This could be an ideal opportunity to write about a compelling reason for a European banking union. With the upcoming release of Hans-Werner Sinn’s new book ” Die Target Falle” (Target Trap) the German economist who initially warned about the systemic imbalances of the Target2 payment system is back in the news.
I believe that looking at this accounting figure provides the best overview of imbalances of capital flows within the Eurozone and allows for a much profound analysis than simply monitoring government bond yields as an indicator of risk in monetary transmission channels.
I will comprehensively give an overview of this system and then demonstrate why severe stress will not be mitigated by government bond purchases. Using the schematic monetary system from a previous post I will add on a central bank system and assume that these banks are in different countries but belong to the same currency union (Eurozone). As before a customer of bank A moves 50 of his deposit to a customer at Bank A to do one of two things:
- Purchase goods from client in country B (process as shown below)
- Or simply moving his money (deposit) to a bank in Country B (Capital flight)!
As shown in the previous post to make this payment the Bank A will draw on its overdraft facility at its central bank and transfer reserves (central bank currency) to the account at CB B. Obviously in the case of capital flight Customer B and Customer A are the same people. In the current example however bank B does not want to lend to Bank A as it regards this as being too much of a risk, even short-term (one of the main reasons for a banking union). In the previous post’s example, in an ideal system money market lending would have extinguished the overdraft at Central Bank A but these funds are now no longer available.
Bank A must now draw on a standing facility with its central bank to fund the withdrawal of deposits. It does so by pledging its assets (previously made loans, bonds etc.) at the central bank and uses these to convert the daily overdraft into a somewhat more permanent overdraft (in case of a Long-Term Refinancing Operation a 3 year overdraft). This is shown below in the semi blue-yellow square. Correspondingly central Bank records a claim vs. central bank B via its payment system Target2. To understand this you could view the entire central bank system holistically and note that central bank B has a liability to its bank but central bank A which was initially responsible for this liability by making the loan still holds the assets as collateral.
The next chart is relatively well known and shows these Target2 claims and deficits for the actual countries Germany and Spain. Germany would be Country B and Spain Country A. The data for the following data is from the corresponding central banks. It thus shows a build up of claims in Germany currently at almost EUR 800bn while the Spanish central bank records a EUR 400bn deficit.
For the final two graphs I have colour coded the lines similar to the first 3 charts. So the purple line corresponds to Target2, yellow to lending and orange to reserves. The following chart specifically shows the Spanish situation where the Target2 deficits almost perfectly offset total lending (LTRO and MRO). This shows that all the liquidity provided from central bank funding is being transferred out of the country.
In contrast the situation in Germany shows a different picture. The two yellow lending lines are almost at 0 and reserves are almost at EUR 300 bn through the deposit facility while the central bank as previously mentioned records a record Target2 claim vs. the Eurosystem.
Two interesting features have to be noted to conclude this post.
In contrast to the US where the FED balance sheet has expanded massively due to outright bond purchases the situation in Europe is somewhat different as outright purchases only account for a fraction of the increase. As shown the lending was conducted to provide a smooth functioning of the payment system and fund deposit outflow from the periphery countries to the core. While in an early phase of the financial crisis these outflows were perhaps to fund imports, undoubtedly the current outflows are predominantly outright deposit withdrawals.
This is a problem that QE and outright purchases of government bonds cannot fix. A banking union can therfore be understood as the predominant framework required for a functioning curreny union. By providing a uniform deposit insurance scheme backed by all members it wil no longer matter whether a German bank lends to a German bank or a Spanish bank. This cross-european guarantee will imply a transfer or further resources from the core to the periphery, but its implemenation is much more urgent and has the power to alleviate many more of the current imbalances than the continued focus on further liquidity measurements and bail-outs.