Yves here. Welcome back Nathan Tankus, who has posted from time to time on Cfdtrade.
Here Nathan describes some critical infrastructure, the payments system, and in particular, the so-called Target2 system. Quite a few financial commentators have taken the point of view that exposures of other nations to Greece through the Target2 system represented a big incentive for them to come to a deal with Greece. The argument went that a either a Greek default or a Grexit would lead to losses being recognized on exposures different nations have to Greece and these would require taxpayers to make up some of the losses.
While politicians might indeed decide to try to make noise about Target2 losses as a way to further demonize Greece, Nathan describes how the importance of this issue is considerably exaggerated. Target2 balances are accounting entries among entities in the ECB system that happen to have physical operations in various countries, as opposed to being assets or liabilities of countries.
A default by Greece in and of itself would not have any impact on the Target2 system. Even a Grexit, which would lead to actual losses (via at a minimum conversion of Greek law contracts and assets and liabilities at Greek banks to drachma, leading to losses on ELA loans by virtue of now being undercollateralized) are not de jure liabilities of the nations of the Eurozone.
If the losses at the ECB are large enough, it would have reduced equity or negative equity. Negative equity doesn’t impact in any way the ECB from conducting monetary policy or National Central Banks implementing it. Disrupting that would have huge negative effects across the entire Eurozone for no economic or political reason. a taxpayer levy on member states of the Eurozone would be a political choice with purely negative economic consequences. Nonetheless, some members of the ECB board, notably the Bundesbank’s Jens Weiemann, are sufficiently inflation averse (and anti Greek) that they are expected to pump for a taxpayer levy across Europe to recapitalize the ECB.
By Nathan Tankus, a writer from New York City. Follow him on at @NathanTankus
Greece has been in a prolonged crisis for what is rapidly becoming a decade. The election of Syriza seems to mark something of an endgame for this crisis in that either the crisis will be resolved or it will (in some sense anyway) destroy Greece.
As we reach this endgame, it is important to understand how the system currently works and doesn’t work while outlining the policy options remaining to Greece. As Yves has outlined before, imposing capital controls much earlier would have put Greece in a stronger position both in negotiating a controlled default and/or exiting the Eurozone. Nonetheless, Greece still has some policy options. However, to understand the policy options it has and the serious issues it faces no matter how the endgame plays out, we must first understand the payment system which rules it.
Target2 is the system through which payments are settled electronically between countries. It is similar to the US system, Fedwire. The difference is that Fedwire is a national system that directly settles payments between banks whereas Target2 settles payments between each country’s “central bank”. This however, is a mirage. These “central banks” are simply extensions of the European Central Bank and carry out its directives. To quote two officials from the Bank of Portugal writing in “Institutional independence means that neither the NCBs nor any member of the respective decision-making bodies may seek or take instructions from any entity outside the ESCB”
Thus the Greek government has about as about as much control over its so called central bank as I do. That last statement is a bit of an exaggeration – but not by much. According to article 109 of the Maastricht treaty, “each Member State shall ensure, at the latest at the date of the establishment of the ESCB, that its national legislation including the statutes of its national central bank is compatible with this Treaty and the Statute of the ESCB”. Thus the elected government can affect any activity of their “central bank”- that hasn’t been outlawed or determined by the “Treaty and the Statute of the ESCB”.
If that’s the case ,what are the large “imbalances” in the Target2 system the media goes on about? They are simply an accounting record of the net amount of settlement balances the ECB has transferred from the accounts of one country’s banks to another. This accounting record becomes more negative when more settlement balances are sent away from that country’s banks than are recieved. This happens when
residents transfer deposits elsewhere in the Eurozone and when more payments are sent out of the country’s banks than towards it. In other words, when there is a bank run and/or a current account deficit. If the Federal Reserve records are good enough and enough research effort were made, I’m sure a similar record could be produced for every state in the country (something I suspect could happen if the threat of a state leaving became serious) going back decades. I would like to emphasize that this is merely an accounting record.
To restate, making payments from one bank to another a bank needs settlement balances. Just like in any other payments system, the central bank must make sure (either through loans or purchases) there are enough settlement balances to clear payments without writing down deposits (ie a “bail in”). During a financial panic, like the 2008 crisis in the United States, the ability of banks to borrow settlement balances from each other can become greatly inhibited. This kind of contagion seems now to be limited to periphery countries and is centered in Greece.
As a result, funds have been extended to Greek banks through an ECB facility called “Emergency Liquidity Assistance.” ELA is supposed to be short-term support for “solvent banks” with the loans “collateralized”. So far, the ECB has continued to provide settlement balances because not doing so would force a Grexit. Even though the ECB has made clear in various ways (meager increases in ELA limits, threats to tighten collateral rules) that is it uncomfortable with its position and is capable of restricting ELA support, experts see any aggressive action as a function of politics (i.e., the ECB at a minimum needs cover) political timetable, not of technical assessments bank equity and collateral.
claim that the National Central Bank is providing ELA to their local banks and “owe” (or are owed) Target balances to the ECB. This however, is nonsense. The national central banks implement monetary policy based on what the Executive Board of the ECB has told them to do. In other words, they are simply agents of the European Central Bank. If I attach a cell phone to the hand of a puppet, and then (as the puppeteer) direct the puppet to lend you the cell phone, you owe me, not the puppet, a cell phone. Further, if you default on your loan of the cell phone I would highly recommend a passersby to ignore me when I accost her claiming that since the puppet borrowed from me near her, the puppets debts were her responsibility.
It must be emphasized that without the accounting trick that is National Central Banks, Target2 balances couldn’t be assigned to any institution or country. There would simply be settlement balances held at the ECB by banks (i.e., liabilities to the ECB and assets to the banks) and loans made by the ECB to banks (i.e.,assets to the ECB and liabilities to the banks). These impose no burdens on any specific geographic area in the Eurozone just like loans to banks in the United States impose no burdens on any specific geographic area A default on ELA loans will reduce the equity of the European System of Central Banks. lays out an arcane system by which these losses are accounted for, but ultimately they don’t matter. There is for the ECB or the participating NCB to have positive equity or for Government budgets to fill those holes. This however, could be changed legally in order to punish Greece. To be clear, any attempt to use the measurement of net transfers of settlement balances from one country to another or negative equity at the Bank of Greece to force additional debt on Greece will be an act of political retribution and economic drivel.
For this reason, it is imperative that if the Eurozone were to force a Grexit by refusing to provide Greek banks the settlement balances it needs to make payments, the Greek government should not take any responsibility for the Bank of Greece. The ECB currently records a small interest charge charged to the Bank of Greece because of its Target2 balances but this could easily become larger. It is possible that the central bank could (through policy or legal change) give Target2 balances for countries outside of the Eurozone a maturity date, greatly increasing their burden.
In addition, Greece being forced into a de facto Eurozone is in a legal gray area. The Bank of Greece is not. A monetary policy based around drachmas, or even one that simply doesn’t conform with ECB directives directly violates the Maastricht treaty and would likely be referred to the European Court of Justice. Creating a new (and in many senses real) central bank would avoid this headache.
Next time, I’ll discuss the issue of capital controls and how (or if) it would be possible to maintain trade flows following defaults and/or an exit from the Eurozone