A couple of days ago, Jens Weidmann, the President of Deutsche Bundesbank, published an op-ed about the ”origin and meaning of the Target2 balances” in Germany’s “Frankfurter Allgemeine Zeitung” and the Dutch daily “Het Financieele Dagblatt”. The Bundesbank has now also produced an English version of Weidmann’s piece. Here it is:
Jens Weidmann, President of Deutsche Bundesbank: "I believe the idea that monetary union may fall apart is quite absurd."
Target2 has recently been subjected to critical scrutiny in connection with the Eurosystem’s role in containing the sovereign debt crisis. But what does this ominous term, which many people equate with additional risks for the taxpayer, actually mean?
Target2 is, in effect, a European money grid through which liquidity circulates in the euro area. It is a payment system used for the cross-border transfer of central bank money between euro-area national central banks (NCBs). This liquidity arises in the individual countries predominantly as a result of the NCB’s refinancing operations with commercial banks.
Liquidity is transferred whenever central bank money is transmitted from one country to another. This results in claims on and liabilities to the European Central Bank (ECB), which acts as a kind of clearing house. The transferring central bank records a liability – a negative Target2 balance. The recipient central bank is credited with a claim – a positive Target2 balance. If euro-area monetary policy were centralised at the ECB, there would not be any Target2 balances; however, this would not inherently alter the risks associated with providing liquidity.
Prior to the financial crisis, these balances more or less offset each other. The NCBs provided banks with liquidity via refinancing operations, chiefly to enable them to meet their minimum reserve requirements and to put cash into circulation. Banks’ cross-border funding requirements were generally met via private capital flows, for instance through interbank lending and borrowing.
With the onset of the financial crisis, and especially following the emergence of the sovereign debt crisis, confidence in public finances and national banking systems started to shrink in a number of countries. Private sources of funding, including the interbank market, contracted, were regarded as too costly or all but dried up. To fund their liquidity needs resulting, for instance, from the sale of goods or capital outflows, banks turned increasingly to the Eurosystem.
This was possible because the Eurosystem has progressively expanded its provision of liquidity since the onset of the financial crisis, now providing unlimited amounts (full allotment), at low interest rates and for significantly longer maturities. At the same time, the Eurosystem has perceptibly lowered its collateral standards, eg for ratings.
This has considerably changed the Eurosystem’s role as a liquidity provider. Whereas before, it provided only the bare minimum of central bank money, the Eurosystem has now largely taken over the liquidity functions of the interbank market and other cross-border capital flows.
The total volume of refinancing transactions has risen from approximately €460 billion on the eve of the financial crisis to over €1,100 billion at last count, and the average maturity of the transactions has spiralled from a few weeks to almost three years. The share of euro-area peripheral countries in the volume of refinancing operations has concurrently climbed from one-sixth to around two-thirds. The continued net outflow of liquidity from the peripheral countries has caused them to accumulate combined Target2 liabilities in excess of €750 billion.
It is the Eurosystem’s task to provide central bank money – to solvent banks in return for sufficient collateral and without endangering price stability. This ensures the provision of credit to the economy, and can also strengthen financial market stability. However, it is essential to keep monetary policy and fiscal policy strictly segregated and, in particular, to stringently observe the prohibition on the monetary financing of governments.
Neither providing life support to ailing banks nor propping up the solvency of sovereigns falls under the remit of monetary policy. Decisions relating to the redistribution of major solvency risks of banks or governments among taxpayers across the euro area is the sole responsibility of elected governments and parliaments.
Admittedly, it is not always possible to clearly differentiate between liquidity shortages and solvency risks of banks and, precisely in times of crisis, a certain degree of flexibility is appropriate for a short time. However, this can also inflate risks on central banks’ balance sheets, and moral hazard may assume a critical dimension.
An increase in Target2 balances may thus mirror a bona fide monetary policy response to a looming liquidity crisis within the bounds of its mandate. To that extent – as the Bundesbank has repeatedly pointed out – criticism of the Target2 balances per se is misplaced.
As I see it, the Bundesbank’s Target2 claims do not constitute a risk in themselves because I believe the idea that monetary union may fall apart is quite absurd. Whether and to what extent losses arising from liquidity provision actually impinge on the Bundesbank’s balance sheet does not depend on the volume of the Bundesbank’s Target2 claims. This is also true for the hypothetical scenario, which has sparked much public debate, of a member state with a negative Target2 balance potentially exiting monetary union.
Even in such a case – which I consider to be highly unlikely – the risk remains rooted in the nature and volume of the liquidity provision. This might result in partial defaults on the ECB’s claims. However, any losses sustained by the ECB would have to be borne jointly by all Eurosystem central banks, irrespective of the size of their Target2 balance.
In the Eurosystem, however, there is broad agreement that the non-standard monetary policy measures are limited and temporary, and that they may on no account be used as a pretext to postpone necessary financial and economic policy reforms. It is an uppermost concern of mine to ensure that this does not give rise to any stability risks, such as would be the case if the public were to believe that monetary policy were being held hostage by fiscal policy.
The risks that the Eurosystem is assuming are, to a certain extent, unavoidable, but we are making every possible effort to ensure that these remain within justifiable bounds. This will be aided by Eurosystem efforts to speedily devise a plan for central banks to scale back the extensive provision of liquidity in a timely manner so as to preclude the danger of inflation. At the end of the day it is the member states, and not the central banks, that hold the key to resolving the crisis.
This is the English version of an op-ed by Jens Weidmann, the President of Deutsche Bundesbank, which was published earlier in “Frankfurter Allgemeine Zeitung” and “Het Financieele Dagblatt”. The translation was provided by Deutsche Bundesbank and is also available on its website.
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