce the debt burden of the periphery, as well as a banking union. Debt relief could take various forms other than Eurobonds, and would be conditional on debtors abiding by the fiscal compact. Withdrawing all or part of the relief in case of non-performance would be a powerful protection against moral hazard. It is up to Germany to live up to the leadership responsibilities thrust upon it by its own success.”


Nouriel Roubini:

“As investors reduce their exposure to the euro zone periphery’s sovereigns, banks and corporations, both flow and stock imbalances will need to be financed. The adjustment process will take many years and, until policy credibility is fully restored, capital flight will continue, requiring massive amounts of official finance.

Until recently, such official finance came from fiscal authorities (the European Financial Stability Facility, soon to be the European Stability Mechanism) and the International Monetary Fund. But, increasingly, official financing is coming from the European Central Bank – first with bond purchases, and then with liquidity support to banks and the resulting buildup of balances within the euro zone’s Target2 payment system. With political constraints in Germany and elsewhere preventing further strengthening of fiscally based firewalls, the ECB now plans to provide another round of large-scale financing to Spain and Italy (with more bond purchases).

Thus, Germany and the euro zone core have increasingly outsourced official financing of the euro zone’s distressed members to the ECB. If Italy and Spain are illiquid but solvent, and large-scale financing provides enough time for austerity and economic reforms to restore debt sustainability, competitiveness and growth, the current strategy will work and the euro zone will survive.

In the process, some form of fiscal and banking union may also emerge, together with some progress on political integration…

Of course, a breakup now would be very costly, requiring an international debt conference to restructure the periphery’s debts and the core’s claims…

But politics in the euro zone does not permit consideration of an early breakup. Germany and the ECB are relying on large-scale liquidity to buy time to allow the adjustments necessary to restore growth and debt sustainability.”


Robert Mundell:

“The process of deficit adjustment has to continue, with austerity, structural reform and new investment strategies. Fire engines have to be ready to put out the financial fires that are engulfing Greece, Portugal, Spain, Cyprus and Italy. Money has to come from the ECB, the European Financial Stability Facility, and the International Monetary Fund. Above all, bailouts have to be linked to some transfer of fiscal authority from countries that have become insolvent to the European Commission acting under the auspices, for constitutional correctness, of the European Council…

The euro area suffers from two great defects. One is that there are 17 banking systems in the euro area, and the other is that there are 17 nations with treasury bills and bonds…

The first (reform needed) is the creation of a unified banking system for Europe, already proposed by Mario Draghi, the president of Europe’s central bank.  This would result in substantial increases in efficiency and productivity.

The other reform needed is the creation of Eurobonds and euro bills. The euro area is now splintered into 17 national treasury bills and bonds, which makes them not very satisfactory reserve assets for central banks and asset managers. Euro area bills and bonds would give Europe a potential supply of international capital from central banks that are or will soon be overweight in dollars. The rest of the world would be a willing lender and happy to shift from other assets to those denominated in Euros.

Of course political reform is also needed. I think ultimately the European Commission should become the executive power, and the Council should be turned into an Upper House of Parliament, with national representations that take some account of population size…”


Fred Bergsten:

The European crisis is rooted in a failure of institutional design. The Economic and Monetary Union (EMU) that Europe adopted in the 1990s comprised an extensive, if incomplete, monetary union, anchored by the euro and the European Central Bank (ECB). But it included virtually no economic union: no fiscal union, no banking union, no shared economic governance institutions, and no meaningful coordination of structural economic policies…

Europe now has only two options. It can jettison the monetary union, or it can adopt a complementary economic union. Given how much is at stake, Europe will almost certainly complete the original concept of a comprehensive economic and monetary union.

From its creation in the 1990s, the common currency has lacked the institutions necessary to ensure that financial stability can be restored during times of acute uncertainty and market volatility. The task before the eurozone’s leaders today therefore consists of much more than putting together a financial bailout sufficient to restore market confidence. They must rewrite the eurozone’s rule book and complete the half-built euro house…

The Eurozone was woefully unprepared for the Great Recession. It entered the crisis as a common currency zone flying on just one engine — the ECB — without the kind of unified fiscal entity that traditionally helps countries combat large financial crises. The eurozone’s leaders have had to build from scratch their crisis-fighting capacities and bailout institutions: the European Financial Stability Facility (EFSF) and, subsequently, the European Stability Mechanism. And in the midst of stemming an immediate crisis, they have had to reform the flawed foundational institutions of the area. ..

On the other hand, unlike the Federal Reserve in the United States, the ECB has not had the luxury of responding to the crisis within a fixed set of national institutions. When the financial crisis hit the United States, the Federal Reserve could immediately create trillions of dollars to steady market confidence with the knowledge that it had a federal government that could formulate a longer-term response (although it has not yet fully done so). The ECB cannot act similarly because there is no Eurozone fiscal entity to which it can hand off responsibility…

The central bank cannot directly compel democratically elected leaders to comply with its wishes, but it can refuse to bail their countries out and thereby permit the crisis to pressure them to act…

It is still possible that Greece will abandon the common currency. But this would leave the eurozone stronger, not weaker, because it would be rid of its weakest economy. The eurozone would address a Greek exit by bolstering its financial firewall and speeding the pace of integration, particularly by creating a banking union, in order to counter the resulting risks of contagion. Most important, the total chaos that would descend on Greece would prompt the other debtor countries to do whatever was necessary to avoid suffering the same fate. Europe’s leaders should try to prevent a Greek exit if at all possible, and they will probably do so, but its occurrence would certainly not doom the euro. ..

The eurozone needs to continue working on a continent-wide stimulus program. At the June 2012 EU summit, the EU member states agreed to boost spending by roughly one percent of the region’s GDP. The pending relaxation of deficit-reduction targets in some of the debtor countries will also help them grow, as will the ECB’s recent decision to cut interest rates by 0.25 percent. But the eurozone can do considerably more on all these fronts. The ECB can stimulate the economy through quantitative easing, and European countries can jointly issue so-called project bonds aimed at boosting spending on infrastructure. These bonds would simultaneously accelerate the continent’s progress toward fiscal union.”


Multiple Central Banks Issuing one Currency

Most monetary systems consist of a single central bank as the operational issuer of a single currency. The central bank issues monetary liabilities in the form of reserve balances held by commercial banks, banknotes held by the public, and deposit balances held by the government Treasury operation. Reserve balances are the “medium of exchange” for commercial banks making payments to each other.

If two commercial banks start with a zero reserve balance, the marginal transfer of a deposit liability from one bank to the other results in a negative reserve balance for the payer bank and a positive reserve balance for the payee bank. Intraday overdraft positions are usually permissible, while day end balances are usually required to be non-negative, with central bank lender of last resort (LLR) privileges as required. These loans are repaid when the borrowing bank is able to source new deposits or sell liquid assets, thereby reversing the original net outflow of reserve balances. Banks are thus expected to operate without chronic dependence on central bank LLR facilities. (As examples, this is a straightforward description in the case of the US or Canadian systems. However, the Eurozone is an “overdraft system”, in which national central banks provide commercial banks with funding in regular refinancing operations, which are distinct from the LLR function.)

A single central bank system is “closed” in the sense that there is no “escape” of bank reserve balances from the system, other than through regular customer demand for the conversion of commercial bank deposits to banknotes issued by the central bank. Central banks debit reserve balances held by commercial banks in exchange for the issuance of banknotes, but control the ultimate net reserve result by acquiring new assets to create replacement reserve balances as required by the system. In general, the central bank has fairly tight control over the magnitude of its system reserve balances.

Conversely, a multiple central bank system is “open” in the sense that payments may be made in the same currency from one central bank area to another. A payment made in customer funds between two commercial banks may be mirrored by payment made in central bank funds, not only at the level of the reserve asset accounts of two different commercial banks, but at the level of the reserve liability accounts of two different central banks. Thus, central bank reserve liability positions can change in concert with commercial bank deposit liability positions. This is not the case in a single central bank system, where payments that create such shifts in commercial bank claims to reserve balances have no necessary effect on the total reserve balances issued by their common central bank.


The Eurosystem and TARGET2

The Eurosystem is a network of multiple national central banks operating according to the monetary policy framework of the European Central Bank (ECB). The ECB is the umbrella central bank that executes policy with the assistance of 17 national central banks. This multiplicity is an important feature of Eurozone central banking operations that should not be overlooked. As noted, there is no strategic issuer of the Euro in the sense of the term as defined earlier. And this means that there is a fundamental institutional risk involving the 17 national central banks, relating to the ultimate sustainability of the currency union as a coherent entity.

There is no comparable structural issue for the US Federal Reserve System. This is an area of Hans-Werner Sinn’s paper that might be treated with some scepticism. He draws a rather strong analogy between the two systems, including an analogous policy prescription for resolving intra-Eurozone TARGET2 imbalances. But the Eurosystem structure is inherently more fragile than the Federal Reserve System structure, due to the absence of a Euro-wide institution with responsibility for strategic currency issuance.

“TARGET2” is the “TransEuropean Automated Real-time Gross Settlement Express Transfer System”. This is the payment and clearing system that connects the 17 national central banks of the Euro system to each other, using ECB books as the payment clearing house. It is an interconnecting system for 17 different operational issuers of the Euro. A transfer of funds from one Eurozone national banking system to another affects reserves issued in each banking system.

