Target2 – Q&A
During the last months, much has been written about Target2, the payment and settlement system of the euro area. If you have read official documents such as the Target2 Annual Reports for 2010 and 2011, the Bundesbank Monthly Report of March 2011, the ECB Monthly Bulletin of October 2011, the explanations by Michael Best (Bundesbank), Ulbrich and Lipponer (Bundesbank) and Bindseil et al. (ECB), the clear and lucid contributions of Karl Whelan in Vox-Eu and elsewhere, or even my earlier blog posts you already know a lot about the nature and functioning of the system.
Nevertheless, as the following examples demonstrate (my emphasis in red) there still exist fundamental misunderstandings which let the burdens and risks of Target2 membership appear scarier than they are in reality rendering a meaningful public discourse of the subject difficult to impossible.
Consider, for example, what Peter Boone and Simon Johnson wrote in The End of the Euro: A Survivor’s Guide, May 29th, 2012:
More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone). This includes 110 billion euros provided automatically to Greece through the Target2 payments system – which handles settlements between central banks for countries using the euro. As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail. This role is taken on by other euro area central banks, which have quietly leant large funds, with the balances reported in the Target2 account. The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.
Another recent example is from a widely noticed speech George Soros gave at the Festival of Economics, Trento Italy on June 02, 2012:
If this continued for a few more years a break-up of the euro would become possible without a meltdown – the omelet could be unscrambled – but it would leave the central banks of the creditor countries with large claims against the central banks of the debtor countries which would be difficult to collect. This is due to an arcane problem in the euro clearing system called Target2. In contrast to the clearing system of the Federal Reserve, which is settled annually, Target2 accumulates the imbalances. This did not create a problem as long as the interbank system was functioning because the banks settled the imbalances themselves through the interbank market. But the interbank market has not functioned properly since 2007 and the banks relied increasingly on the Target system. And since the summer of 2011 there has been increasing capital flight from the weaker countries. So the imbalances grew exponentially. By the end of March this year the Bundesbank had claims of some 660 billion euros against the central banks of the periphery countries.
The Bundesbank has become aware of the potential danger. It is now engaged in a campaign against the indefinite expansion of the money supply and it has started taking measures to limit the losses it would sustain in case of a breakup. This is creating a self-fulfilling prophecy. Once the Bundesbank starts guarding against a breakup everybody will have to do the same.
My last example is a text from ZeroHedge about Europe’s Bailout Costs In One Chart: €2 Trillion And Counting, refering to this chart:
Source: Brandywine Global High Yield Perspectives, Ifo.
Tyler Durden wrote on June 3rd, 2012:
This chart, better than any we have seen so far, summarizes just how much has been injected already to preserve the Eurozone from collapse.
This is what is known as a sunk cost, because last time we checked (and just as we explained back in March at the market highs when everyone was euphoric that Europe is now fixed) nothing has been fixed, and Europe is one ‘rogue’ democratic vote away from an EMU exit, and thus oblivion (or so they said last year, now everyone is prepared for a Greek departure, or so they say now, expect for the Greeks of course – they go straight to the 10th circle of hell and do not pass go). The truth is that by the time the status quo finishes its extend and pretend game, which incidentally has only one real outcome, the €2 trillion spent to date, will be orders of magnitude higher…
What is wrong with these statements? Maybe I can make my point clear answering the following questions.
- How is Target2 organised?
- Who participates in which way in Target2?
- Which role do national central banks (NCBs) fulfil in Target2?
- How are payments settled in Target2?
- Is liquidity generated in Target2?
- Do participating NCBs provide collateral in Target2?
- What does the Bundesbank (or any other NCB) do?
- What does the Bundesbank not do in Target2?
- Which risks do NCBs run participating in Target2?
- How do Target2 balances arise?
- How are Target2 balances treated for accounting purposes?
- To which corporate legal form does Target2 resemble and why does this matter?
- What if a country of the euro area abandons the euro?
- What happens with Target2 if the euro is abolished?
How is Target2 organised?
