The fuss about TARGET2
For months on end there have been rumours that the German Bundesbank is in effect financing the huge debts of Greece and other European countries via the European payment and settlement system TARGET2. In an often reckless and irresponsible manner “experts” and commentators are fuelling anxieties and animosities in an already heated and panic-ridden environment. The following contribution tries to sort out some arguments and clear some misunderstandings.
Take a look at the following figure. What you see is settlement balances in the European payment and settlement system TARGET2 at the end of 2010.
The first thing you may notice is differences. A few countries have positive balances. These are Germany, Luxembourg, the Netherlands, Finland and Italy. Many others have negative balances.
Source: Deutsche Bundesbank, Monthly Report, March 2011, pp 34 f.
The next thing we notice is strong differences in size. With more than €300bn Germany has by far the highest positive settlement balance while Ireland, Greece, Portugal and Spain have noteworthy negative balances, although no individual balance is below – €150bn. Apparently there is no 1:1 correspondence between positive and negative balances of countries in that the excess of claims of one country equals an excess of liabilities of another one.
These figures are accumulated net balances. They show large variations in accumulated differences between cross-border claims and cross-border liabilities of countries. Obviously, end of 2010 in Germany and Ireland the gap between claims and liabilities was much bigger than, say, in Italy where the match was almost perfect. What do these numbers tell us?
Let me emphasize what they do NOT tell: They give no information about gross cross-border payments and their determinants. Hypothetically, these may have been much higher (or lower) in Italy than in Ireland – we do not know. Further, the numbers allow no conclusion about net or gross cross-border payments in subperiods which for example may have been higher, say, in Greece than in France, at least temporarily.
The last point we have to find out is what kind of activities are behind these payments. The Bundesbank mentions three major components with payments carried out via the banking system: foreign trade transactions, securities transactions and lending transactions. All three are reflected in interbank claims or liabilities vis-à-vis the rest of the world and can be settled using TARGET2.
Keeping in mind these points, in principle, we now have all information we need to approach the question who is paying for whom or what in Europe , and how TARGET2 becomes involved, and the time has come to have a closer look at the functioning of a payment and settlement system.
Real-time-gross-settlement in Europe
The Trans-European Automated Real-time Gross settlement Express Transfer (TARGET) system is used to settle cross-border payments individually as soon as orders are sent. The system allows for what is called intra-day finality which is the certainty that transactions will not be unwound if a party fails to settle. Real-time-gross-settlement or RTGS-systems have the disadvantage that, in contrast to former systems, they require a lot of liquidity since during the day orders are not accumulated and netted befor payments are made. RTGS-systems were established in reaction to several incidents which threatened to severely destabilize the international financial system. One of them was Barings. As I wrote elsewhere (Reszat 2005, Chapter 4):
“When in February 1995 one of the oldest British merchant banks, Barings Bank, went bankrupt after one of its traders had lost about ¥850 million on the Singapore and Osaka futures exchanges one widely unnoticed effect was a resulting problem in the then existing ECU clearing system. This threatened to block settlement of ECU50 billion of payments. Barings itself was involved in less than one percent of those payments. The case is a classic example of the systemic risk inherent in large-value net settlement systems. These systems are constantly keeping track of banks’ net positions including thousands of payment instructions in the course of the day. At day’s end the net amounts owed are settled. If clearing becomes impossible for one party, settlement between all participants is blocked and no payments are taking place at all.”
In contrast to a net settlement system in TARGET2 both legs of a transaction are settled independently of each other via the national central banks. Take the example of the unwinding and repayment of a Greek position by a German investor: Assume a Greek bond falls due for repayment and the German lender wants the money back instead of reinvesting it in Greek bonds again. In this case money is flowing from Greece to Germany including the following steps:
- A Greek bank is transferring the amount of money to the German investor’s German bank via the Greek central bank. This means that the amount will be credited to the account of the German bank at the German Bundesbank.
- Technically, now the Bundesbank has a new liability (equal to the amount from the Greek investment on the central bank account of the German bank).
- But at the same time, the transaction generates a claim for the same sum of the Bundesbank on the sending Greek central bank.