If a Spanish bank customer transfers Euros from a deposit account with Banco Santander to Deutsche Bank in Germany, Santander loses a deposit liability and Deutsche Bank gains one. The German central bank credits Deutsche Bank with a reserve balance to match its deposit liability. Deutsche Bank then has a nominal balance sheet that is in balance, asset for liability. The German central bank has created its own liability in issuing those reserves to Deutsche Bank. Therefore, it also requires a matching asset (or some matching liability reduction) in order to achieve balance in its own balance sheet, asset for liability. No bank, central or commercial, will accept a banking customer liability without such offset, since that would entail a loss of balance sheet equity.

The Eurosystem provides the required adjustment using TARGET2. The German central bank will offset its reserve liability with a TARGET2 asset as a claim on the ECB. This becomes an ECB liability, which the ECB covers with its own TARGET2 claim on the Spanish central bank. TARGET2 nets all such bilateral claims across all central banks in the Euro system, arriving at an individual net result for each central bank against the system as a whole. The ECB becomes the clearing house for all such original bilateral central bank claims. And the ECB ends up with its own balance sheet profile of TARGET2 assets and liabilities, with the 17 NCBs as counterparties.

While TARGET2 resolves asset-liability matching associated with such payments, it leaves in its wake a revised distribution of bank reserves originally issued by these two different banking systems. In our example, the payer Spanish central bank (Banco de España) will have eliminated reserve balances it previously issued, by debiting the paying commercial bank (Banco Santander), and the payee German central bank (Bundesbank) will have created new reserves it now issues by crediting the payee commercial bank (Deutsche Bank).

Each national central bank may choose to correct its share of the reserve redistribution effect that results from net TARGET2 payments. The Spanish central bank may proceed to replace reserves lost. The German central bank may proceed to withdraw reserves gained. This requires domestic monetary adjustment that is operationally distinct from the international TARGET2 reserve effect. (This type of adjustment is described in a further section below.)

When a customer holding a deposit with a Spanish commercial bank makes a payment to a customer of a German commercial bank, TARGET2 settles this transaction in central bank money (reserve balances). The Spanish commercial bank is debited in its reserve account; the German commercial bank is credited in its reserve account. The commercial banks are made whole with respect to the positions of their customers. However, the central banks still require a further adjustment beyond just the change in their reserve liability positions. If the Spanish central bank were to lose a reserve liability without losing an asset (or gaining a replacement liability) along with it, that would result in an undeserved economic benefit. And if the German central bank were to gain a reserve liability without gaining some asset (or losing some liability) along with it, that would result in an undeserved economic cost.

The potential cost due to an inequitable redistribution of liabilities becomes clear when institutional arrangements require or have the potential to require the payment of interest on reserves. Absent further asset-liability adjustment, the balance sheet for each bank would be changed through the equity position of each bank accordingly. The equity of the Spanish central bank would increase, and the equity of the German central bank would decrease, reflecting an offset to the respective liability change in each case. Such equity changes would be beneficial and detrimental respectively, particularly if institutional arrangements include the potential payment of interest on reserves. Of course, this is not what happens in accounting logic or practice. The Bundesbank in particular is not going to accept an increase in reserve liabilities from the Spanish central bank without some further accounting asset-liability adjustment. That required adjustment is inherent in the TARGET2 clearing process. In fact, the Spanish Central Bank incurs a new liability that replaces the reserve liability it lost. And the German central bank gains an asset to offset its new reserve liability. The new Bundesbank asset is a TARGET2 claim on the ECB. The corresponding Spanish central bank liability is a TARGET2 claim issued to the ECB.


TARGET2 Balances

We noted at the beginning that the Bundesbank has accumulated a TARGET2 net asset position in excess of 700 billion euros. This is a significant portion of the total of all Eurozone positive TARGET2 positions, which currently exceed 1 trillion euros.

Balances for the most significant positions (10 of the national central banks) at July 31, 2012 were (billions of euros):


Germany                   727

Netherlands              130

Luxembourg             124

Finland                       59

Spain                          (423)

Italy                            (280)

Greece                        (105)

Ireland                       (98)

Portugal                     (73)

France                        (3)


The source for this data:

Germany’s surplus position has more than doubled over the past year. Each of Spain’s and Italy’s deficit positions has increased more than ten-fold.

The 2011 ECB annual report includes a description of the TARGET2 system, along with the historic trend of TARGET2 balances for the 17 national central banks up to the end of 2011. (pages 35 to 37)


TARGET2 Balances as Loans of Bank Reserves

The TARGET2 system of assets and liabilities is coherent from an accounting perspective. But what does a TARGET2 asset or liability balance really represent? What is the substantive economic and financial meaning to the accounting entry?

Carrying on with the same example, Germany’s TARGET2 asset may be interpreted as a loan of bank reserves from the German central bank to the ECB, followed by a loan of bank reserves from the ECB to the Spanish central bank, which becomes the latter’s TARGET2 liability. The ECB stands between the two central banks, so that there is a sequence of claims rather than a direct claim of the German central bank on the Spanish central bank.

The term “loan” as applied to a TARGET2 asset has a more restricted meaning than is normally the case. Lending typically incorporates credit risk as part of the loan exposure. In this case, the TARGET2 loan does not include credit risk in a direct sense. The credit risk that might normally apply to a loan of this type is found upstream to the TARGET2 claim, distributed across the asset portfolios of the various Eurosystem central banks. That risk and related losses are for the account of the Eurosystem as a whole, not just for the account of the TARGET2 asset holder. Losses resulting from such risk are distributed across all constituent national central banks, according to the proportionate share of ECB capital they each hold – not according to TARGET2 assets that they hold.

TARGET2 imbalances reflect to a great degree instances of capital flight from areas of the Eurozone that are considered risky to those that are considered relatively safe. Credit risk that resides in Spain and that may ultimately impact the ability of Spain to repay its TARGET2 liability becomes a risk for the shared account of the Eurozone as a whole, by design. In that sense, it does not matter whether the TARGET2 asset is a claim held by Germany, France, or any other Eurozone country. Nor does it matter what the size of a particular TARGET2 asset is. The TARGET2 asset is not a direct measure of credit risk. It is an operational result of liquidity behavior that is in turn an indicator of credit risk that is “upstream” to the TARGET2 asset-liability distribution.

Thus, TARGET2 asset-liability distribution is an indicator of underlying credit risk, but it is not the defined channel for the exposure to the risk or the distribution of subsequent losses. The term “loan” as used here refers to the nominal liquidity and balance sheet characteristic of such an asset and not to any proportionate measure of credit risk that may be associated with such a loan or any proportionate allocation of subsequent losses. This separation of liquidity and credit risk characteristics was an important point of contention in the early responses to Sinn’s original blog post on TARGET2 (see Appendix III links).

Critically however, the intended separation of liquidity and credit risk aspects of TARGET2 balances depends on the continued viability of existing Eurozone risk sharing arrangements. But the defined channel for loss distribution may be at risk itself. In the most disruptive circumstances, the loss channel may involve actual TARGET2 asset exposures more directly. This is a very fundamental qualification to the integrity of the liquidity/credit risk separation, as discussed in a subsequent section.

For simplicity, in our example we’ll temporarily ignore the ECB intermediation function and think of the marginal transaction as a TARGET2 claim of the German central bank on the Spanish central bank. Then, the substance of the claim is as if the German central bank had loaned reserves to the Spanish central bank, with the Spanish central bank initially depositing these borrowed reserves with the German central bank. That allows the German central bank to debit Spain’s reserves and credit them to the payee German commercial bank (Deutsche Bank) in the transaction. So it is as if the Spanish central bank had its own reserve account with the German central bank, acting as a user of German bank reserves, at the same monetary level as the German commercial banks. The clearing of these reserves from the Spanish central bank’s temporary holding of them to the German commercial bank’s claim on them completes the payee end of the original transaction. The loan of reserves from the German central bank to the Spanish central bank becomes the former’s TARGET2 asset and the latter’s TARGET2 liability (with the ECB as the intermediary).

The Spanish central bank’s TARGET2 liability constitutes funding that replaces the reserves it has debited (i.e. destroyed) from the reserve account of the Spanish payer commercial bank (Banco Santander). The TARGET2 liability represents funding, not in the form of reserves, but in the form of borrowed reserves. The generic difference between a reserve liability and a borrowed reserve liability was noted earlier in the case of commercial banks operating within a single central bank system. The analogous distinction applies here to the case of different central banks operating with a multiple-central bank system.

In summary, the Spanish central bank borrows reserves from the German central bank in the form of a preliminary TARGET2 bilateral clearing position, prior to ECB multi-lateral clearing and consolidation of all such transactions. This enables the payee German commercial bank (Deutsche Bank) to be credited with reserves (as a Bundesbank liability) in exchange for the payment it has received from the Spanish commercial bank (Santander). The Spanish central bank debits reserves on its own books from the account of the payer Spanish commercial bank (Banco Santander). Spanish issued reserves decline and are replaced with a Spanish issued TARGET2 liability. German issued reserves increase, along with commercial bank deposit liabilities.

