In the monetary policy analysis only the consolidated balance sheet of the Eurosystem is relevant. In a decentralised central banking system individual national central banks’ balance sheets are relevant when assessing banks’ short-term financing needs vis-à-vis each of the national central banks. Apart from this, the decentralised system also opens the tricky issue of intra-area (TARGET) balances.
The issue has caused an intense debate in many forums (see for instance Buiter et al 2011, Jobst 2011, Tornell and Westermann 2011, and Whelan 2011 on this site). How to interpret these balances? Have the deviations gone too far? What are the underlying causes for deviations? Should some policy changes be made or should some quick fixes applied to cover the deviations? This note discusses some policy options, especially in case the deviations threaten to become more or less permanent.
Liquidity movements and central banks’ intra-area TARGET balances
The Eurozone central banks manage the TARGET system, which is an online real-time payments settlement system of the Eurosystem. According to the balance-of-payment terminology the system registers current-account transactions as well as the balancing financial account transactions. Thus, the Eurosystem decentralised financing operations and the TARGET settlement systems replace the need to use currency reserves as the final balancing source for the balance of payments inside a currency union. The settlement system is a central arrangement in the Eurozone and is not a source of troubles as such. On the other hand, if large and permanent balance deviations in the intra-area accounts do occur and prevail for a longer period, they indicate important market tensions that need to be analysed and cautiously corrected.
Before 2007 the TARGET balances were well within a narrow €100 billion range. The deviations caused by the cross-border flows were mainly balanced through interbank transfers without difficulties. A significant change happened during the 2008, however, and again towards the end of 2011. The change was due not so much to national level current-account differences between the EU countries but rather to problems stemming from financial items; partly from difficulties in banks’ own funding and partly from changing funding practices inside the EU banking sector.
Especially in stressed situations the Eurozone banks’ shorter-term funding from private sources and partly also deposits tend to have only one direction: from banks in the countries under stress to banks in the so-called core Eurozone countries or even outside the Eurozone. This has resulted in a subsequent uneven distribution of central bank financing and also in TARGET deviations. If the underlying trend cannot be reversed there may be an awkward situation looming where much of the shorter-term funding and deposits have become concentrated in some banks while the assets and loans have not moved but mainly stayed in other banks – a situation that cannot be stable.
The role of interbank markets
In March 2012 the TARGET liabilities of the ‘periphery’ central banks to the Eurozone ‘core’ central banks through the ECB account were in the region of €800 billion. This was, however, somewhat less than the periphery-country financial institutions’ borrowing from the periphery-country central banks and also somewhat less than the core-country financial institutions’ deposits in the core-country central banks. As far as the sheer volumes are concerned one can then easily see that if the interbank markets had worked properly, the borrowed and deposited amounts in the respective central banks could have gone down and the TARGET balance deviations could also have vanished.
We must also recognise that the TARGET deviations can be balanced in different ways. A properly functioning interbank market is the first natural alternative, but it requires full credibility and trust among banks. The other more permanent alternative would be to transfer assets and loan packages from ailing banks to more stable banks with full market-value compensation. For this type of transfers to succeed it would require appropriate trading platforms or resolution mechanisms that do not exist in the EU today. Thirdly, one must also note that administrated bank liquidations would also align the TARGET balances but this would only come at some expense to central banks’ profits through the loss-sharing arrangements between the Eurozone central banks.
What if the underlying funding and TARGET deviations keep on accumulating?
The question is how to make the alignment process function again, how to restore credibility, and how to make the interbank markets (or administrated remedial measures) work properly. The longer the funding bias continues the more central bank funding is needed. The ECB’s three-year longer-term refinancing operation (LTRO) funding will temporarily alleviate banks’ funding situation but is not a lasting solution. The risk is that the public-sector responsibilities will be exacerbated if both the funding and capital become dependent on public-sector back-ups.
The need for banking sector restructuring
If large dislocations on banks’ shorter-term funding and in TARGET balances become a permanent feature in the Eurozone, this signals a need for structural changes in the Eurozone banking sector. Permanent funding biases can be corrected if banks and the banking sectors, especially in the so-called periphery countries, can deleverage and also cautiously shrink in the longer run. In addition, administrated transfers of bank assets and loan packages from struggling banks to more stable banks would do the same, representing a sort of permanent interbank transfer. Whichever method is used, if the changes are market-led or can happen over time in a managed way this would not threaten the flow of credit to the whole Eurozone. Persistent deviations in the TARGET balances roughly indicate the amount of restructuring needed in the Eurozone banking sector. If, however, structural changes and restructurings are not allowed to happen, the troubled banks will undoubtedly need continued central bank and/or other public-sector support.
The other proposals either to limit TARGET deviations or to settle balances with real asset transfers between central banks do not make sense. These would only make the settlement of payments and financial transactions impossible in the Eurozone. If the central banks were to settle the TARGET balances with real asset transfers, that would only lead to the imposing of intransigent limits to settlement processes also. Even more important in this proposal is to note that if the TARGET balances were settled by central banks the underlying deviations in the Eurozone banks’ shorter-term funding would remain the same. The underlying causes would best be corrected through restoration of credibility in one way or another followed by subsequent automatic corrections in the banks’ funding flows and in the TARGET balances.
Forced recapitalisations may increase credibility but should not be done as one-off measures. Capitalisation measures need to be complemented with rigorous longer-term viability tests, and should allow restructuring and reorganisation of the banking sector. If these are not allowed to happen, the freezing of present structures will continue.
The growth of the Eurozone banking sector over the last decades has been dependent on the public sector’s implicit protection, which has now become questionable. Permanent funding flow and subsequent TARGET account biases signal a need for change and restructuring in the Eurozone banking sector. However, not much has happened in this respect over the last few years. Moreover, the prevailing attitude of looking at banks as national entities has not made cross-border restructurings any easier. Too much emphasis may also have been placed on recapitalisation as a one-off tool without thinking about complementing measures. In the longer run the restructuring needs will need to be met in the regulated banking markets.
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