The Run on Europe

german_bank_run_50There is a lull in negative news from Europe. However, it is short lived.

There are four facts that are very important to understand:

  1. Most European banks are insolvent
  2. The ECB is massively monetizing to keep the system operational
  3. Germany is doing a back-door bailout of peripheral countries by racking up huge IOUs issued by the ECB
  4. The credit risk of the ECB has substantially increased

Let’s go through these one by one.

1. Zombie Banks

We all know that the so-called “stress tests” are not really testing a stressed scenario. The latest round of European stress tests showed a short-fall of €115 billion. [Details ] It is safe to assume that there is a much larger deficit.

It is instructive to look at the indirect evidence.

  • European banks don’t want to do business with each other because they don’t trust each other’s solvency
  • ECB has had to take extraordinary measures which include three year loans at very cheap rates [Details]
  • ECB has had to allow European banks to pledge lower quality collateral (because the higher quality collateral is running out – or has run out) [Details]
  • Investors are wary of these banks and are shifting business to non-EZ banks they perceive to be safer.
  • Policy makers have imposed and extended short-sale bans on Eurozone banks [Details]

2. Euros, Euros, Everywhere

The difference between spin and reality is stark. There has been so much talk about the ECB being stubborn and not willing to turn on the spigot. The reality is quite different.

The ECB balance sheet has exploded to €2.7 trillion which is approaching one quarter of Eurozone GDP. [Details] This is a bigger expansion than the Federal Reserve undertook in the depth of the U.S. financial crisis. [Fed balance sheet.]

The ECB is also effectively monetizing by making subsidized, three-year, 1% loans to Eurozone banks. This is called Long-Term Refinancing Operations or LTRO. It is simple for the banks to take these loans and then invest in many other assets that are yielding 4% or more. The spread is a direct subsidy to these banks. But many banks are not doing this. They are taking the loan and depositing the proceeds at the ECB (at a rate of 25bps) to “reduce” their risk. However, there are recent reports that they are now using some of the new funds to buy higher yielding bonds.

As mentioned earlier, accepting lower quality collateral is another way of monetizing.

The Federal Reserve is also involved by making it easier for European banks to get access to dollar funding. [Details (subscription may be required)]

3. Backdoor German Sponsored Bailout

A number of months ago I highlighted a story in Frankfurter Allgemeine about the TARGET2 system (which is like the Fedwire system in the U.S., TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer). Here is a good introduction to TARGET2. See pp. 35-40.

Here is how it works. Suppose a Greek national wants to buy a BMW at €30,000. In usual circumstances, the car buyer goes to his local bank and borrows €30,000 and these euros are transferred to BMW’s German bank. Indeed, the Greek bank would usually borrow the €30,000 from the German bank and deposit the borrowed money into BMW’s German bank account.

However, this doesn’t work anymore. There is no way that German bank will loan money to the Greek bank for this transaction because the Greek bank is known to be insolvent and Greece’s national central bank is not in much better shape.

Enter TARGET2 and the ECB. Let’s follow the money.

First the loan:

  1. Greek BMW buyer borrows money from local Greek bank using the car as collateral (or perhaps even Greek government bond as collateral!).
  2. Greek bank borrows from Greek national central bank (NCB).
  3. Greek national central bank borrows from the ECB.

Second, let’s follow this through to Germany. (The first three steps mirror the borrowing above.)

  1. Greek BMW buyer deposits (borrowed) euros into local Greek bank to pay for car.
  2. Local bank deposits the funds with Greek NCB.
  3. Greek NCB deposits with the ECB.
  4. ECB ‘deposits’ via TARGET2 the amount at Bundesbank (that is, the Bundesbank gets a ‘credit’ from ECB);
  5. Bundesbank sells some assets (high quality assets like German government bonds) for cash;
  6. Bundesbank deposits money with BMW’s local German bank.

For another description of the transactions, see Has the Bundesbank reached its limit?”

Effectively, the Bundesbank is swapping high quality assets (like Bunds) for credits with the ECB. The Bundesbank has racked up a massive amount of ECB credits. Consider the Deutsche Bundesbank’s Monthly Report, Section XI External Sector, Table 9 External Position of the Bundesbank in the European Monetary Union, column 7 Claims within the Eurosystem. (I am being specific here because the English version is published two months after the German version).