It is worth re-emphasizing that the TARGET2 funding liability of the Spanish central bank does NOT provide it with Spanish central bank reserve liabilities. It provides it with a loan of reserves. The loan of reserves provides substitute funding for the reserves that were lost. This distinction is overlooked by some commentators. Reserves are the medium of exchange for entering and exiting a loan of reserves. Germany lends Spain reserves (via the ECB) so that the Spanish central bank can receive a credit on Bundesbank books, subsequently debited so that the payee German commercial bank can be credited on Bundesbank books. The Bundesbank is the issuer of these reserves originally loaned to the Spanish central bank (via the ECB) for this sequential purpose.

From an operational perspective, the TARGET2 entry is made without the use of an actual Spanish central bank reserve account with the Bundesbank. But preliminary TARGET2 bilateral netting amounts to the same thing. And more generally, the 17 Eurozone NCB operational currency issuers operate as users in each others’ jurisdictions in order to make cross border payments on behalf of their commercial bank customers.

Spain’s TARGET2 liability is in effect a promise to make a future payment in bank reserves – i.e. to create a reserve liability on Spanish books. But it is a promise of indeterminate maturity, an undertaking to issue reserves sometime in the future to settle a payment on behalf of some other Eurozone central bank. Conversely, the Bundesbank TARGET2 asset balance is a claim of indeterminate maturity on reserves issued by other Eurozone central banks. This indeterminate maturity characteristic is an aspect of illiquidity which may be problematic from a Eurozone structural risk perspective, to be described further below.


TARGET2 Balances as “Supra-Reserves”

An alternative view interprets TARGET2 balances held by Eurozone central banks with the ECB as analogous to reserve balances held by commercial banks with their central bank. In this framing, TARGET2 asset balances held by NCBs are net positive settlement balances of a “higher order” form of reserve. TARGET2 liability positions become deficit (borrowed) positions in these higher order reserves. This “higher order” form of reserve might be identified as a special type of reserve held by national central banks with the ECB, or a “supra-reserve”. This concept abstracts from the regular “lower order” case in which commercial banks hold reserves with a single central bank.

Within a single central bank system, a commercial bank payment includes the transfer of a reserve balance from payer to payee commercial bank. If the payer bank starts from a zero reserve position, it incurs a liability to the central bank for reserves owed (overdraft or borrowed reserves). The payee commercial bank will increase its reserve balance. Because the debiting and crediting central bank is the same bank, there is no net change in the central bank’s own reserve liability balance.

Within a multiple central bank system, a cross-border commercial bank payment will include a similar redistribution of reserve balances. The payer commercial bank’s reserve account will be debited by its central bank and the payee’s account credited by its central bank. But debiting and crediting central banks are different in this case. One will lose reserve liability balances; the other will gain them. As described above in the case of the Eurosystem, the payer central bank will incur a TARGET2 liability to offset its reserve liability reduction and the payee central bank will gain a TARGET2 asset to offset its reserve liability increase.

The relationship between the ECB and multiple NCBs in the clearing process for TARGET2 balances is similar to that between a single central bank and its commercial banks in the clearing process for regular reserve balances. A payment between two commercial banks in a single system results in a reserve decrease and a reserve increase. A payment between two central banks in a multiple CB system results in a TARGET2 liability and a TARGET2 asset. Thus, TARGET2 balances in a multiple CB system are functionally analogous to regular reserves in a single CB system. They both provide a clearing and settlement function for their own mode of inter-institutional payment.

The ECB acts as the clearinghouse for initial bilateral entries of TARGET2 balances, which sum to zero for the 17 central banks of the Eurozone. This zero sum characteristic is analogous to a regular commercial bank reserve system with a zero reserve requirement (e.g. Canada). Some banks hold positive balances while others borrow balances. The net reserves of those who have borrowed are zero, individually and collectively, while those with positive balances collectively hold the system excess reserve position that results from the uneven system reserve distribution.


Repayment of TARGET2 Liabilities

Having created a TARGET2 liability, how does the Spanish central bank “repay” it (in our example)?

International capital flows in a single currency are “self-funding” in the sense of accounting identities. For example, suppose the TARGET2 imbalance was created by a euro funds outflow on current account from Spain to Germany. The payment results from a transaction, say, in which a Spanish farmer purchases a tractor from a German manufacturer. (The tractor example is perennial in blogosphere TARGET2 discussion, usually with Ireland or Greece as the purchasing country.) This is a current account transaction in which Spain experiences a marginal (transaction level) deficit. The marginal deficit is offset by a marginal Spanish capital account surplus.

There are two possibilities for the return flow of funds to Spain on capital account. The first is that the reserve distribution effect of the current account outflow is left as a net residual inside the German banking system, with a corresponding TARGET2 asset held by the Bundesbank. The Spanish TARGET2 liability is the corresponding capital account surplus inflow in this case. The other possibility is that the return flow of funds instead consists for example of a German commercial bank making an interbank loan to a Spanish bank. The TARGET2 net asset effect of that flow reverses the reserve effect of the current account transaction, with a net TARGET2 impact of nil, and a net reserve impact of nil.

A TARGET2 liability can only be repaid by reversing the original reserve effect associated with its creation. The reserve debit created by the original funds outflow from Spain created a funding gap in the Spanish central bank balance sheet that was filled by a TARGET2 liability. In order to repay that liability, a new reserve credit must replace it. That requires a net international inflow of euro funds with a net reserve credit effect. Such a reserve credit would have been provided in the case of the German interbank transaction just noted. And such a transaction or something with similar reserve effect could achieve this rebalancing in future.

Examples of flows out of Spain that may not be matched by proactive return flows in this way include the current account tractor example, the failure of German banks to renew interbank loans to Spanish banks, or the movement of customer funds from Spanish bank deposits to German bank deposits. In all three cases, unless there is a return of capital flow from Germany to Spain through some proactive channel, the outflow from Spain will result in net reserve redistribution and a net TARGET2 liability position. And in order to “repay” the resulting TARGET2 liability in the future, Spain must attract those kinds of proactive reversing flows that it has so far failed to attract in the period over which the existing imbalance has developed.

As a matter of operational and accounting logic, it is not possible to produce such a rebalancing effect in Spain (i.e. eliminate a net TARGET2 liability) through domestic monetary operations. For example, the Spanish central bank could create new reserves on its books by acquiring a domestic asset. But that adds both an asset and a liability to its balance sheet, which does nothing to repay the net TARGET2 liability. The central bank may also create new reserves by redeeming bank notes. That eliminates a banknote liability and replaces it with reserves, but that again achieves nothing by way of repaying a TARGET2 liability. Repayment requires a reversing net international funds inflow with another Eurozone national central bank as reserve payment counterparty.

The question arises as to whether a national central bank with a TARGET2 liability position (e.g. Bank of Spain) can do something on its own account to facilitate its “repayment”, or conversely, whether a national central bank with a TARGET2 asset position (e.g. Bundesbank) can do something to liquidate its TARGET2 claim. In order to address this issue, we turn to the analogous commercial bank position as described above.

In a normal environment, commercial banks seek to optimize their holdings of excess reserves to minimal levels. This motivation acknowledges the fact that interest on reserves, if paid at all, tends to be at or below the generally available interest rate on most other types of market assets, with the possible exception of certain short dated risk free assets such as government securities. (The post-2008 financial crisis environment is a special case, with related zero bound and chronic excess reserve conditions that have added to an unusual configuration in the interest rate complex.)

Thus, the excess reserve position of a commercial bank tends to be associated with a short term mismatch in the liquidity position of the rest of its balance sheet. A bank with excess reserves has more funding in effect than it requires for its assets. And a bank with deficient reserves has the opposite position. Banks restore their reserve and balance sheet positions to a more matched liquidity profile by pricing and competing for deposit and asset shares accordingly. In this way, an aberrant residual position in reserves reflecting such a temporary liquidity mismatch is restored to a more normal profile.

Commercial banks conduct proactive wholesale money market operations in order to manage their reserve positions in the context of this dynamically changing residual profile. They will tend to add money market funding to repair temporary shortfalls and add money market assets to use up surpluses.

At the same time, commercial banks respond continuously in their passive role as agents to the normal movement of customer money around the banking system. For example, banks generally have no direct control over the decisions of their customers to move deposit money around the banking system. These movements affect balance sheet profiles and corresponding reserve positions for the various banks. Banks will respond to such reserve imbalances with active money market strategies in order to reorient their asset-liability profiles and reserve positions.

Thus, there are two ways in which a commercial bank’s reserve position can be affected. The first is as agent for customer transactions – e.g. if a customer makes a deposit transfer from one bank to another, reserve assets migrate along with the deposit liability. The second is as a principal operator on its own account – a commercial bank that buys a treasury bill from another bank or from an agent with a deposit account at another bank will cause a transfer of reserves to that bank without affecting its own deposit liabilities. Banks actively use this principal management function in money market operations to manage their overall nominal balance sheet positions, partially in response to the residual reserve effect of its customers’ transactions in aggregate.

A commercial bank reserve position is the residual result of all such activity in both agency and principal modes of banking operations. Banking includes this combination of passivity and activity in reserve management operations.