- The Greek central bank in turn debits the central bank account of the originating Greek bank.
In my interpretation the third step is what observers think they see in the figures for the German TARGET2 settlement balances: Claims of the Bundesbank on Greece. What they overlook is
a) that the position in our example is not a claim on Greece, or on the Greek central bank, but on the Eurosystem, on TARGET2. The source of the misunderstanding is probably the fact that TARGET2 does not provide a central counterparty which would serve as a seller to all buyers and a buyer to all sellers. Instead, the participating central banks are directly offsetting the positions as soon as orders are reaching them.
b) that such a claim is only one of two legs of a transaction that is merely settled via central bank cooperation. The other leg is the liability the Bundesbank has to the German bank which is receiving the payment.
Payments via TARGET2 in general involve four parties: two central banks and the initial payer and receiver. The payment may result from an export or import of goods or services, from a securities sale or purchase or from cross-border lending and borrowing. In these and other cases the principle is always the same: four legs with a match of claims and liabilities. As the Bundesbank writes:
“From a euro-area perspective, TARGET2 balances largely disappear, just like the national current-account balances within the euro area. The claims of the Bundesbank (and other national central banks) on the ECB are offset by the liabilities of other national central banks”.
Source: ECB: Statistics Pocket Book, September 2011.
The Role of the ECB
The ECB comes into the picture by the fact that it is the keeper of the TARGET2 balances within the Eurosystem: Usually, the claims and liabilities generated at the national central banks by thousands of transactions (as the above table shows the monthly volume of transactions between 2005 and 2009 ranged from about 300.000 to 400.000 payments) do not fully balance out over the course of a day. The outstanding claims and liabilities of all national central banks are then transferred to the ECB at the end of the day and netted out.
Why is the TARGET2 settlement balance for Germany so high? The Bundesbank states that, above all, this is due to the current tensions in the money market and the financial sector. Currently, Germany’s cross-border payments are far from balanced reflecting, for example, changes in banks’ refinancing operations in the euro area. While funds tend to continue to flow into Germany from non-bank payments from current-account surpluses and securities transactions as well as from banks’ own operations, there is a growing unwillingness or inability of German banks to lend funds to foreign financial institutions. The result is that there are more payments channeled through TARGET2 in one direction than in the other.
Which are the risks? There is always a danger that one leg of the transaction is paid and the counterparty is not willing or able to fulfil its part of the business. For this eventuality banks have to provide collateral. Assume, in the example the Bundesbank has paid out the amount to the German bank, but the Greek bank fails and the Greek central bank is not able to collect the money because collateral is insufficient to realize the full amount. In this case an actual loss occurs, but this is not borne by the Greek or the German central bank alone, but by the Eurosystem as a whole. The cost of the loss is shared by national banks in line with the capital share. Accordingly, the Bundesbank has to pay 27% of a loss no matter in which country it occurs.
Confusion partly stems from the dual role of the ECB as central counterparty for TARGET2 balances and as central bank for the euro area. In the latter function it offers member banks the opportunity to both posit cash there and get cash against collateral establishing borrower/lender relations. Both types of activities trigger payments which are settled using TARGET2. Again the question is: Which are the four legs?
Assume an Italian bank is getting a loan from the ECB against collateral. Four parties are involved: the Italian bank, the Italian central bank, the ECB in its role as loan-granting central bank of the euro area (only in this role money is owed to it by the Italian bank) and the ECB as participating member central bank of TARGET2 which is processing the related payments.
So, as Robert Peston asked in a recent article about TARGET2 balances, what’s all the fuss about?
The answer is that those “experts” and observers obsessed with the idea that against official claims the Bundesbank forces German taxpayers to pay for the debt of Italy, Greece and other countries simply confuse money flows generated from debtor/creditor relations with the processing and settlement of related payments. Claims and liabilities in a payment and settlement system must not be regarded isolated for individual members. There is one recipe to pick one’s way through this jungle of positions and activities: Search for the four legs! Then it becomes clear where the money flows, who gives it and who takes it.