Notes from the Vault
The TARGET2 Settlement System in the Eurozone
Gerald P. Dwyer
The payment system in the eurozone, or TARGET2, has generated a substantial amount of press lately, with various claims flying, such as one article stating that the eurozone central bank system is "massively imbalanced." The article in the German publication Spiegel Online (Kaiser 2012) also suggested that TARGET2 "sounds about as exciting as the title of an accounting seminar." The term "massively unbalanced" applied to eurozone central banking does sound rather ominous, though.1
What's the fuss about?
The fuss concerns balances associated with the European Central Bank's payment system, TARGET2.2 It is possible for banks and central banks in the eurozone to build up liabilities to other central banks in unlimited amounts on this system. The balances in the TARGET2 system represent assets and liabilities, and the "unlimited" balances sound scary to some people. They are not really frightening, though, but there are risks.
Chart 1 shows estimates of the TARGET2 balances on December 31, 2011, for the countries in the eurozone. The positive values indicate asset positions—lending—in these accounts at the end of December 2011. The negative values indicate borrowing through these accounts.
Measured in billions of euro, the negative values represent large amounts of borrowing. Greece's gross domestic product (GDP) is estimated to have been 215 billion euro in 2011, and its TARGET2 liability balance was 109 billion euro at the end of November 2011. Germany—a larger country—has GDP of 2.6 trillion euro for 2011 and an estimated TARGET2 asset balance of 495 billion euro.
How do these balances arise?
In the eurozone, the euro circulates in various countries and can move from one country to another. This is similar to the flow of dollars in the United States, where a person may get cash in Georgia and spend it in Washington State. Similarly, someone may transfer funds from a bank account in Georgia to an account in Washington State. The monetary union in the United States relies on the free movement of currency and transfer of funds across state borders to keep the value of a dollar bill and a dollar deposit in Georgia the same as its value in Washington State. The system functions this way because the United States has had a monetary union since the late 18th century.
The European Monetary Union (EMU) also relies on the free transfer of funds across countries' borders to keep the value of a euro the same in all the countries in the EMU. The movement of currency across borders is not even perceptible when the currencies are identical, as euro bills are. (Coins have different designs on their backs, indicating the country in which they were minted.)
The free transfer of funds in banks across borders is necessary to maintain the same value of deposits in various countries. If it were difficult—i.e., expensive—to move deposits from a bank in France to a bank in Germany, a 100-euro deposit in France might not be accepted by a German company in exchange for a good priced at 100 euro in Germany. The free movement of deposits is crucial to maintaining the common value of a euro deposited in a bank in any country in the EMU.
What happens when a depositor wishes to transfer funds from a bank in one country, for example, Greece, to a bank in another country in the EMU, such as Germany? Similar to what happens in the United States, the depositor need not do much more than order an electronic transfer. The rest of the transaction is irrelevant to the depositor.
On the bank's end, the transfer from one bank to another is a decrease in deposits at the Greek bank and an increase in deposits at the German bank. These deposits are liabilities of each of the banks. The German bank will not accept the liability, the deposit, without receiving something in exchange: either an asset or a reduction in some other liability. The Greek bank can satisfy the German bank in various ways. One is to transfer reserves, which are an asset, through the European Central Bank (ECB).
Another way to complete the transaction is for the Greek bank to promise to pay the German bank later, effectively obtaining a loan from the German bank. Or in a more complicated arrangement, the Greek bank could borrow reserves from another bank—for instance, a French bank—at the ECB. The French bank could then transfer the reserves to the German bank in exchange for payment on the loan later.
Transfers of deposits across countries also can be financed by creating TARGET2 balances for central banks. In the eurozone, national central banks lend to banks in their respective countries. If a customer transfers deposits from a private bank in Greece to another bank in Germany and the private Greek bank's best option is to borrow the reserves, the Greek bank can borrow the reserves from Greece's central bank. To facilitate that transaction, the private Greek bank provides collateral to Greece's central bank for the loan. The transfer of assets to the private German bank then occurs through Greek's central bank accruing a liability at the European Central Bank with Germany's central bank—the Bundesbank—accruing an asset at the ECB and providing reserves to the private German bank. TARGET2 balances can change in other ways, but this particular change illustrates how the balances in TARGET2 can arise.