  • 2007 €84 billion
  • 2008 €129 billion
  • 2009 €190 billion
  • 2010 €338 billion
  • 2011 €476 billion (December 2011 data in January 2012 bulletin — in German)

Note 1. The German commitment to the European Financial Stability Facility (EFSF) is only €119 billion.

Note 2. The German commitment to the new €500 billion European Stability Mechanism (ESM) is €190 billion.

The TARGET2 balance alone is the size of the entire €500 billion ESM – and it is all from one country. It is a massive back door bailout.

In my opinion, the Bundesbank’s press release in February 2011 is not helpful:

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.

To decode, a country’s TARGET2 credit is an ECB liability – not an individual central bank’s liability. In my example with the BMW, the Bundesbank has a credit from the ECB – not the Greek National Central Bank. There is no risk — if the Euro survives. But that is a big “if”. The explosion in the TARGET2 balance is due to the large German trade surplus, German banks’ unwillingness to lend to certain Eurozone banks, and a flight to quality – or run, whereby people from all over the Eurozone want to get their savings into banks in Germany.

4. Junk Collateral

The key question for the German public is: “Are you comfortable swapping high quality assets for ECB credits knowing that the ECB has been degrading the quality of the collateral that it accepts? ”

Indeed, the Bundesbank is close to exhausting its high quality assets. What is next? The gold stock? Are Germans going to be OK selling gold for credits at the ECB? By the way, there is only €139 billion at the Bundesbank in gold and gold receivables. Given the current run rate, that buys about nine months. [From December 2010 to November 2011, the net Claims within the Eurosystem increased by €170 billion.]

It’s just a matter of time. Collateral will get lower and lower quality. It’s unsustainable.

The Run

Putting this altogether, it is no surprise that the Euro has been dropping. The surge in German TARGET2 balances is consistent with a run. The increased credit risk of the ECB is heightening the probability of a run. So all eyes are on the policy makers … and expectations of success on the political front are low.

Political Quagmire

Now that we have reflected on the (fourth) “historic” EU meeting, the cracks are fully in view. I estimate that it could take years to implement (if everyone agrees) – and Europe does not have years to work this out. Investors realize this and this just fuels the run on Europe.

Let’s first decode what happened at the EU Council. Statement found here.

Fiscal Compact

The centerpiece of the agreement is a ” fiscal compact”. The essential items are:

  • Structural deficits limited to 0.5% of GDP
  • Cyclical deficits to 3% of GDP
  • Max 60% government debt to GDP
  • “automatic” sanctions
  • “ex ante” review of bond offerings
  • Commitment to “write in stone” these rules at country legislative and/or constitutional levels

What is new?

Not much. Items 1-3 simply restate what is already in the Financial and Stability Growth Pact of 1997. Importantly, very few countries have taken these rules seriously. Currently, 13 of 17 Eurozone members are offside – including Germany. Greece has been serially offside. Indeed, there is only one country, Estonia, that is running a fiscal surplus!

The automatic sanctions are new. In addition, they are not very automatic. A country is called offside. A plan is presented and then a second vote is taken with the European Council. Two votes. In addition, a 2/3 majority could override the sanctions. If there is a problem, you go to the European Court of Justice. Who knows how long it will take there. To me, this is not “automatic”.

The approval of bond offerings before the fact, i.e. “ex ante”, seems very similar to the “automatic” sanctions. I am not impressed.


The basic idea is that enforcement would come from the European Council –and eventually through the European Court of Justice. However, not all countries are on board. Indeed, the U.K. vetoed.

Hence, you have the dysfunctional situation of the ECJ enforcing rules on some countries in the EU but not others. It is a legal nightmare.

UK Veto

David Cameron has taken a lot of heat. However, his decision to veto, in my opinion, was a no brainer.

The financial services industry is crucially important to the U.K. economy. Agreeing to the EU proposal would have put this industry at great risk.

The EU is pushing a so-called Tobin Tax – or transactions tax. While no big deal for markets in Europe (they are relatively small), it would be devastating for London – the world’s leading financial center. Even a small transaction tax would see investors choosing to trade in New York, Singapore or other markets that have no transactions tax. It would be crushing to the UK economy. I understand Cameron’s veto.

