TARGET2 Balances from a German Perspective

TARGET2 Balances from a German Perspective

KUTSCHEID Markus, (GER)

July 2012

ABSTRACT

In 1999, TARGET (T rans-European A utomated R eal-time G ross Settlement E xpress T ransfer System) was introduced as a payment system for the EURO. In 2007, it was replaced by TARGET2. TARGET2 serves the daily transfer of money between the participating banks. With the collapse of interbank transactions in Europe as a result of the financial crisis, the European System of Central Banks (ESCB) was forced to take action in order to assure the necessary liquidity for capital outflows and the purchases of goods between European countries. The requirements for collateral for granting bank loans have been successively reduced. This has led to a situation where the EURO system has replaced the interbank market to a large extent. The majority of cross-border financing requirements of the banks are no longer satisfied by loans made between the commercial banks of the participating countries themselves; the commercial banks in the importing countries refinance themselves through their national central banks and the cross-border payments are handled by the European Central Bank (ECB) and thus by the TARGET2 system. The national central bank of the exporting country then receives a claim against the ECB and the national central bank of the importing country receives a corresponding liability. The Deutsche Bundesbank (German Central Bank) in recent years has accumulated in this way TARGET2 claims totalling around EUR 700 billion. This article shows that these claims are debts of the European periphery countries vis-à-vis Germany, that the TARGET2 system contributes to a misallocation of productive resources, that it fosters the accumulation of debt by the European periphery countries, and that a lack of collateral deepens the European balance of payments crisis. It is shown that the TARGET2 balances are representing considerable risks for Germany.

KEY WORDS

Deutsche Bundesbank (German Central Bank), Emergency Liquidity Assistance (ELA), European Central Bank (ECB), European System of Central Banks (ESCB), GIPS Countries, GNLF Countries, Interbank Market, R eal T ime G ross S ettlement (RTGS), TARGET2 Balances, T rans-European A utomated R eal-time G ross Settlement E xpress T ransfer System (TARGET).

INTRODUCTION

In order to overcome the previously existing boundaries between the various payment systems in the European Union (EU), the TARGET system was introduced in 1999 under the auspices of the European Monetary Institute. TARGET stands for T rans-European A utomated R eal-time G ross Settlement E xpress T ransfer System. It is the real-time gross settlement system for the EURO.

TARGET was composed of 15 national real-time gross settlement systems and the payment mechanism (RTGS System - R eal T ime G ross S ettlement) of the European Central Bank (E uropean P ayment M echanism - EPM), which were linked to each other so that a unified platform for processing cross-border payments was established. TARGET was developed to fulfil the following three main requirements:

1. To provide a safe and reliable mechanism for processing cross-border payments on an RTGS basis;
2. To increase the efficiency of cross-border payments within the EU;
3. To supply an instrument for implementing the monetary policy of the E uropean S ystem of C entral B anks - ESCB).^[1]

Because of its decentralized structure and the different national characteristics, the TARGET system quickly reached its limits.

The technological infrastructures of the individual payment systems of the national central banks in the EURO zone and the European Central Bank were therefore brought together with the introduction of the second generation of the TARGET system (TARGET2) beginning on 19th November 2007.^[2] The gross clearing system serves the daily transfer of funds between the affiliated banks. "Gross" means in this context that each individual payment is immediately transferred from the central bank reserves of the instructing bank. The ECB stands in the middle as clearing agent.

Through TARGET2, cross-border EURO transfers in the interbank domain are processed and booked within seconds through national central banks via ECB. According to the Deutsche Bundesbank, a daily average of 350,000 payments with a value of EUR 2,500 million are processed via TARGET2.

The balances of the central banks of the EURO zone and the European Central Bank represent a portion of net capital movements transacted between the system members over the EURO system. They are called TARGET2-balances. The balances of the EURO central banks may be positive or negative. This means that the central bank of a EURO country can have claims or liabilities vis-à-vis the ECB. Central banks outside the EURO system, which participate in the TARGET2 system and all commercial banks, must have at least TARGET2 balances of zero at the end of the day.

The article shows how these balances have developed. It examines the reasons for these developments and what impact they have on the EURO system participating countries and in particular the Federal Republic of Germany.

MATERIAL AND METHODS

Literature research, case studies.

RESULTS AND DISCUSSION

The Collapse of Private Funding Sources

In the period before the financial crisis (before 2007), the balances of the national central banks in the EURO zone were largely offsetting. Commercial banks received liquidity from national central banks essentially for liquidity reserves and the circulating cash. Cross-border financing requirements of banks where generally met by private capital flows, that is, for example, by loans, which the commercial banks of participating countries gave to each other.^[3] With the outbreak of financial crisis and the resulting sovereign debt crisis, the confidence waned in the public finances and the banking systems of some countries such as Greece, Italy, Portugal and Spain (by some economists called GIPS countries or peripheral countries, they have negative TARGET2 balances, in contrast to the core countries, or GNLF countries, which maintain positive TARGET2 balances, i.e. Germany, Netherlands, Luxembourg and Finland). Private refinancing sources were less abundant, very expensive and eventually dried up almost completely. This means, for example, that German commercial banks were no longer willing to refinance Greek commercial banks through the interbank market at reasonable interest rates.