The post Keynesian description of commercial banking observes that commercial banks do not “lend reserves”. This is correct for the most part, including bank transactions with non-bank counterparties, which comprise the great majority of all bank transactions, at least by net balance sheet effect. One exception is the case of interbank markets that are designed explicitly to accommodate such transactions, as is the case with the US fed funds market for example. And commercial banks also are able to borrow reserves from their central banks by utilizing the lender of last resort (LLR) facility. But banks do not borrow reserves from or lend reserves to non-banks.

Thus, in general, commercial banking operations neither lend nor borrow reserves directly in dealing with non-bank customers. But bank principal role activity does have the potential to affect reserve positions when dealing with counterparties with accounts at competitor banks. Indeed, the core functional role of the reserve balances held by commercial banks with central banks is to be the medium of exchange for making payments with counterparty banks, settling both principal and agent type transactions.

In the context of bank transactions with non-bank counterparties, the intended effect of bank “cash management” using money market operations becomes a matter of attempting to “pull” or “push” reserve balances around the banking system through such activity that has the desired residual reserve effect. This corresponds to intended proactive asset-liability management of bank balance sheet composition. For example, the only thing a commercial bank can do on its own account, in an attempt to force undesired residual reserves out into the system, is to acquire assets or reduce liabilities, with competitor banks as reserve payment counterparties. A commercial bank will typically engage in money market transactions as a short term solution to the problem of deploying its liquidity in a more effective way than holding it as excess reserves.

The financial crisis has changed the nature of these commercial bank reserve management challenges. For example, deployment of excess reserves has become somewhat problematic in the present case of the US banking system, due to the enormous excess system reserve position that the Federal Reserve has created in the wake of the crisis. For example, JP Morgan may find it difficult to “export” its excess reserve position out into the rest of the banking system, given the environment of chronic excess system reserves in the Federal Reserve system and the likelihood that JP Morgan probably has a non-trivial share of these reserves on its own books just as a matter of its natural participation as a share of the total US banking system. JP Morgan also has excess deposits (as reported in conjunction with the recent “Investment Office” trading loss episode). But for rational strategic purposes, the bank may not want to attempt to run down this deposit base as a way of “pushing out” its excess reserves toward other banking counterparties. There is a point at which the persistence of the Federal Reserve in swamping the US banking system with excess reserves results in commercial bank treasurers “crying uncle” on the issue of trying to “get rid” of them. This is the bank treasury version of the so-called “liquidity trap”. JP Morgan almost certainly doesn’t want to discourage or run down its excess customer deposits, since they are in all likelihood viewed as a long term strategic strength of the bank, but if it did, that would be a potential conduit through which to attempt to push its excess reserves out to the rest of the US Banking system. Moreover, beyond the scope of short term money market operations that generally involve low risk forms of asset accumulation, longer term lending is simply not a rational response to excess reserve accumulation, given bank capital management discipline. Bank risk taking in this broader sense is a function of capital, not of reserves. This fact is slowly being absorbed as knowledge by the economics academic community.

Does an analogous “reserve management function” exist in the case of Eurosystem national central banks in managing their TARGET2 positions? Using the “supra-reserve” interpretation of TARGET2 asset balances, the Bundesbank for example might attempt to reduce its own excess position by acquiring other financial claims directly from other Eurozone areas. Its existing TARGET2 asset position would then be a source of credit for the TARGET2 liability accounts of other national central banks.

In practice, it is unlikely that such nonstandard options are available in an effective way for Eurozone central banks. NCBs implement ECB policy within domestic spheres, but not usually across borders into other central bank territories. This is where the analogy with commercial bank reserve management falls short. Commercial banks are expected to resolve their reserve imbalances by dealing with counterparties of all types, including cross bank and cross border counterparties who wish to deal in a currency issued by a single central bank. Conversely, Eurozone NCBs are expected to deal with monetary policy implementation within domestic spheres, but not necessarily with other central banks or commercial banks whose main reserve accounts are held with other central banks. This reduces natural opportunities for central bank initiated rebalancing of TARGET2 positions. Such rebalancing is normally left to the initiative of commercial banks and their customers, which means in effect that there is probably little that a Eurozone NCB will attempt to do as a principal actor in the management of its TARGET2 position.


TARGET2 and Domestic Banking System Reserve Management

A central bank in a single central bank system creates its own reserve liabilities by new lending or acquiring financial assets. When the Federal Reserve buys Treasury bonds or undertakes system repo operations, the payment it makes is settled as a reserve credit to a commercial bank. This is the case as well for a central bank in a multiple central bank system such as the Eurozone.

For example, the Spanish central bank undertakes regular “main refinancing operations” (MROs) on its books as part of Euro system monetary policy implementation, whereby it lends to banks as a regular feature of monetary operations. Such lending creates reserve liabilities for the Spanish central bank, at the margin of such transactions. As with most central banks, the effect of such reserve creation over the longer term is normally to replace reserves that are lost to the system when commercial banks exchange their positions for newly issued banknotes. On a shorter term basis, such intervention is often required for purposes of distributing liquidity and mitigating undesirable interest rate volatility.

Because of the nature of this commercial bank refinancing function, the Eurosystem is sometimes referred to as an “overdraft system” for monetary policy implementation. Reserves are created by regular lending to banks. The Fed by contrast is an “asset based” system, in which such regular lending to commercial banks is avoided by creating a similar reserve effect through the purchase of US Treasury securities already held by banks and primary dealers and others.

Eurozone MRO operations play an important role when the NCBs respond to the net reserve effect associated with TARGET2 balance shifts. An increase in the German TARGET2 asset position is the result of an increase in outstanding central bank reserve liabilities in Germany due to an inflow of funds. An increase in the Spanish TARGET2 liability position is the result of a decrease in outstanding reserve liabilities in Spain due to an international outflow of funds. Generally speaking, each central bank will respond with domestic reserve adjustments in order to rebalance the reserve effect of changes in their TARGET2 balances.

These domestic responses are operationally separate from the international capital flows and TARGET2 reserve effects that logically precede them. Notwithstanding a natural causal association between TARGET2 reserve effects and domestic monetary response, the two types of transactions are distinct.

In our continuing example, the German central bank balance sheet initially expands with an increase in reserve liabilities and a nominally matching TARGET2 asset. The commercial banking system balance sheet may expand due to the addition of deposit liabilities and reserve assets. Or it may remain unchanged in size in the case of a commercial bank principal transaction, such as the maturity of an interbank loan. Other things equal, in either case the German central bank may want to respond by withdrawing the reserves that have just been added to the system by TARGET2 net settlement. It can do this in the way that central banks normally do it, which is to sell or mature existing assets. The act of accepting payment for those maturity or sale transactions will drain reserves. The German central bank in fact has been doing this. Its MRO lending portfolio has declined as its TARGET2 asset position has grown.

This reserve draining response is similar to what the Fed or the Bank of Canada does when faced with a comparable system reserve situation, albeit with a different cause, particularly when such action is advisable in offsetting potentially undesirable interest rate effects (although such a reaction was more predictable in the case of the Fed in the pre-2008 environment when excess reserves were minimal and interest was not paid on reserves).

The German central bank has a variety of options for reserve draining, but the standard one would be to reduce the size of its MRO portfolio. There would be natural demand for this adjustment through reduced commercial bank need for funding, given incremental activity such as the inflow of bank deposits or the maturity of interbank loans that created the reserve increase in the first instance.

In fact, Eurozone central banking operations include a range of reserve creation and elimination methods. These include main refinancing operations (MRO), long term refinancing operations (LRTO) or emergency lending assistance operations (ELA). Any of these may be used to produce a desired marginal reserve impact. In addition, the NCBs offer standing deposit facilities as an option for commercial banks to convert excess reserve balances to interest bearing ones.

Continuing with our example, the creation of reserve balances at the Bundesbank is in excess of what the German commercial banking system needs. Other things equal, it does not need these additional reserves for operational purposes. Accordingly, the Bundesbank will likely to take steps to drain those excess reserves, as would any central bank when reserves exceed the operational requirement for other purposes (again, this is truer in a normal non-quantitative easing crisis environment). From the commercial bank perspective, newly imported deposits or reduced interbank lending permit the unwinding of funding previously provided by central bank refinancing. And from the central bank perspective, the TARGET2 asset replaces refinancing loans previously assumed by domestic banks.

Conversely, the Spanish central bank may want to respond to a situation in which it has lost reserve liability balances by creating new reserves. So it can undertake main refinancing operations (MRO) or long term refinancing operations (LRTO) or emergency lending assistance operations (ELA). Any of these will have the desired incremental reserve effect.

The active management of outstanding reserve balances in each system is important for the central bank policy in interest rate transmission and control. TARGET2 balances are compensated at the MRO rate set by the ECB for monetary control purposes. This ensures equitable interest rate and interest margin effects throughout the system of Eurozone central banks. The German central bank for example would be at a financial disadvantage if it earned no interest on a TARGET2 asset that ends up replacing an MRO asset that did earn interest.