Will the UK become isolated? Yes, but they are already isolated. It is really no big deal. The key for the UK is to protect their growth opportunities and you can’t do that if you seriously wound your leading industry.

Set in Stone

Another hurdle to the agreement is to implement legislative and/or constitutional change in each EU country to recognize the balanced budgets. This is probably a good thing (i.e. fiscal discipline written into law – because it enables lawmakers to deflect blame when they vote against spending increases). However, it will not be so easy to implement.

There are two main problems: France and Germany. I don’t think it will be easy for either country to approve this and they are the nexus of the EU!

In France, it is an issue of yielding sovereignty (effectively to Germany). This is enormously unpopular – and could be the election issue that brings down Sarkozy. Check out the statements from Marine Le Pen who would take France out of the Eurozone. [In French]

In Germany, the basic story is very similar. They need to amend their constitution. The German Federal Court decision in September made it very clear that any extra-sovereign control over budgets was unconstitutional. Hence, changing the German constitution is the only option. However, it is naïve to think this is easy. The rank and file in Germany is very nervous. They believe that this is a prelude to a ” transfer union” – where the Germans are in a continual state of bailing out weaker EU members. Put bluntly, Germans are working to age 65 or 67 before retiring – but they are funding Greeks (and potentially other countries like France) that are retiring at 55. Not fair. Not popular. And naive to think that the Chancellor can wave her wand and make this happen.

In addition, I think the German public will be furious when they fully understand that they have almost single handedly been bailing out the periphery by selling their high quality assets for ECB credits. At some point, enough is enough.

Germany is the winner?


It is true that Germany has done well with the Euro. They are the strongest economy in Europe. They have hugely benefited from a cheap Euro. Their trade surplus is 5.7% of GDP – which is even bigger than China’s 5.2%.

However, we know there are no free lunches. Now, is the time to pay the price.

Germany is in an awful lose-lose-lose situation.

They are a loser if they have to single handedly continue to bailout the peripheral countries. Frankly, who else can afford to do it? The next three biggest countries in Europe – France, Italy, and Spain – certainly cannot contribute in a big way. The latter two are recipients! The UK is on the sidelines. But

Germany does not have unlimited resources. Remember they are offside already on the debt to GDP measure.

They are a loser if the ECB continues to monetize. This likely means future inflation which is simply a tax that especially hurts Germany – not just because it is wealth, but because of their history and the country’s extreme aversion to inflation.

They are a loser if the Eurozone breaks up. A new Deutschemark or new Euro based on subset of strong countries, would soar in value. This would be devastating for the export sector (which is 46% of German GDP). In a previous blog, I speculated that German could lose half of its exports on a revaluation. While export revenue might remain the same (if the value of the currency doubled), it would be devastating for certain industries – and lead to severe unemployment – another thing that Germany has a strong aversion to.

Parallels to the U.S. experience

To really answer the question of whether Germany is better off under the Euro, let’s explore a recent parallel example – the U.S.

The Federal Reserve maintained a policy of very low interest rates – on a real basis, negative interest rates, for an extended period under former Chairman Greenspan. The result of this policy was an economic boom largely driven by construction and housing. Consumers were refinancing their mortgages at lower rates and doing “mortgage equity withdrawals” (increasing their mortgages and using the extra money to spend). The U.S. is now paying the price for this structural dislocation. The U.S. is facing a ‘lost decade’. Is the U.S. better today off as a result of the cheap interest rate policy? No.

Now to Europe. Countries like Greece, Italy and others were faced with the ability to borrow at very low (German) interest rates. They exploited this cheap financing – just like the U.S. construction industry did. Germany was booming with exports and running a massive trade surplus given the cheap exchange rate.

Now they realize that there is a price to pay. It is not the question of are they better off right now. You need to factor in the future costs.

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15 Responses to The Run on Europe

  1. Joseph Vogelsong says:

    Prof Campbell – I enjoyed your insights. One question for clarification – you state that even a small transaction tax would see investors choosing to trade in
    New York, Singapore or other markets that have no transactions tax and that this would be crushing to the UK economy. But Britain already has a transaction tax – the SDRT which was introduced some 25 years ago. Why does that not harm the financial sector?