Emergency Liquidity Assistance

In the absence of sufficient private funding sources, the EURO system, and thus the European Central Bank (ECB), has increasingly had to take over the funding of liquidity needs and capital outflows from purchases of goods. While the refinancing by the ECB in the previous example done for the German commercial bank, now the Greek commercial bank itself is being refinanced. This has been made easily possible because the system has gradually expanded its liquidity provision since the outbreak of the financial crisis. The program for short-term emergency loans "Emergency Liquidity Assistance", in short ELA, was created for the national central banks of the EURO system as a way to grant liquidity support to solvent but temporarily illiquid banks against collateral. The decision on such assistance is at the discretion of each national central bank, which also bears the risks and costs of the transaction. So they, and not the European Central Bank, fulfil the function of the lender of last resort in the EURO system.

Dramatic Increase in the TARGET Balances

The almost unlimited provision of liquidity associated with ELA, lent at low interest rates and for significantly longer maturities, has led to the situation that not only the minimum necessary central bank money is provided, but rather that the EURO system has replaced to a great extent the interbank market and other cross-border capital flows. The total volume of refinancing operations has increased from around EUR 460 billion immediately before the financial crisis to over EUR 1,100 billion by March 2012 with the average maturity increasing from a few weeks to nearly 3 years. Through the continued net outflow of liquidity from the peripheral countries, TARGET2 debt has soared to an amount of EUR 750 billion.^[4]

illustration not visible in this excerpt

Figure 1 TARGET2 Balances in the Euro System

Source: DEUTSCHE BUNDESBANK: Newsletter Zahlungsverkehr und Wertpapierentwick-lung, 2012, 9th edition, March 2012, p. 2.

Figure 1 shows the development of the TARGET2 balances in the EURO system from 2009 to 2011. Alone in 2011, the claims of the Deutsche Bundesbank against the ECB on the settlement of cross-border transactions in TARGET2 increased from EUR 326 billion to EUR 463 billion. On 30th Jun 2012, the TARGET2 claims of the Bundesbank amounted to almost EUR 730 billion (net positions from TARGET2 balances according to the Deutsche Bundesbank). In turn, the ECB itself has claims against other national central banks of the EURO system.^[5] For example, the claims of the ECB against the Bank of Greece at the end of April 2012 amounted to about EUR 98 billion.

The former president of the Bundesbank, Helmut Schlesinger (president from 1991 to 1993), noticed at the beginning of 2011 that the claims against other national central banks had risen in the balance sheet of the Deutsche Bundesbank in comparison to the time before the EURO crisis nearly twenty times. As Schlesinger inquired among his former colleagues what the reason for this was, he received no satisfactory answer. He then turned to Hans Werner Sinn, an economist and president of the ifo Institute for Economic Research in Munich. The investigation led Hans-Werner Sinn to the conclusion, that the balance sheets of national central banks hide risks in the billions of EURO. He assumes that the Bundesbank, in extreme cases, could be left holding worthless claims of more than half a trillion EURO. In his view, the Bundesbank had accumulated as of the end of 2011 debt of this amount against the GIPS countries under the TARGET2 system.^[6]

Public Discussion on the TARGET Balances

Sinn´s publications on this topic in different media and his lecture on "Is there Still Hope for the EURO (ist der Euro noch zu retten)" at the Maximilians-University Munich gave the impetus for the TARGET2 debate, initially primarily in academic circles. In the meantime, however, the discussion has reached a wider audience.

In essence (and possibly incomplete) the discussion centres around the following hypotheses, which are examined in this article:

1. The current account deficit of the GIPS States is credited on the TARGET2 system. There is a credit transfer from Germany to the GIPS countries. The negative TARGET2 balances reflect these credits. The German Bundesbank has no choice. It is forced to make these loans to the GIPS States.
2. The automated funding through TARGET2 led the GIPS countries to live beyond their means.
3. The large claims of the Bundesbank against the EURO system pose significant risks for Germany.^[7]

Already on 22nd May 2011, Carl-Ludwig Thiele, member of the board of the Deutsche Bundesbank and responsible for cash management, payment and settlement systems, stated: The sums are high. But the TARGET2 balance is not an independent risk for the Bundesbank. The risk for both a commercial bank as well as for a national central bank always lies in the loan book, and not in how the customer uses the proceeds of the granted loans.^[8]

According to a newspaper report in February 2012, Bundesbank president Jens Weidmann warned ECB president Mario Draghi of growing risks in the EURO system. As the "Frankfurter Allgemeine Zeitung" reported beforehand, citing a letter from Weidmann to Draghi, the Bundesbank president refers to the growing claims of the Deutsche Bundesbank resulting from the TARGET payment system. These claims had reached a value of more than EUR 500 billion. In his letter, he warns of a loss of reputation and stimulated a debate on the TARGET risks. Should a part of the debt claims fail, the national central banks of the EURO system could possibly not be in a position to bear the losses and the EURO countries would possibly not be able cover the claims. Accordingly, Weidmann suggested a collateralisation of the claims of the ECB against the financially weak national central banks of the EURO system.