Target2 is a Real-Time-Gross-Settlement system operated by the Eurosystem, the monetary authority of the euro area. The Eurosystem consists of the ECB and the NCBs of those EU member states that have adopted the euro.
Target2 is a system of multiple technically centralised, but legally decentralised autonomous national RTGS systems. For example, the Bundesbank runs TARGET2-Bundesbank.
Who participates in which way in Target2?
In 2011, Target2 had 976 direct participants, 3,465 indirect participants and 13,083 correspondents processing a daily average of 348,505 payments, representing a daily average value of €2,385 billion and connecting 23 European countries (ECB). Including branches and subsidiaries, almost 60,000 banks across the world can be adressed via Target2.
Direct participation with maintenance of an own RTGS account is restricted to the European Economic Area (EEA). This includes the 27 EU member states plus Iceland, Liechtenstein and Norway.
Indirect participants send and receive payment orders via a direct participant.
Which role do national central banks (NCBs) fulfil in Target2?
All NCBs in the euro are are obliged to connect to Target2.
NCBs of non-euro area EU countries can connect to Target 2 if they conclude an agreement with the euro area NCBs, but they have to maintain a positive balance vis-à-vis the ECB (ECB, p. 35). As of 31 December 2011 there were six non-euro area NCBs participating in TARGET2: Българска народна банка (Bulgarian National Bank), Danmarks Nationalbank, Latvijas Banka, Lietuvos bankas, Narodowy Bank Polski and Banca Naţională a României (ECB).
Connected non-euro area NCBs participate without voting rights. They are required to pay up 3.75% of their share in the ECB’s subscribed capital as a contribution to the operational costs of the ECB. They are not entitled to receive any share of the distributable profits of the ECB, nor are they liable to fund any loss of the ECB. NCBs of member states that are neither euro area NCBs nor connected NCBs have observer status only (details).
The participating euro area and non-euro area NCBs provide payment and settlement services for participants in the EEA via Target2. They are the owners of the ECB and thereby of Target2. The following table shows the subtotal of paid-up ECB capital of euro area NCBs:
As of December 2011, non-euro area NCBs accounted for about another €121 million paid-up capital.
How are payments settled in Target2?
Target2 runs on a Single Shared Platform (SSP) jointly provided by the Bundesbank, the Banque de France and the Banca d’Italia. From there it offers settlement services to all participants, irrespective of the country from which they connect (ECB, p. 18). Further, there is no difference in the treatment of domestic and cross-border euro payments (Bundesbank, p. 72)
Payments in Target 2 are processed centrally via the SSP. As I wrote elsewhere, here the ECB functions as CCP becoming a buyer to the seller and a seller to the buyer.
Target2 is governed by the ECB Governing Council. The division of tasks between the ECB Governing Council, the Eurosystem NCBs and the three NCBs providing the SSP is determined in Annex I of this guideline.
Is liquidity generated in Target2?
Target2 balances of NCBs reflect the distribution of central bank liquidity within the euro area. However, liquidity cannot be generated via Target2 becaused it is a closed system which is merely transfering central bank money between accounts (Bundesbank, p. 35). Being processed very fast the funds can be reused several times a day (ECB, p.5).
To cite the Bundesbank in its latest annual report (p. 49): “Providing liquidity is one of the key tasks of any central bank. The exact manner in which this is achieved in the euro area is decided by the Governing Council of the ECB as part of its monetary policy mandate (my emphasis)” – and not as part of its management of the payment and settlement system.
Do participating NCBs provide collateral in Target2?
The NCBs that connect to Target2 do not provide collateral. They are running the system and providing the settlement services. As owners of the ECB and Target2 they paid up their share of capital.
What does the Bundesbank (or any other NCB) do?
- Contributing to the provision of liquidity in the euro area on behalf of the ECB.
- Processing payments via its RTGS system.
What does the Bundesbank (or any other NCB) not do in Target2?
- Making monetary policy decisions (not in Target2 and not in any other context).
- Borrowing from, or granting loans to, other NCBs.