    Looking forward to your response,


    • charvey says:

      You are correct that the UK has the SDRT and, indeed, has had a stamp tax for centuries. Unknown to many, the U.S. has a small stamp tax too. However, all of these apply to equity transactions on certificated equity. The first version of this had to do with land taxes. When ownership transferred, there was a stamp duty, a SDLT (where L is land).

      The current proposals are far different than this. The SDRT is a very small fraction of what would be taxed under the proposed Tobin tax. SDRT applies to equities (and most equity transactions are exempt). The Tobin proposal would affect a much larger market. As you know, the derivatives market is enormous compared to the equities market.

      Now to be clear, the SDRT also applies to a very small subset of derivatives (essentially to eliminate the situation where people try to bypass the usual equity transaction tax using derivatives). However, again, the current proposal is far more wide ranging.

  2. sk says:

    Dear Prof Campbell, interesting piece, and agree with many of the substantial conclusions.

    But item 5 in the part about the Target2-balances is just factually wrong. The Bundesbank wouldn’t sell any assets as part of the transaction you described. Tornell/Westermann have misunderstood how ECB’s monetary operations work, which is a great shame, since their claims are now being repeated.

    Karl Whelan (bluntly) put it this way in his blog post on the Tornell/Westermann piece: “The crazy thing is that the Euro area is undergoing a real crisis and there is a huge need for an informed public debate on potential solutions. We don’t need academics making up fake crises and stirring intra-European resentments based on a misunderstanding of central bank arcania.”

    As it happens, there are some correct descriptions of how Target2-balances arise, e.g. the piece by Clemens Jobst (Austrian central bank) at VoxEU. Willem Buiter, Karl Whelan and some others have also written about the issue.

    • charvey says:

      Thanks for the comment SK. It is true that there is much “central bank arcania” and this is part of the problem. There is a remarkable lack of transparency. This opacity feeds the uncertainty and makes things worse. A great example were the EBA’s previous stress tests (not the most recent one), where almost all banks got passing grades. No one believed that at the time and now few believe that 115 billion is the true short fall today.

      I strongly disagree with Whelan that “academics are making up fake crises”. We didn’t make up a fake crisis. We are in the middle of a crisis. I am most concerned that the average person (especially in Germany) does not appreciate the commitments that are being made on their part.

      It is a fact that the credit risk of the Bundesbank has dramatically increased. That was the main point of my blog. Let’s just look at one channel — Germany’s the trade surplus. It used to be that given the surplus with peripheral countries, Germany could just buy peripheral assets. They are not doing that anymore. Instead, they are taking credits with the ECB in the form of the TARGET2 balances. A massive amount of private savings in Germany is effectively “invested” in the ECB. We all know that the ECB’s risk has mushroomed. The balance sheet has expanded to 22% of EZ GDP; they have increased duration; they have lowered the quality of collateral; and they hold by my estimates three quarters of a trillion euros of peripheral exposure.

      The simple point is that these balances are creating risk that is not appreciated. As I said in the blog, Germany gets an ECB credit – not a credit from the individual peripheral countries (and I agree there is some misunderstanding among commentators on this particular point). Presumably, the credit could be fulfilled by printing Euros. However, this all assumes that the eurozone carries on.

      • sk says:

        Thanks for the response.

        Certainly the ECB’s credit risk has increased, and thereby also the credit risk of the Bundesbank. And to be fair to Whelan, he is quite clear that he agrees that there is a crisis. His criticism is that many seem to be interpreting the Target2-balances as an additional risk on top of the risk involved in ECB’s monetary policy operations (and to my understanding he and others are correct in the interpretation that that just isn’t the case; but I am certainly open to arguments that demonstrate the contrary).

        I genuinely think that it is the accounting arcania, which is confusing. A way of framing the issue is as follows: Suppose that all of the ECB’s monetary policy operations were conducted centrally from the ECB instead of from the national central banks, i.e. all banks would have their accounts with the ECB rather than the national central banks. Suppose also that the ECB’s capital key is as it is today. Would Germany’s risk exposure be any different? No. It would lose the same amount if, say, a Greek bank defaulted as it would today. It would also face the same risk if a country were forced to exit the eurozone. Would anything, in fact, be different (except from an operational perspective) than it is today? Not really. But there would be zero “Target2-balances”.

