Target II and the supposed Stealth ECB Bail Out

What’s at stake

There has been a very heated debated this week on the blogosphere about the undercover role that the ECB could be playing in the current European bail-outs. Indeed, some argue that the ECB has engaged through its payment system in an untold bail out. Monetary Policy experts argue that this is a misinterpretation of the functioning of the eurosytem. This however raises a number of question about the role that the ECB plays in the support to member states, the financial system and the risks it takes in doing so.

Hans-Werner Sinn from the IFO institute by whom the controversy started argues that the ECB has played a much bigger role in supporting peripheral countries than officially acknowledged through its Target 2 accounts which essentially reflect the position of national central bank against the eurosystem. For example, the Bundesbank’s Target claims ballooned from €5 billion in 2006 to €323 billion by March 2011. The counterpart to these claims were the GIPS’ liabilities, which had grown to about €340 billion by the end of last year, this allowed to fund current account deficits of this magnitude it also restricted lending in Germany. The ECB’s policy was not inflationary, because the aggregate stock of central-bank money in the eurozone was unaffected. But, as GIPS’ central-bank lending came at the expense of central-bank lending within the eurozone’s exporting countries, the policy amounted to a forced capital export from these countries to the GIPS.

Martin Wolf, Paul Krugman and Felix Salmon contributed to spread this argument across the waves and the web. The main argument is that the ECB plays a quasi fiscal role of sorts by allowing its target II system to provide a generous helping hand to countries in difficulty. Huge asset and liability positions have now emerged among the national central banks, with the Bundesbank the dominant creditor (see chart). Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.

Karl Whelan violently rejects those arguments and explains that the Target II balances are the products of deleveraging from Banks in creditor countries which have interrupted lending to peripheral banks which is effectively being replaced by ECB lending through the ECB market operations. The risk taken by the Bundesbank in this operation is not a risk on the peripheral countries through the Target II balances but a risk on the ECB through refinancing operations. Whelan also denies that this affects the amount of base money available to creditor countries’ banks especially because the ECB still provides liquidity at a fixed rate and on a full allotment basis. He finally rejects the idea to cap or settle the Target II balances each year (which would have equated to Ireland handing over a full year of GDP to the ECB in 2010) and rejects the analogy with the Federal Reserve Fedwire payment system.

Olaf Storbeck also rebutes this argument by quoting examples from the Target II annual report and the ECB monthly bulletin that detail the actual functioning of the payment system. He explains along with the Bundesbank that one reason why those claims have risen is due to the fact that German banks are hoarding money for precautionary motives and the Bundesbank effectively substitutes itself to what would otherwise be standard interbank activities.

A series of letter to the FT have also been sent to straighten the facts, one from Lucrezia Reichlin from the London Business School, another from Guntram Wolff, and still unpublished one by Gustav Horn and Fabian Linder from the macroeconomic research institute.

Karl Whelan in a second post moves to make the counter argument and shows that Germanyis actually a beneficiary of the Target II balances. Indeed, ECB operations allowed the German banks to turn risky loans to Irish banks into completely safe deposits with the Bundesbank (the Bundesbank’s Target 2 balances are the mirror image of these deposits). Now, of course, Germany will share 28% of the credit risk stemming from these operations. But the rest of the Eurosystem has taken on 72% of the risk of operations that have hugely benefited German banks and the taxpayers that would have had to recapitalise them in the absence of the ECB operations.

The Bundesbank before this controversy erupted release a statement detailing the functioning of the target II balances. It explains that the size and distribution of the TARGET2 balances across the Eurosystem central banks are,  however, irrelevant to their risk exposure from the provision of funds by the Eurosystem: TARGET2 balances do not pose specific risks to individual central banks. In addition, as the German banking system became increasingly stable, there was an inflow of liquidity from the rest of the euro area, allowing German banks to reduce their refinancing operations with the Bundesbank. Conversely, since then banks domiciled in a number of other euro-area countries have been receiving larger amounts of central bank money through the Eurosystem. These changes in the structure of refinancing operations are a major reason for the growing volume of TARGET2 claims on the part of the Bundesbank. However, this does not create any new specific risk not already contained in monetary policy refinancing operations, with respect to which, no matter which national central bank executes the Eurosystem refinancing operation, the risks are always borne by the Eurosystem as a whole.

Matt Persson from Open Europe argues that such confusion is turning the ECB into a bad bank. He quotes Lorenzo Bini Smaghi who in a long interview to the FT argued that the ECB wasn’t taking as much as risk as is often assumed with its securities market program. He explained that the total Securities Market Programme is around €77bn. The ECB’s share is 8 per cent, which is a bit more than €6bn. It’s less than the risk provision. Hence, the risk would be mainly on the central bank of the country that defaulted because the banks would be defaulting there. This argument hasn’t been formally clarified and Nout Wellink argues that a greek default would cost the Dutch central bank some 4bn euros. One reason that even the ECB's leaders seem unable to give straight answers on these matters is that the prospect of such potential losses appears to have been considered too unthinkable to plan for—much like the euro-zone bailouts themselves.

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