Which risks do NCBs run participating in Target2?
As I described in detail elsewhere, in Target2 there is always a danger that one leg of a 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. If collateral turns out to be insufficient to realize the full amount the resulting loss is shared by the euro area NCBs in line with their capital shares. However, given existing risk control measures, and the high share of low-value transactions, the risk is minimal.
At this point, it need to be stressed that a claim in Target2 does not in itself reflect an NCB’s exposure to financial risk. This must not be confused with the counterparty risk central banks face when implementing monetary policy and providing central bank liquidity. This counterparty risk – which is wholly unrelated to the payment processes in Target 2 – is met by the Eurosystem’s collateral framework (details ECB, p. 40).
How do Target2 balances arise?
Target2 balances of euro area NCBs reflect the fact that the distribution of central bank liquidity within the Eurosystem is uneven. They arise from the settlement of cross-border payment flows which results in intra-Eurosystem obligations. These are aggregated and netted out at the end of each business day.
The sum of all balances of NCBs and the ECB is zero (ECB, p. 35).
How are Target2 balances treated for accounting purposes?
Target2 positions of euro area NCBs are established vis-á-vis the ECB. Due to the decentralised nature of the system they are booked twice:
In the balance sheets of the national central banks they are consistently booked as ‘intra-Eurosystem liabilities’ and, at the end of each business day, aggregated Eurosystemwide and consolidated – resulting either in a claim (a positive Target2 balance) or a liability (a negative Target2 balance) of the respective NCB vis-à-vis the ECB as the central counterparty (Bindseil et al.).
In the ECB balance sheet these positions are booked in consolidated form under Intra-Eurosystem claims or liabilities as Other claims (liabilities) within the Eurosystem (net).
These ECB positions also include other items such as the interim profit distributions to NCBs. (These are interim because ECB’s income on euro banknotes in circulation and income arising from securities purchased under the Securities Markets Programme is due to the eura area NCBs in the financial year in which it accrues.)
The positions of non-euro area NCBs vis-á-vis the ECB arising from their participation in Target2 are disclosed as Liabilities to non-euro area residents denominated in euro in the ECB balance sheet.
It needs to be stressed again that this accounting treatment results from the decentralised nature of the Target2 system with its legally independent national RTGS components. In a fully centralised system, similar payment flows would not give rise to these kind of claims and liabilities. Accordingly, in the consolidated balance sheet of the Eurosystem (ECB, p. 200 f.) the respective positions do not appear.
To which corporate legal form does Target2 resemble and why does this matter?
I am not an expert of business or corporate law, but an organisation
- consisting of a multitude of legally independent firms under one common roof,
- supplying services against payments,
- with decisions made centrally but carried out decentralised,
- with profits and losses distributed according to a key of fixed ratios,
- and a consolidated balance sheet and profit and loss statement
— to me, such a construct resembles a holding company.
I found that this analogy strongly enhanced my understanding of debt and payment issues in the Eurosystem. For instance, coming back to the Target2 balances: In a holding, claims and liabilities arising from business activities of group members, and disclosed in a netted and consolidated form in the balance sheet of the parent company, do not represent individual profits or losses, but intra-group flows of payments.
In my feeling, thinking about what happens if in a holding
- a firm, either going bust or being sold, is leaving the group or
- the whole group is broken up and ceases to exist
proved extremely helpful in answering the last two questions.
What if a country of the euro area abandons the euro?
If a member country decides, or is forced by circumstances, to abandon the euro, the structure of autonomous national RTGS systems should facilitate an orderly transition and return to the processing of payments in national currency.
The rules state that euro area NCBs are obliged to connect to Target2. A NCB which is no longer part of the euro area may stay connected but only via an agreement with the remaining euro area NCBs and under the condition that it maintains a positive balance vis-à-vis the ECB. (The latter refers to its liquidity status and not to borrowing/lending relations with the Eurosystem.)
How about claims and liabilities?