        Another way of looking at it: If, say, all German retirees who enjoy a pleasant life in Southern Europe decided to transfer their deposits with Southern European banks back to German banks, that would hugely increase Germany’s Target2-balance vis-a-vis the rest of the Eurozone. This would seem rather prudent, but according to the Target2-credit-risk-logic this move would imply an immense increase in the credit risk of Germany. Now, to be clear this might involve a credit risk to Germany, but not because of the Target2-balances. Presumably, the Southern European banks would face a liquidity shortfall, they’d only be able to cover via lending at the ECB. And Germany would be on the hook for any losses the Southern European banks might face in proportion to Germany’s share in ECB’s capital. (And in the extreme case of a split of the Eurozone I’m fairly certain that Germans would be happy that they managed to repatriate their funds.)

        • charvey says:

          SK you are very well informed and I really appreciate your comments.

          It is not clear that we disagree. My point is the following. If German banks and Bundesbank were actively buying peripheral sovereigns to deal with imbalances, the public would be up in arms. Instead, Germany is amassing a huge TARGET2 surplus – and TARGET2 is not well understood. TARGET2 is just replacing the risk exposure– it is not creating extra risk. I hope that makes sense. The risk is being housed in TARGET2 balances – rather than other means. The Bundesbank’s credit risk has greatly increased (and it would have risen using other means too). The key difference is that the “accounting arcania” is confusing and I do not think that the German public fully appreciates that half their savings is exposed to significant credit risk. I saw numbers today showing the ECB has over 700 billion in peripheral bank exposure and over 200 billion peripheral sovereign exposure. In addition, it is not clear that these numbers take into account the recent LTRO in December. It is safe to forecast that with the next round of LTRO and resumption of SMP that the ECB’s balance sheet will explode. They are printing and printing way faster than the Fed did during the U.S. crisis. And there is no end in sight.

          I am not in Germany and it is difficult to read translated versions of the local press there. I am of the opinion that the German public does not appreciate the risk to their savings and that the “transfer union” is not just a concept, it has already happened.

          • sk says:

            I am not sure we disagree either. But I do think the whole discussion of the Target2 claims and liabilities (originally initiated by Hans-Werner Sinn) has done more to obfuscate than to clarify (but perhaps only because I feel that I do have a clear picture of what Germany’s and other countries risks are).

            I think of the Bundesbank’s risk as follows. It is essentially a co-owner of the ECB, and if I recall correctly its capital share is somewhere short of 30%. If the ECB lends 100 to a bank – whether in Germany, Spain, Greece, or another country – the Bundesbank has basically lent the 30 of these. If that counterparty defaults, the ECB will take whatever collateral the counterparty has posted and sell it. The Bundesbank’s loss is then 30% x (100 – market value of collateral) – and zero if the market value of the collateral is more than 100, which ideally it is, if the ECB uses proper values for updating the value of its collateral + reasonable haircuts. And that’s it. (I won’t go into the whole issue of what happens if a country decides to exit the euro zone, because the process is much less clear then.)

            Does this put the Bundesbank at great risk? Not if, say, the banks post e.g. German government bonds as collateral. But I can easily think of situations in which the ECB’s system puts Germany and other countries at risk. For instance if there is a kind of “financial repression” (to use Carmen Reinhart’s term) in which banks and governments collude. A bank might buy the bonds of its own government at an inflated price, and finance most (in percentage terms = 1-ECB’s haircut for those bonds) of the purchase as collateral. If both the bank and the government go bust, the other euro countries will lose quite a lot, and have in fact been financing that country’s deficits.

            Anyway, my point would basically be that these are the types of risks people should be focused on, not on the Target2-balances, which are not a direct measure of Germany’s or any country’s risk.

          • charvey says:

            This is where we disagree – but probably not by a lot.

            I do not think that the Bundesbank has substantially reduced its risk by taking TARGET2 credits from the ECB.