Hans-Werner Sinn has suggested that the German central bank is exhausting its balance sheet capacity for the potential provision of liquidity to German commercial banks, given that TARGET2 asset accumulation is continuing apace, and displacing the residual stock of MRO funding previously supplied to commercial banks. However, several related factors characterize German liquidity conditions. First, the liquidity in question has already been supplied by “imported” funding such as bank deposits that led to net TARGET2 reserve credits in Germany in the first place. Second, the ECB, using the NCBs as operational agents, has committed to provide MRO operations on demand in assuring viable Eurozone liquidity in the midst of the European debt crisis. If solvent commercial banks need liquidity, they get it on a collateralized basis. Third, if necessary, the Bundesbank can broaden the spectrum of its liability management in order to fund an expanding TARGET2 asset portfolio. Should Germany’s TARGET2 asset position expand beyond existing balance sheet dimensions, any excess reserves associated with such expansion can be absorbed by issuing alternative liability forms that assure the continuous implementation of ECB interest rate policy. This might include additional use of the regular deposit facility, as well as the potential issuance of special liabilities that paid interest at the higher MRO refinancing rate, if necessary.


TARGET2 and Eurozone Capital Flow Composition

As the situation stands today, the German central bank has built up a significant, positive TARGET2 balance: 727 billion euros as at July 2012. Several other NCBs have smaller but directionally similar positive balances, and the remaining “periphery” central banks by contrast are in a deficit TARGET2 position. The German central bank TARGET2 asset balance is a reflection of net Eurosystem inflows and bank reserves initially created on German central bank books. This is the result of current and capital account inflows that were not reversed by capital outflows other than those reflected in the TARGET2 residual asset position.

Funds flows between two Eurozone countries can be classified as either current account (e.g. a cross border tractor purchase) or capital account (e.g. a cross border bank deposit transfer). Either type of flow can lead to a TARGET2 imbalance. The residual TARGET2 asset and liability positions record capital flow offsets.

Flows can also be classified as “active” or “passive” according to TARGET2 effect. For example, a current account transaction in which a Spanish farmer buys a tractor from a German manufacturer is an active private sector transaction. It has the redistributive reserve effect described in the example. A capital account transaction in which a Spanish investor moves a deposit from Banco Santander to Deutsche Bank similarly is an active transaction with the same reserve effect.

The German TARGET2 asset that is created (initially) by such flows constitutes a return capital flow in itself. This is a fact of double entry bookkeeping. It can be characterized as a type of default result, given the absence of more proactively initiated return capital flows and the net reserve residue that is left by this form of return flow. The failure of proactive capital flow channels leaves excess bank reserves in Germany (prior to any associated domestic adjustment).

International accounting logic requires that proactive cross border transactions produce a reversing flow of funds on either current or capital account. For example, a current account inflow offset by a current account outflow represents marginal current account balance. The bank reserve effect is net neutral, and there is no effect on TARGET2 balances for either country.

If a current account flow from Spain into Germany is offset by a capital account outflow from Germany, there are two possibilities. If the capital account offset consists of a proactive outflow such as an interbank loan from Germany to Spain, the bank reserve effect will be net neutral, and there is no effect on TARGET2 balances. But if no such proactive capital account outflow is forthcoming, a TARGET2 imbalance will result with a net reserve excess as the residual, passive, default result.

Because of the multiplicity of flows in both directions on both accounts, it is difficult to identify marginal mismatches according to pairs of such transactions. But a TARGET2 imbalance in aggregate represents an accumulation over time of such mismatched proactive and passive flows.

In our example, Spain’s TARGET2 liability is the end result of an initial flow of funds from Spain to Germany on current (or capital) account, with a subsequent failure to attract offsetting capital inflows through non-TARGET2 (i.e. mostly private sector) channels. The “failure” here is defined as an absence of German counterparties who might normally acquire Spanish assets on capital account (in a simplified 2 country case). More generally, beyond this bilateral example, the multilateral TARGET2 imbalances on ECB books reflect the absence of counterparties in TARGET2 surplus nations who might normally acquire financial assets from TARGET2 deficit nations through non-TARGET2 channels.

TARGET2 positions represent cumulative “default” international capital flows in which mostly private sector flows have failed to fill in the gap of required international funding within the Eurozone. As noted, these positions can arise as net offsets to original flows on either current or capital account. The accurate identification of the current/capital account mix of these precipitating flows was one of the contentious issues that arose in the early response to Hans-Werner Sinn’s analysis. Willem Buiter produced analysis pointing to a relatively poor correlation between current account patterns and the buildup of TARGET2 positions. Buiter contended that it was likelier that TARGET2 mismatches across the Eurozone were mostly attributable to precipitating capital flows. In other words, rather than being explained as the result of tractor-type current account payments, the pattern that has emerged has been due mostly transactions such as the repatriation of interbank lending or shifts of wholesale and retail deposits from one jurisdiction to another. This “capital flight” characteristic is an important aspect of Eurozone risk, revisited in the next section.

Here is Buiter’s analysis of the current/capital account issue, short and long versions (other aspects of TARGET2 are also addressed in these essays):


Eurozone Risk Once Again

TARGET2 asset and liability positions reflect mismatches in the cross border flow of funds relative to normal patterns of private sector capital flows. These liquidity imbalances can indicate the reluctance of the domestic private sector (e.g. Germany) to assume foreign credit risk (interbank lending withdrawal), or risk averting behavior initiated by asset holders in other Eurozone jurisdictions who seek to move their assets (e.g. bank deposits) to a safer country (capital flight). This results in TARGET2 asset balances building up in “core” countries such as Germany and TARGET2 liability balances accumulating in the “periphery” countries such as Ireland, Greece, Spain, and Italy.

TARGET2 asset balances are associated with credit risk, but they do not incorporate credit risk. The related credit risk is found by tracking down the balance sheet assets of Eurozone national central banks and their commercial banking systems. For example, German commercial banks may withdraw from interbank lending to Spanish banks due to credit risk on the balance sheets of the latter group. Those banks turn to the Central Bank of Spain for replacement funding. This central bank replacement funding provided by the Bank of Spain absorbs some of the risk exposure that private sector depositors have fled. However, this risk is not for the account of the Spanish central bank alone. It is for the shared account of all 17 Eurozone national banks, according to the formula for such loss sharing by Eurozone members, based on the share of capital each NCB has invested in the ECB. And although TARGET2 asset-liability positions do not necessarily represent specific allocations of credit risk exposure, they do represent a type of intra-Eurozone liquidity imbalance that is attributable to private sector avoidance of risk in those areas whose central banks end up depending on TARGET2 funding.

A TARGET2 asset claim such the 727 billion euro position held by the Bundesbank (July 2012) has no contractual repayment characteristic. Its duration is indefinite. We simply don’t know how long it will be before this position is reversed. The existence of the position reflects a failure of proactive German capital outflows to recycle funding inflows on current or capital account. The German private sector is avoiding periphery risk (e.g. avoidance of interbank lending). And the periphery private sector in some cases is seeking shelter from their own domestic risk (e.g. cross border deposit outflows).

A future reversal of the German TARGET2 asset position would require a reversal of this general pattern of periphery risk avoidance. Given the current distribution of perceived risk across different Eurozone areas, it is unclear how or when such a reversal of capital flows would be forthcoming. A TARGET2 asset is extremely illiquid, due to its unknown duration and the challenge of extinguishing it through reversion to more normal financial flows.

We referred earlier to nonstandard transactions that the German central bank might itself undertake. For example, German TARGET2 asset balances might be “liquidated” in theory by direct exchange for actual reserves (or equivalent deposits) held by the Bundesbank with another Eurozone central bank. But actual reserves wouldn’t be much more useful than the TARGET2 balance (which can be interpreted as a loan of reserves). The German central bank as described earlier has the option in theory of purchasing foreign financial assets, which would create reserve credit for the account of another Eurozone NCB with a corresponding debit to the German TARGET2. Such a strategy would include taking on the credit risk specifically associated with such purchased assets. However, it is unclear how this would benefit Germany, since the result won’t necessarily change the credit risk exposure already existing on peripheral NCB balance sheets, for which the Bundesbank has shared accountability through the Eurosystem loss sharing formula.

It is not just TARGET2 asset holders who face credit risk exposure inherent in the ECB asset mix. All 17 national central banks face this risk, regardless of their individual TARGET2 positions. This is because any such losses are allocated according to the share that each of the 17 Eurozone members has in ECB capital. So the individual burden of credit risk exposure is the same, whether a particular TARGET2 asset is held by Germany or Luxembourg, for example. It is in this sense that there is a clear operational separation between the basic liquidity properties of a TARGET2 asset and the original credit risk exposure that may have been the risk catalyst for the creation of that asset.

But this intended separation of liquidity and credit risk according to Eurosystem design is not the end of the story. This is because in the worst credit risk scenarios, the intended Eurosystem function is itself at risk, meaning that the loss sharing formula is at risk. Germany’s outsized TARGET2 asset position indicates a deteriorating asymmetry of credit risk distribution across the Eurozone. While Germany is not exposed to a risk share that correlates exactly with the relative size of its TARGET2 asset, the size of its TARGET2 asset does indicate growth in the risk that it may be exposed to according to its committed share. So the fact that its TARGET2 asset is growing is not to be ignored.