If the country in question refrains from staying connected to Target2 and, at the same time, is abandoning the ECB – in my understanding (but we must ask the jurists to find out) its paid-up capital will have to be returned plus its share of profit, or minus its share of loss according to a consolidated closing balance sheet and profit and loss statement.
How much is it?
In 2011, the net profit of the ECB prior to a a transfer of €1,166 million to the risk provision – was €1,894 million (ECB, p. 171). After risk provision €728 million were distributed to the euro area NCBs. Target2 itself is collecting revenues, 98% of which are generated by the SSP, but these are not yet recovering the Target2 costs (ECB, p. 27).
Currently, paid-up capital of Greece and Germany – to name two examples – amount to about €178 million and €1.7 billion respectively. That is, the loss for the Eurosystem of an exit of both countries in 2011 could have been fully absorbed by the system’s annual net profit alone.
Two further exit scenarios are conceivable:
- If the country in question keeps its ECB share and stays connected to Target2 in order to process the euro side of future transactions (which in my view seems the most probable alternative), its changed status as a non-euro area member means that its NCB is no longer entitled to receive any share of the distributable profits of the ECB, nor is it liable to fund any loss of the ECB. On the other hand, like other non-euro area members it probably will have to pay a lower capital share.
- If the country in question keeps its ECB share without being connected to Target2, which is possible as long it remains an EU member, it will be restricted to observer status only.
What happens with Target2 if the euro is abolished?
I can only speculate, but again, several scenarios seem conceivable. So far Target2 is only processing payments in euro. A return to national currencies would require either a system change to process multi-currency payments or a complete dissolution.
The first is largely a technical matter which cannot be discussed here. The second sounds probably more dramatic than it is, given the autonomy of the national RTGS components. As in the case of unilateral exit of countries a consolidated closing balance sheet for the ECB would have to be drawn up, outstanding claims and liabilities would have to be settled and the remaining capital shares plus any profits left would have to be distributed among member countries.
The way the issue of Target2 balances is discussed in public is most regrettable. The ever new records of unmanageable bilateral debt allegedly heaping up in the system arouse fears which are wholly unreasonable and stand in the way to finding a viable crisis solution. Two points should be kept in mind: Monetary policy matters such as the creation of central bank money must not be confused with the process of payment and settlement of central bank money, and intra-group payment flows as part of the normal business of the system must not be confused with profits and losses.
At closer inspection, the €2 trillion debt scenario conjured up by some observers in an utterly irresponsible way is evaporating into thin air and the euro crisis – although still a very serious problem and a big challenge – appears as one that probably can be handled.
I would like to add two references.
The first is a new excellent paper by Clemens Jobst, Martin Handig and Robert Holzfeind from the Oesterreichische Nationalbank: Understanding Target2: The Eurosystem’s Euro Payment System from an Economic and Balance Sheet Perspective, to which my attention was drawn by Alea’s blog. The most interesting aspect of this paper, in my view, is a short speculative discussion of what would happen in the theoretical case of a country withdrawing from EMU. The paper emphasises the difference between losses in monetary policy operations (which might happen) and losses in Target2 (which would not be incurred).
The second is an ECB Legal Working Paper by Phoebus Athanassiou cited in the above mentioned paper by Jobst et al.: Withdrawal and Expulsion from the EU and EMU. As you can see from the following extract from the abstract its findings cast doubt on the validity of the exit scenarios I described above:
This paper examines the issues of secession and expulsion from the European Union (EU) and Economic and Monetary Union (EMU). It concludes that negotiated withdrawal from the EU would not be legally impossible even prior to the ratification of the Lisbon Treaty, and that unilateral withdrawal would undoubtedly be legally controversial; that, while permissible, a recently enacted exit clause is, prima facie, not in harmony with the rationale of the European unification project and is otherwise problematic, mainly from a legal perspective; that a Member State’s exit from EMU, without a parallel withdrawal from the EU, would be legally inconceivable (my emphasis); and that, while perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible.
This is an important paper, which should be widely read, and I will have to think about its implications. However, since I am no legal expert, and still confused by these new findings, I add this without modifying my initial text.