            Your example is correct if the risk is idiosyncratic. Let’s say the system is working fine and all countries are on side. One smaller country has a negative shock. Given its risk, Germany elects not to buy its sovereigns. Instead, it accumulates TARGET2 balance which is shared by all member countries. The exposure is approximately 30% – as in your posting. Effectively, Germany has reduced its risk by spreading it to the ECB.

            But today this is not the situation. Almost all countries are off side. It is not just an idiosyncratic shock to one small country (like Greece). There are at least five countries that are in deep trouble. There are two countries that are closing in – France and Belgium. So there is a substantial probability of systemic risk. In the systemic situation, the risk is not effectively shared. Yes, there are a handful of strong countries (like Finland) – but they are small. Hence, the exposure is not 30% – it is probably closer to 75%.

            Hence, I agree with you that TARGET2 balances are not a direct measure of a country’s risk — they are an indirect measure. To me, the balance reveals important information.

  3. sk says:

    My last comment, promise! (it’s been a very interesting discussion, though)

    Just to be completely sure we end up more or less on the same page, I’d just like to recap the mechanics of Target2-balances (also for other readers of your blog who might find them interesting):

    Target2-balances arise when banks from one country transfer money to another country. Say, for example, that Unicredit (Italy) makes a payment to Commerzbank (Germany). This reduces Unicredit’s account balance, which is a liability to Banca d’Italia, and similarly increases Commerzbank’s account balance, which is a liability to Bundesbank. Now, at the ECB-level assets equal liabilities, but the same is not true for Banca d’Italia or Bundesbank whose individual balance sheets are just components of the ECB balance sheet.

    A Target2-liability is then added to Banca d’Italia’s balance sheet, and a Target2-claims is automatically added to Bundesbank’s balance sheet, and now their balance sheets “balance” again. (As I noted in one of my earlier comments there would be nothing called Target2-balances if the banks nominally held their accounts with the ECB instead of with national central banks since there would be no need for such accounting entries.)

    Nothing else happens to either Banca d’Italia’s or the Bundesbank’s balance sheet, and no sovereigns or other assets whatsoever are bought or sold by either central bank. (This is where Tornell & Westermann got the “arcania” wrong. As for your last comment, I’m not quite sure how shocks to countries fit into this picture, except maybe to reduce the value of collateral posted by banks.)

    In fact, why do the central banks bother to make these accounting entries other than maybe to please their auditors? The real reason: To distribute seigniorage revenues.

    Perhaps it is easier to illustrate the mechanics in a world without electronic payment systems such as Target2, but in which the only means of payment is cash. Now, let’s for the sake of example say all European banks choose to, or can only, get all of their notes and coins from the Bundesbank. Before we start making any accounting manoeuvres, the Bundesbank’s balance sheet is now identical to the ECB’s. Its assets are now interest-bearing loans to banks, who in return receive notes and coins, a liability to the central bank. The banks physically move all of the cash not needed in Germany to their branches in the other euro countries, but no one actually has a clue how much cash is each country.

    This arrangement is not very fair to the other countries, since Germany receives all of the seigniorage revenue. So the countries invent a fictitious “capital key”, which says that x% of the cash is really issued in France, y% percent in Belgium, etc. And each of the national central banks therefore record accounting entries called something like “claim due to issuance of notes and coins” (asset) and “notes and coins issued” (liability). As the only country Germany records a huge reduction its official amount of “notes and coins issued”, and adds a corresponding liability to its balance sheet. Again, no actual assets are exchanged between the central banks, and the only way sovereigns are possibly included is as collateral for the banks loans with Bundesbank.

    This is essentially how the ECB accounts for cash in practice. (And as a matter of fact most cash is issued in Germany, and the Bundesbank therefore has a liability of more than 100 bn euros related to cash issuance.) It is also completely parallel to the Target2-balances issue; the only difference is that the ECB precisely knows where the money goes when it is transferred electronically, and therefore doesn’t need any capital key to divide seigniorage revenue (this is accomplished by the Target2-balances).

    In the system I just described the liability of Bundesbank would be equal to (1-Germany’s share of the capital key) times the total amount of notes and coins issued, and the total assets of all other euro countries would equal the same amount. There is really no behavior going on here; it is identically true. And hopefully people will agree that Germany ‘s debt has not changed one iota just because it has “built up” a massive liability to the rest of Europe.