In March 2012, Jens Weidmann expressed himself in a more deescalating way in the Frankfurter Allgemeine Zeitung. He wrote: For me, the TARGET2 claims of the Bundesbank are also not an independent risk because I consider a breakup of the monetary union simply absurd.^[9] Weidmann states that in the case of a withdrawal from the EURO area of a country with negative balances on TARGET2, all the remaining banks must bear the losses. That same month, the German government entered into the TARGET2 debate. In a reply to a request from the CSU-Representative Peter Gauweiler, the ministry of finance stated that target loans do not exist. The claims and liabilities are rather merely clearing items within the European Central Bank used to bring the balance sheet back in balance.^[10]

Without mentioning Hans-Werner Sinn by name, the European Central Bank in its October 2011 report contradicts the central thesis of the ifo chief in its entirety.

Model for Testing the Hypotheses

illustration not visible in this excerpt

Figure 2 How the TARGET2 Balances Arise

Source: Inputs by QUAAS, Georg, Ein kritisches Resümee des Target2-Problems, 2011, Wirtschafts-dienst - Zeitschrift für Wirtschaftspolitik, 91, issue 2011-12-1212, p. 1-3; FISCHER, Malte, KUNZ, Anne: Deutschland in der Euro-Falle, 2012, WirtschaftsWoche Online, 2012-02-06, http://www.wiwo.de, graphics by the author.

Figure 2 shows in a fictitious example how the TARGET2 balances arise:

A beverage producer in Greece decides to buy a filling machine with a value of EUR 100,000 from a German supplier.

1. First, the beverage producer takes a loan from its commercial bank in Greece (house bank). He deposits collateral, which must meet the standards of his bank, because they bear the risk (e.g. a mortgage or a government bond). The credit is posted in its entirety to the beverage producer´s account at the commercial bank.
2. The supplier will now export the ordered filling machine from Germany to Greece.
3. After the arrival of the machine, the beverage producer instructs his commercial bank to pay EUR 100,000 to Germany to the commercial bank account of the supplier. The transfer results in a debiting of the account of the beverage producer with EUR 100,000.
4. After the Greek commercial bank has received the transfer order, it instructs the Greek national central bank to transfer the money within the European System of Central Banks. The prerequisite is that the commercial bank has an account with sufficient central bank money to cover the debit at the national central bank.
5. The Greek commercial bank has purchased in advance central bank money against collateral at the national central bank from which it now pays EUR 100,000 to its account at the national central bank. This creates a credit balance that can be charged through the international transfer. After the transfer, the credit balance of the Greek commercial bank no longer exists at the national central bank.
6. Through the deposit at the national central bank, EUR 100,000 are withdrawn from circulation. The money supply in Greece is reduced by this amount.
7. Due to the issue of central bank money, the ability of the Greek commercial bank to lend is reduced. To refresh its stock of central bank money, the Greek commercial bank may now pass the collateral that it had originally received from the beverage producer to the Greek national central bank and receive fresh central bank money in the amount of EUR 100,000.
8. The Greek national central bank is now charged internally at the ECB with a debt of EUR 100,000 (enters the TARGET2 system as a liability).
9. This liability is offset by a claim of the German national central bank against the ECB of EUR 100,000 (enters the TARGET2 system as a claim).
10. The German national central bank credits EUR 100,000 to the account of the German commercial bank at the German national central bank. Now the German national central bank can give central bank money, for example in the form of newly printed banknotes, to the German commercial bank. After the transfer of EUR 100,000 of central bank money to the commercial bank, their credit at the German national central bank will be deleted. The money supply in Germany has increased by EUR 100,000 as a result of money creation by the German national central bank.
11. The German commercial bank will, in the next step, credit the EUR 100,000 it has received from the national central bank to the filling machine supplier and pay it out, if requested.^[11]

[...]

^[1] see: Europäische Zentralbank 1998: TARGET, p. 4

^[2] see: Europäische Union 2007, p. 1

^[3] see: Weidmann 2012, p. 3

^[4] see: Weidmann 2012, p. 3f.

^[5] Deutsche Bundesbank 2012, Newsletter, p. 2

^[6] see: Fischer 2012, p 1f.

^[7] see: Quaas 2011, p. 1f.; Sinn 2011; Sinn 2012, p. 1

^[8] see: Burgold, Voll 2012, p. 12

^[9] see: Weidmann 2012, p. 5

^[10] see: Rickens 2012, p 1

^[11] see: Quaas 2011, p. 2-4