And with growth in the depth and breadth of aggregate credit risk, there emerges the compounding complication that Germany’s formula share of loss absorption (currently about 27 per cent) may default into a de facto larger share, based on the risk that other Eurozone members may fall into circumstances in which they would not be able to meet their own loss share obligations. One must consider the scenario where larger events overtake intended system design, in which an NCB might end up defaulting on its shared obligation. This is conceivable when considering the possibility of Eurozone structural breakup, where a number of countries with outsized existing TARGET2 liability positions might leave the Eurosystem and fail to meet their liability obligations within it. Not only could the aggregate risk grow larger in such a scenario, but the number of countries capable of sharing in related losses could shrink as well. This suggests a potential negative convexity effect of accelerating aggregate losses combined with decreasing numbers of Eurozone members able to absorb them. Troubled countries may grow in number. And therefore the number of remaining countries capable of absorbing ever greater losses shrinks, and the share of those remaining countries in absorbing the losses grows. And this revised de facto loss distribution could be more concentrated than the original 17 member pro rata capital key formula.

Hans-Werner Sinn in his June 2011 paper described a TARGET2 “stealth bailout” of the periphery by the core. TARGET2 is not the immediate source of risk. But its imbalances reveal a flight from risk in peripheral asset portfolios. The Bank of Spain’s MRO asset positions for example transmit credit risk to the rest of the Eurozone, through the potential for losses and the subsequent activation of the loss sharing formula. The imbalance represented by Spain’s TARGET2 liability and Germany’s TARGET2 asset is symptomatic of German private sector avoidance of that risk. Critics of Sinn implicitly assume that the loss allocation and funding mechanism would function as intended under all circumstances, and that fiscal resolution of losses works according to formulae created under assumptions of continuing Eurosystem viability. This is a non-trivial assumption in the current environment.

In this connection, foreign exchange risk becomes a close relative of credit risk within the profile of comprehensive Eurozone risk. Some analogize the Eurozone as a fixed exchange rate system. The euro in this view is in effect a foreign currency for each of its 17 operational users, fixed by its original booking exchange rate to the predecessor currencies such as the Deutschemark. Structural foreign exchange risk may emerge with contingencies such as the departure of a member nation or broader Eurozone zone break up. Again, some analysts assume the ECB functions smoothly under such conditions, and that all operates according to plan regarding the allocation of risk and loss. But loss sharing formula itself may be at risk in the event of sufficiently disruptive losses.

Such a scenario probably underlies Sinn’s point about stealth bailout. Structural risk in the Euro system may include the possibility of exit and currency conversion for certain peripheral nations. This puts TARGET2 Euro claims of asset holders such as Germany at a new particular risk for a counterparty foreign exchange obligation. It creates an additional risk layer beyond that associated with a single currency. Indeed, some have suggested outcomes as radical as Germany itself exiting and converting to a new Deutschmark.

As already noted above, dismissing the relevance of central bank capital is generally short sighted. Central bank losses matter, despite the natural capacity of central banks to earn seigniorage income. And the popular argument that central bank solvency is not an issue because of built in recapitalization requirements also misses the point. It is mandatory that ECB capital must be replenished to required levels in case of losses. But this expected mechanism does not mitigate the importance of losses. The issue here is the substance of the fiscal connection between central banks and their sponsoring authorities. In the case of the Eurozone, the potential deficit impact is reflected across all 17 Eurozone government budgets in such a loss scenario, with the risk of more concentrated loss absorption than that in extreme outcomes, as described above.



TARGET2 is the payment and clearing system for multiple Eurozone national central banks. Residual TARGET2 assets and liabilities indicate an imbalance in the normal pattern of private sector capital flows between regions. The current configuration of imbalances reflects net private sector flows from “periphery” to “core” countries, offset by the public sector recycling of those flows back to the periphery via the ECB. It is likely that most of this pattern is attributable to risk aversion in capital flows more so than changes in current account patterns.

TARGET2 asset-liability patterns are a characteristic of Eurozone liquidity risk. These positions do not incorporate credit risk directly. However, they do indicate underlying developments in Eurozone credit risk. The capital flows that create the TARGET2 imbalances are in effect seeking shelter from credit and contingent foreign exchange risk in the periphery countries. The liquidity risk in question is managed automatically by the TARGET2 system, in which central banks automatically “plug” the gap created by private sector flow imbalances as a matter of regular clearing and settlement of inter-region payments. To the degree that such liquidity patterns indicate underlying asymmetry in the distribution of Eurozone credit and contingent foreign exchange risk, the continued ability of the system to handle this asymmetry is called into question. In particular, countries where credit risk is concentrated are at some risk in terms of their continuing viability within a currency union. Default and/or exit are not unimaginable. Considering the possibility of such events, the stability of the risk sharing formula for the Eurosystem is also called into question. And in that case, the TARGET2 exposure of a particular nation such as Germany takes on a different and more urgent credit risk characteristic.

Accordingly, the skewed distribution of TARGET2 balances should be an additional incentive to public policy action in order to avoid broader risks to the Eurozone or the exit of some members. Potential action includes a menu of institutional and instrumental elements. It will likely involve additional elements of short term monetary easing combined with longer term fiscal management conditionality. A partial list of existing and potential adjustment mechanisms includes main refinancing operations (MRO), long term refinancing operations (LTRO), the emergency liquidity assistance program (ELA), the securities markets program (SMP), the European Financial Stability Fund (EFSF), the European Stability Mechanism (ESM), additional bond buying by both the ECB and the ESM, bank deposit insurance, bank capitalization, Troika funding co-ordination, Eurobonds, and the charting of the path to ultimate fiscal and political integration. Eurozone risk mutualisation is a characteristic of all of these modalities. And while current TARGET2 related risk and loss potential incorporates a similar element of risk mutualisation by design, there is the potential for not so mutual outcomes in the event of more abrupt change in the Eurozone structure itself.


Appendix I

TARGET2 Accounting


Suppose a customer of Banco Santander in Spain makes a payment in euros by cheque to a customer of Deutsche Bank in Germany. For example, a Spanish farmer purchases a tractor made by a German manufacturer. We assume no other transactions occur. This simplifies the explanation of the clearing process between the two banking systems. The example uses a simple cheque transaction. Examples where the mode of payment is by electronic instruction instead of cheque may differ in the operational order of the clearing sequence, but the logic that matches the final TARGET2 accounting interpretation should be the same as described below.

The banking system handles the payment and the resulting TARGET asset/liability entries as follows, at the conceptual level of accounting logic. The accounting entries are expressed from the perspective of the books of the specific institutional issuer of the relevant money form at each stage of the process:


Spanish Books                       German books


Customer deposits                                                                           credit manufacturer

Commercial bank reserves                                                             credit Deutsche Bank

TARGET2 balances                                                                         credit Bundesbank

TARGET2 balances                         debit CB Spain

Commercial bank reserves             debit Santander

Customer deposits                           debit farmer


Deutsche Bank credits the German tractor manufacturer’s deposit account

The Bundesbank credits Deutsche Bank reserve balances

The ECB credits the Bundesbank (German TARGET2 asset)

The ECB debits the Bank of Spain (Spanish TARGET2 liability)

The Bank of Spain debits Santander reserve balances

Santander debits the Spanish farmer’s deposit account


Extending this example to the actual number of central banks in the Eurozone, the consolidation of all such bilateral claims becomes 17 net positions on the books of the ECB, with corresponding counterparty positions on the books of the NCBs.


As explained earlier, TARGET2 asset balances may be interpreted as loans of bank reserves. Here is a modified matrix to fit that logic. Again, the debit and credit accounting entries are expressed from the perspective of the books of the specific institutional issuer of the relevant money form at each stage of the process. We advise reading the explanation following the matrix in order to follow the accounting logic:


Spanish books           German books


Customer deposits                                                                           credit manufacturer

German bank reserves                                                                    credit Deutsche Bank

Loan of German bank reserves                                                      debit CB Spain

German bank reserves                                                                    credit CB Spain

German bank reserves                                                                    debit CB Spain

Loan of German bank reserves                  credit CB Spain

Spanish bank reserves                                debit Santander

Customer deposits                                       debit farmer


The Spanish farmer pays X euros by cheque to the Germany tractor manufacturer. The manufacturer presents the cheque to Deutsche Bank. Deutsche Bank credits the manufacturer’s deposit account with X euros (top entry).

Deutsche Bank now has a cheque that is an obligation of Santander to pay. Deutsche Bank presents that cheque to the German Central Bank, the Bundesbank, which credits Deutsche Bank’s reserve account with X euros (second down).

At this point, Deutsche Bank has completed its end of the payment and has given credit to the tractor manufacturer and received credit from the Bundesbank. The Deutsche Bank balance sheet is “in order”, in the sense that an increase in deposit liabilities has been matched by an increase in reserve assets.

But the Bundesbank now requires a funding source to cover the credit to Deutsche Bank reserves. If the transaction had been a payment of funds from another German commercial bank, the Bundesbank would have debited its reserve account. But the actual payment has originated from a bank (the Central Bank of Spain) that does not maintain an actual reserve account with the Bundesbank. This requires a different type of transaction.

Under the reserve lending interpretation, the Bundesbank lends the Bank of Spain X euros (third down).

The Bank of Spain “deposits” this amount with the Bundesbank (fourth down).

This deposit is more virtual than real, as the Bank of Spain is only a momentary holder of reserves issued by the Bundesbank. This is because the Bundesbank debits the Bank of Spain account for X euros (fifth down).

The debit to the Bank of Spain account (fifth down) pays for the credit to Deutsche Bank reserve balances (second down). Payment is in effect a transfer of liabilities on the books of the Bundesbank – comparable to the way it would be done in fact if both payment counterparties had been German commercial banks.