  4. Christian Kurzer says:

    Dear sk,

    could you please explain this statement
    “Say, for example, that Unicredit (Italy) makes a payment to Commerzbank (Germany). This reduces Unicredit’s account balance, which is a liability to Banca d’Italia, and similarly increases Commerzbank’s account balance, which is a liability to Bundesbank.”

    Why are accounts of the banks liabilities of the NCB? Which item in the balance sheet does this correspond to?

    Thanks in advance,

  5. sk says:

    Dear Christian,

    If you have an account at a bank, it’s a liability to that bank (example: You have 100 in cash, but decide to go a bank, and they open an account for you. The they register an asset, cash, and a liability, your account balance). It’s no different with a bank having an account at a central bank.

    If you want an example, check out e.g. the Bank of England’s 2011 annual report (link: It’s total liabilities are 225 billion pounds, and of these the 154 billion are “deposits from banks and other financial institutions”. And you’ll find a similar liability in any other central bank’s balance sheet as well.

  6. Christian Kurzer says:


    In your sentence it sounds as if it is an identity: For every Target2-Claim there is a deposit from a commercial bank at the central bank.

    But the commercial bank could also buy an asset instead of transfering the additional deposits to the central bank (even if the other case is more likely if one looks at the growing use of the deposit facility). However, in this case the balance sheet of the NCB would only balance if the central bank sells some of its assets. So Tornell & Westermann would be right?

    Curious to hear your thoughts,

  7. sk says:


    1) There definitely isn’t an identity in the sense that there is a Target2-claim for every deposit. If banks never made cross-border payments in Target2, there wouldn’t be any Target2-claims. If the amount of transfers going to and from countries, there wouldn’t be any claims wither.

    2) No banks transfer extra deposits in my example. One bank pays another bank, and that’s it. Think of it this way: Suppose you’re a customer at bank in London, and you want to transfer money to your friend who happens to have an account in the same bank, but with it’s Liverpool subsidiary. Suppose further that the bank, for whatever reason, has separate balance sheets for each subsidiary. Ask yourself the following questions: What accounting entries would you record to account for that transaction? Would the subsidiary balance sheets “balance” afterwards? If not, do you really think the Liverpool subsidiary would sell of assets to make the balance sheet balance?

    Now think banks which are “customers” at the ECB which has “subsidiaries” (national central banks). Suppose that there are two banks from different countries, A and B, and suppose we live in a world in which these banks have their accounts directly in the ECB (as opposed to in their national central banks, because monetary policy is implemented decentrally in the Eurosystem). Okay, now what happens if bank A transfers money to bank B (via Target2)? This is just a decrease in bank A’s current account balance with the ECB (so the ECB’s liability to that bank drops), and a corresponding increase in bank B’s current account balance with ECB (so the the ECB’s liability to that bank increases). For the ECB’s balance sheet as a whole, this transfer doesn’t change anything, and there is no such thing as “Target2-balances”.

    Enter decentralised accounts: Now bank A has its account with central bank A, and bank B has its account with central bank B. Bank A’s transfer now reduces a liability at central bank A, while a liability is increased at central bank B. Clearly, the central bank’s balance sheets do not “balance” now, since CB A is missing a liability, and CB B has too many liabilities. If you add up their balance sheets, of course, everything still balances at the ECB-level.

    Does CB A sell off assets to make its balance sheet balance? No. (And if, in fact, it sold off assets, the balance sheet still wouldn’t balance, since there would also be corresponding reduction in liabilities due to the sale… after all, someone has to pay for the asset.) Does it even matter that the balance sheet doesn’t balance? Well, yes: Because CB A has too many assets compared to liabilities, it’ll earn a disproportionate amount of the “monetary income” (interest earned on assets minus interest paid on liabilities). And that’s why CB A records a liability (to the ECB) that pays interest, and CB B records an asset (from the ECB) that earns interest.

  8. sk says:

    Correction: “If the amount of transfers going to and from countries, there wouldn’t be any claims wither.” should have been “If the amounts being transferred to and from countries were identical, there wouldn’t be any claims either.”

  9. Christian Kurzer says:

    Dear sk,

    thanks for your extensive answer. Now I see a few things clearer.