What is the significance of these assets and liabilities?
Interest is paid on TARGET2 balances. In the sense of generating income, positive TARGET2 balances are an asset, for example, for the Bundesbank.
Are these assets a risk to which the Bundesbank is exposed? For example, what happens in the event of a default by the Greek bank? The loans by the Central Bank of Greece to private Greek banks are collateralized. These collateralized loans involve assessing the value of the collateral provided and then generally lending a fraction of the value of the collateral. The difference between the value of the collateral and the value of the loan—known as a haircut—provides insurance against decreases in the value of the collateral. If the value of the collateral does not fall more than the haircut, the Central Bank of Greece can sell the collateral and cover the balance at the ECB in the event of a default by the private Greek bank.
What happens if Greece's central bank defaults? The specifics of what would happen if such an event occurred are highly speculative, but it is certain that the losses by the Bundesbank through the ECB would not be directly related to its TARGET2 balance. In the event of default, losses to individual countries in the EMU would be proportional to their capital contribution to the ECB.
Consider an example for Germany and Greece. Germany provided about 27 percent of the capital of the ECB provided by countries belonging to the euro area (Bank of Spain 2012). Greece's TARGET2 balances are on the order of 100 billion euro. If something happened and those balances became worth half, losses would be 50 billion euro and Germany's exposure 27 percent of that, or on the order of 13 billion euro, a far cry from what might be suggested by its TARGET2 balance of approximately 500 billion euro. Furthermore, Germany's TARGET2 balance itself could be zero and the loss would be the same in this example. It is the net exposure of the ECB to countries that determines any risk associated with TARGET2.
The bottom line
Liability balances in TARGET2 do represent liabilities of the central banks of the respective countries. On the other hand, these liabilities are associated with collateralized loans to individual banks. There is risk associated with the borrower and the value of the collateral.
Asset balances in TARGET2 are assets in the sense that the central banks with positive balances receive interest on the balances. The balances on a national central bank's balance sheet do not represent that central bank's risk of loss, which is shared by other countries in the EMU. TARGET2 balances may well suggest a "massively unbalanced" system, but those balances reflect transfers of deposits that must be freely available in a functioning monetary union.
Gerald Dwyer is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. Thomas Cunningham provided helpful comments. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
1 A large online discussion has examined the issues touched on here. Initial claims by Sinn (2011) have been subjected to withering criticism and clarification (Bindsell and König 2011, Buiter et al. 2011, European Central Bank 2011, Whelan 2011, Whittaker 2011). The purpose of this brief piece is not to summarize all that discussion or even summarize all the conclusions. Rather, the purpose is to indicate a couple of basic aspects of these balances, aspects consistent in broad outline with discussions by Buiter et al. (2011) and Whelan (2011), for example. Garber (2010) provides an early, clear discussion.
2 TARGET2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system, version two.
Bank of Spain. 2012. The share in the capital of the ECB. Bank of Spain website.
Bindsell, Ulrich, and Phillip Johann König. The economics of TARGET2 balances. Unpublished paper, Humboldt University.
Buiter, Willem H., Ebrahim Rahbari, and Juergen Michels. 2011. The implications of intra-euro imbalances in credit flows. Centre for Economic Policy Research, Policy Insight No. 57.
European Central Bank. 2011. Target2 balances of national central banks in the euro area. Monthly Bulletin, October: 35-40.
Garber, Peter. 2010. The mechanics of intra european flight. Deutsche Bank Special Report.
Kaiser, Stefan. 2012. The Hundred-Billion-Euro Bomb. Spiegel Online, March 6, 2012. At Spiegel Online: 'Euro Crisis.'
Sinn, Hans-Werner. 2011. The ECB's stealth bailout. VoxEU.
Whelan, Karl. 2011. Professor Sinn misses the target. VoxEU.
Whittaker, John. 2011. Intra-eurosystem debts. Unpublished paper, Lancaster University Management School.