For reference again, the last three entries from the matrix (sixth, seventh, eighth down):


Spanish books           German books


Loan of German bank reserves                  credit CB Spain

Spanish bank reserves                                debit Santander

Customer deposits                                       debit farmer


The loan of reserves from the Bundesbank to the Bank of Spain shows up on the latter’s books as a liability (sixth down).

(The loan of reserves becomes intermediated in the full clearing process by the ECB, where it becomes two loans of reserves in sequence – Bundesbank to ECB and ECB to Bank of Spain. These reserve loans are the TARGET2 entries. The Bundesbank TARGET2 asset is a loan of reserves and the Bank of Spain liability is a position in borrowed reserves. Thus, the Bundesbank has a TARGET2 asset claim on the ECB, and the Bank of Spain has a TARGET2 liability issued to the ECB. For simplicity of the reserve lending exposition, this consolidating step is not shown in the matrix above.)

To complete the payment circuit, the Bank of Spain debits the reserve account of the paying bank, Santander (seventh down), and Santander debits its paying customer, the Spanish farmer (eighth down).

Note that the debit to Santander reserves (seventh down) is replaced in terms of funding by the loan of German bank reserves (sixth down).

As noted, extending this 2 bank example to the actual number of central banks in the Eurozone, the consolidation of all such bilateral claims becomes 17 net positions on the books of the ECB, with corresponding counterparty positions on the books of the NCBs.

Finally, as described previously, the Bundesbank’s TARGET2 asset can be interpreted alternatively as a “supra-reserve”, or a special form of money issued only by the ECB. The Bundesbank holds a “TARGET2 money” balance. The Bank of Spain liability in this interpretation is not for regular commercial bank reserves borrowed on the books of another central bank (and cleared through the ECB). It is rather a liability for ECB “TARGET2 money” borrowed from the ECB. Interestingly, the accounting logic for this interpretation better matches the simpler matrix version presented initially above.

Note that either interpretation (loan of reserves or “supra-reserve”) works in terms of accounting logic and coherence. The preferred interpretation is optional in this sense.



Appendix II

The Special Case of Eurozone Banknotes


Suppose that the Spanish farmer pays the German manufacturer with Euro banknotes instead (for comparative purposes only; an example involving tourism would be more realistic).

Here is the payment sequence:

The Bank of Spain issues banknotes to Santander in exchange for a debit to Santander’s reserve account. Santander issues the banknotes to the farmer in exchange for a debit to the latter’s deposit account. The farmer pays the manufacturer with banknotes. The manufacturer redeems the banknotes with Deutsche bank in exchange for credit to a deposit account. Deutsche Bank redeems the banknotes with the Bundesbank in exchange for a credit to its reserve credit.

When the Bundesbank redeems banknotes and issues bank reserves, it switches one liability (banknotes) for another (reserves). That liability switch is economically equivalent to an alternative balance sheet adjustment – the addition of a liability (reserves) and the addition of an asset (banknotes). It amounts to the same thing, because the incremental banknote asset cancels out against a previously issued banknote liability of the same magnitude. This representation is as if the Bundesbank held the redeemed banknotes as an asset instead of cancelling previously issued banknotes for the same amount as a liability.

This revised representation depicts the transaction as if the Bundesbank has a new banknote asset and the Bank of Spain has the corresponding banknote liability (which it issued originally in order to meet the demand for banknotes from the farmer).

These two entries are analogous to the TARGET2 asset held by the Bundesbank and the TARGET2 liability issued by the Bank of Spain in the earlier case where the farmer/manufacturer transaction was conducted using the medium of bank reserves rather than banknotes.

The revised presentation in gross asset and liability form explodes the transaction into its logical gross positions, which are obscured in more standard netting when banknotes are redeemed for bank reserves.

In fact, the ECB uses an accounting adjustment along these lines in tracking the economic effect of the intra-Eurozone flow of banknotes. In our example, the end result in standard accounting terms (including netting) is that the Bank of Spain will have issued more banknotes and the Bundesbank will have issued fewer banknotes (after accounting for the redemption) than would otherwise be the case. This skews the distribution of net banknotes issued when there is a capital flow from one region to another in the form of banknotes. One of the effects of this is that different central banks will earn different shares of aggregate Eurozone seigniorage due to banknote issuance, depending on their share of issuance. In the example, the Bank of Spain will have a greater share than before, and therefore will earn a greater overall share of Eurozone seigniorage due to the interest margin benefit of having issuing more banknotes.

The ECB “normalizes” such effects through the type of accounting modification described. In fact, it recognizes such changes in banknote issuance by charging interest on “excess” banknotes issued and paying interest on the corresponding banknote “assets” that have been redeemed by another central bank. The identification and tracking of such excess liability and asset positions is done by setting normalized levels for shares of banknote issuance for each NCB in the Eurozone, where normal levels are defined according to each NCB’s share of ECB capital investment. The described differential positions are referred to as “banknote adjustment” positions on NCB balance sheets. The general idea is to avoid inequitable distributions of seigniorage benefits that are otherwise attributable to intra-Eurozone banknote capital flows.

(Using this framework, one can construct an interesting, abstract interpretation of banknotes as financial instruments. Banknotes may be seen as economically equivalent to a securitization of bank reserves. In the example, the sequence starts when Santander exchanges its reserve balances for banknotes. The banknotes can be viewed as a securitized loan of reserves to the Bank of Spain. The customer farmer uses this “banknote bond” as the medium of exchange in dealing with the manufacturer. The manufacturer redeems the “bond” in exchange for a deposit with Deutsche Bank. Deutsche Bank redeems the “bond” in exchange for reserve balances with the Bundesbank. And the Bundesbank “holds” the bond as an asset against newly issued reserves (in the sense of the described alternative accounting representation).)

The result is the creation of banknote adjustment assets and liabilities that have the same economic meaning (in the sense described earlier as loans of reserves) as TARGET2 assets and liabilities. TARGET2 clears reserve effects through the banking system directly. Banknote adjustment clears the reserve effect transmitted through the medium of banknotes considered as a type of (retail) bond in bank reserves. Banknotes are in this sense a form of securitized bank reserves, used in mobile form largely by the retail sector.


Here are several references on banknote treatment:


John Whittaker – November 2011

Clemens Jobst, Martin Handig, Robert Holzfeind – 2012





Appendix III

Additional References


Hans-Werner Sinn – June 1, 2011 (post):

Olaf Storbeck – June 6, 2011 (response):

Karl Whelan – June 7, 2011 (response):

Hans-Werner Sinn – June 24, 2011 (major paper):


Peter Garber – 1998

Peter Garber – 2010

Ulrich Bindseil, Philipp König – June 11, 2011

John Whittaker – March 30 2011

Stephan Homburg – 2012

‘RebelEconomist’ – July 6, 2011

Ramanan – November 12, 2011

Alea – May 31, 2012


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4 years 6 months ago

” The US Treasury didn’t spend that money. It bought securities with it. The money wouldn’t have been “spent”, unless and until it was lost. Same point for TARGET2.”

Why are you distinguishing spending in this manner?

Seems to me “buying” securities is spending. It is when I buy securities. Did someone “sell” or get rid of said securities. Did they book a profit from the sale?

4 years 6 months ago

In the case of the government, I’m distinguishing spending as spending on goods and services – something that has an effect on GDP output and income.

Versus a central bank asset swap – or a Treasury asset swap which is what TARP was.

TARP was an exchange of bank equity securities for government debt, in effect. (The government raised the cash by issuing bonds and paid the cash to the banks in return for securities).

An asset swap has no direct or immediate effect on GDP output and income. That’s not to say other things may happen down the road that do reflect GDP output changes. For example, when banks take credit losses, that reflects a reduction in income and corresponding GDP from what otherwise would have been the case without those losses. Similarly if the government had taken direct losses on TARP.

When you buy a security, you are engaging in an asset swap – cash for security. That transaction in itself has no direct or immediate effect on your output or income or anybody else’s. Other things may happen down the road that are related to output or income, beyond the transaction itself.

And people use the term “spend” as they prefer in the vernacular, which is fine. It’s just that it’s helpful in discussion at macroeconomic levels to keep terms to standard and consistent use.

4 years 6 months ago

So are you saying that buying securities from Merrill Lynch does not add to GDP?
Is the financial activity of those firms, trading securities with the public not a GDP affecting activity? It certainly leads to the employment of brokers. As I understand GDP the sale of used cars is not a a factor but other activities that a used car dealer might do do contribute, like selling of parts. Is selling of securities like selling used cars, unless its an IPO or a primary bond auction?

Yes the CB can only do asset swaps but the Treasury does purchases …

4 years 6 months ago

“Is the financial activity of those firms, trading securities with the public not a GDP affecting activity? It certainly leads to the employment of brokers.”


Services of the firms is included in the GDP. But that is different from including the full amount of the transaction (such as executing a buy order via a broker) in the GDP.

To make sense – try to find out the volume of financial transactions happening in the financial markets daily over one year and compare it to the annual GDP.

4 years 6 months ago


See above first paragraph to JKH

4 years 6 months ago

A good reference is SNA2008

6.157 onward

4 years 6 months ago

Yeah okay but I don’t like usage of the phrase “export” in the sense you have used 🙂

Nothing wrong of course but has the potential to lead to ambiguities.

4 years 6 months ago
“So are you saying that buying securities from Merrill Lynch does not add to GDP?” No, not saying that. “Is the financial activity of those firms, trading securities with the public not a GDP affecting activity? It certainly leads to the employment of brokers.” Yes. Agree. “As I understand GDP the sale of used cars is not a factor but other activities that a used car dealer might do contribute, like selling of parts.” Yes. Agree. “Is selling of securities like selling used cars, unless it’s an IPO or a primary bond auction?” No. All three are like selling used cars in that sense. The money raised from an IPO conceivably adds to GDP if it is spent on GDP expanding activities. That’s why I used the phrase “down the road”. The transaction itself doesn’t add to GDP other than the income payments to the service workers associated with it, etc. But that’s a small margin around and outside the principal value of the transaction itself. The principal value of the transaction has nothing directly to do with GDP, just as the principal value of a used car sale has nothing directly to do with GDP. The selling activity around that does though. There’s a difference between the selling activity and the principal value of the transaction. The money raised at a primary bond auction conceivably adds to GDP if the government spends it on GDP expanding activities (again “down the road”). There’s a wrinkle there in the sense that the money might be spent on transfer payments, which are not directly GDP expanding, but whose downstream expenditure may be GDP expanding.’ The principal value of the bonds is acquired through an asset swap (bank deposits for bonds, usually) and that is not part of GDP or GDP expenditures or… Read more »
4 years 6 months ago
Thanks for the extensive answer JKH I certainly never thought that all financial transactions were part of GDP seeing as there are many times more trillions of financial transactions a year relative to GDP but obviously they have some affect. Hell our biggest export for the mid 2000s was mortgage debt wasnt it ? : ) “I’m trying to point to the distinction between financial transactions and the use of the money that gets reshuffled subsequently because of the financial transactions.” Got it. There is definitely a distinction I can appreciate there. Sounds difficult to measure though. “You can never attach GDP creating activity directly to financial transactions unless it results in the kinds of income payments we just discussed – things like commissions or salaries of the service workers, similar to used car dealer salaries. But there are “down the road” effects obviously when people borrow money to do stuff with it.” Got it . “It’s arguable that Treasury shouldn’t be doing asset swaps as a matter of course, but in fact they did do an asset swap with TARP. As I described, it was a swap of cash for bank equity securities in the first order of things and a swap of government bonds for bank equity securities in the second order (Treasury finances the raising of cash through bonds, at the margin). The argument for putting this on Treasury’s balance sheet rather than the Fed’s is that it is equity security risk, which the Fed is probably not authorized to assume, and certainly doesn’t in the normal course. It’s not suitable for monetary operations – unless the Fed were to go to “end of days’ quantitative easing mode.” I assume this is because the bank securities were actually tied to a physical structure in many instances? “Note… Read more »
4 years 6 months ago
“I assume this is because the bank securities were actually tied to a physical structure in many instances?” Interesting question, but I don’t think so: The purpose of equity capital is to absorb the risk of losses as well as any actual losses that may ensue. So, the first order swap of cash for equity securities leaves Treasury holding equity securities instead of cash. So all of a sudden, Treasury holds the riskiest type of financial asset (stock) instead of the most risk free type of financial asset (balances at the central bank). The equity securities issued by the banking system have virtually nothing to do with physical investment in this case, at least not directly. What they did was enable the banking system not to collapse in connection with an immediate market perception of insolvency (in some cases), which is basically the perception of the inability to absorb losses, which is basically a manifestation of the perception of inadequate equity capital. (Mosler’s proposal was that Treasury should have instituted “regulatory forbearance”, which is a suspension of capital rules, rather than an equity security restructuring for the banks. I very strongly disagree, but that’s too long a discussion for here.) The reason for this equity investment to be on Treasury books is that it is pure equity risk. It could be roughly analogized to merchant banking investment instead of money market lending. The central bank arguably engages in the latter. Also, the central bank is generally restricted to collateralized lending, with the exception of outright Treasury and agency purchases. But all these classifications of distinction are more rough than precise. It is simply too much risk for the central bank to take on in the context of the existing institutional configuration. “If instead they paid new car prices for those… Read more »
4 years 6 months ago

Thanks again for the detailed response. I’m fighting up a few (quite a few)weight classes so I appreciate you dignifying my queries with such detail. Some of the details for me are a little numbing ( I suppose you might feel likewise if we were discussing something more in my area) but one thing that I see you saying again and again, and this might just be the difference between a finance guy and an average Joe just using dollars to survive and try to have fun, is risk management.

Seems like, to all the people who are managing money, money is simply a contract which is about risk. I knew this on a certain level to be true already. Money is certainly, at least in modern economies, just an institutional arrangement that tries to unify a groups definition of value and attach a number to it, but this particular understanding really drives home,at least for me, why enforcement of contracts AND existence of contracts for EVERYTHING is not just desirable but necessary. Nothing in our life, IF we are to continue in this current system, should be free from a contractual obligation. That especially includes employment and its compensation since citizens borrowing from banks need some assuredness of how much they know they can pay back and for how long, otherwise the only ones with the ultimate risk are those responsible for actually doing the work of producing the stuff we use.

Nefarious activity always migrates to the level of the weakest contractual enforcement.

4 years 6 months ago

“One thing that I see you saying again and again … is risk management.”

You’ve “outed” me.

Yes, that’s my personal top-down view of the whole thing. The financial crisis was a failure of risk management at banking (commercial, investment, and shadow) and supervisory levels. But it was a very interesting failure – because it stemmed from overzealous intellectual faith in the very short sighted quantitative approach of “value at risk” and its derivative forms, which were originally developed and billed as “advances” in risk management techniques. These are value added techniques in their place, but their place is relatively small, and risk management is more than technique.

As another small example, IMO monetarism fails at risk analysis. Interesting that Woodford develops that theme indirectly in his zero bound paper, in parallel with his “endorsement” of NGDP targeting. One or two of the market monetarists noticed that combination (especially Nick Rowe).

Interesting emphasis on contracts; thanks

4 years 6 months ago

Stealth bailout? I thought one had to very careful to distinguish between lending and spending?

And if his great revelation is that a common currency implies some sort of shared liability, I’d say it’s hard to point out anything more obvious.

Snark aside, I seriously wonder what alternative he has in mind? The differences between a currency union à la EMU and a bunch of countries that decide to peg their currencies to some common denominator are manifold. Quite apart from the fact that the prior has proven historically to be an unstable arrangement, any such system can only function with the help of all other sovereign tools with which to manage a currency, including capital controls and at least the last option of unilateral depreciation. None of these options existed within the EMU and the absolute minimum compensation for such a lack of sovereignty is a via an automatic clearing system. A world with neither one nor the other is pure fantasy – complete Unsinn, so to speak. I also doubt whether it matters for overall risk distribution within a union whether reserve balances are allocated vertically via the ECB or whether lending goes on horizontally between financial institutions. It’s only that the prior shows up in a nice crisp number, that can be nicely packaged for nationalist political ends, whereas the latter benefits from the aura of self-equilibrating free market obscurity. Intuitively it seems like the effect would be the same in the event of a break-up.

4 years 6 months ago
“Stealth Bailout … careful to distinguish between lending and spending” That’s a good generic point. It applies to TARP as well. The US Treasury didn’t spend that money. It bought securities with it. The money wouldn’t have been “spent”, unless and until it was lost. Same point for TARGET2. I qualified the bailout language somewhat in my interpretation, but maybe not enough. “I seriously wonder what alternative he has in mind?” If you look at Sinn’s post and paper, he proposes annual settlement of TARGET2 imbalances in some form. So Germany would be “paid off” for its TARGET2 claim each year, with some other sort of financial claim(s). This was a big point of argument in the original debate (see Whelan link). Sinn compared this annual settlement to Fed Reserve settlement of intra-district positions. That’s a highly questionable comparison for a few reasons. I mentioned this aspect at a general level in the essay. “Intuitively it seems like the effect would be the same” There are some differences. Both the aggregate amount of losses absorbed by Germany and the distribution between public and private sectors would be different. The German banks benefit when they call in their interbank loans to the periphery, since they shed that credit risk. NCBs then provide the replacement funding to the periphery banks, and the ECB provides TARGET2 funding to the periphery NCBs. So the same original credit risk becomes part of the risk profile faced ultimately by the Eurosystem as a whole. That transfer of risk becomes an exposure for the Bundesbank according to its share. So what was an aggregate exposure for the German banking system becomes a shared exposure for the Bundesbank (according to its 27 per cent share of the Eurosystem) and therefore a corresponding exposure for the German Treasury, and… Read more »
4 years 6 months ago

Thanks for the reply. I do admit i didn’t read the original post by Sinn. Not a big fan of his, to say the least.

Fed Up
4 years 6 months ago

First, any way to say all that in fewer words?

Next, aren’t central banks just hedge funds with little capital and supposedly (with emphasis) very low risk assets?

Lastly, is it possible to have a “central bank” that has only liabilities and intangible assets (no tangible assets and no capital)?

Dunce Cap Aficionado
4 years 6 months ago

JKH, verbosity be thy name.

Looking forward to finding some time to absord this.