News that the Bundesbank is fast approaching a zero domestic asset balance-sheet situation from a eurozone Target2 payment perspective has caused a bit of a stir in the financial commentariat space.
Critics suggest it’s largely unimportant, since there is no limit on Bundesbank transfers even if it runs out of assets.
And yes, this is true. In reality there is a constant churn. As Karl Whelan of the University of Dublin explains when one central bank deducts from its reserves and credits another, this results in it accumulating an asset in the form of a Target2 credit. But at the same time it results in a liability in the form of a credit to the German banking system’s reserve account:
Consider a transfer from a Greek commercial bank to a German commercial bank. The additional layer is that the Bank of Greece incurs a liability to the Eurosystem (via its TARGET2 payments mechanism) and the Bundesbank receives a credit from the Eurosystem.
The Bundesbank’s balance sheet shows an additional asset in the form of a TARGET2 credit and an additional liability in the form of a credit to the German commercial bank’s reserve account. Note that the Bundesbank is not lending money to the Bank of Greece. It is receiving a new additional asset. It is inaccurate to claim that such a transaction requires the Bundesbank to sell some of its assets to be able to deposit the funds into the Greek residents’ private Frankfurt bank account. No assets need to be sold. Once it receives the TARGET2 credit, the Bundesbank creates the money to deposit in the commercial bank’s reserve account and the Bundesbank’s accounts stay balanced.
But that’s not really the issue, in our opinion. While Target2 payments can flow eternally between banks, the point here is that every time the German Bundesbank attracts commercial liabilities (deposits) via this process, in an ideal world it would want to sterilise them to keep its bond market in check with ECB policy.
In order to do that, it would be inclined either to offer domestic assets into the market outright or unwind the number of bank loans it has extended against domestic collateral — assets which Whelan rightly points out come in the form of collateral for bank loans, conducted through repurchase agreements rather than outright securities owned. In the event that the Bundesbank runs out of domestic assets to sell or bank loans to unwind, this limits its firepower in the repo markets considerable, and via that its ability to dictate or set rates there.
It is for this reason German bund yields and repo rates are diverging so dramatically from the rest of the eurozone system.
The danger here, therefore, is not that the ECB will run out of money or assets. That was never the case. The danger is that the ECB’s monetary policy transmission mechanism might become compromised due to a lack of domestic assets held on the primary balance sheet, which is currently absorbing deposits on the eurozone’s behalf. Without those assets the Bank cannot ease the collateral crunch easily.
If the ECB can’t control German repo rates, or the private market’s average repo rate (which is now dedicated by quality bonds only) this inhibits its control over its primary mandate, which of course is ensuring price stability:
On that note, Perry Mehrling, Senior Advisor at the Institute for New Economic Thinking makes some interesting observations.
First of all, it’s important to relate everything that’s going on in the eurozone to the ‘collateral crunch’ which is hitting the system.
As Mehrling notes, while a lot of that crunch is related to private markets demanding collateral for all interbank lending, there are other factors that have contributed to it as well:
A second source of demand for collateral is the discount lending by national central banks to their own private bank clients. And a third source is the Eurosystem lending between national central banks, which takes place more or less automatically through the operation of the TARGET2 payments system.
That’s a lot of collateral! Some of it can probably be used more than once, but each time it is used there is another haircut, and the haircuts are getting bigger all the time. Consequence, collateral crunch.
So, NCB lending to banks and Target2 transfers are just as much of a collateral cruncher as anything else.
In that case, Mehrling suggests, why not bring in the IMF to act as an intermediary for the system instead? Not only can it act as a CCP for the NCBs, being the IMF, it could do so without requiring collateral in exchange, easing the existing collateral crunch considerably:
So here’s where the IMF can help. If the surplus NCBs (Germany) shifted their lending to the IMF instead of the Eurosystem, they would not require collateral. And if the IMF in turn bought the sovereign debts currently held by private banks, then those banks would not need to finance their holding, and hence would not need collateral to do so.
One consequence of such a refinancing would be to shift existing TARGET2 imbalances off the balance sheet of the Eurosystem–the accumulated stock is not going away soon and so long as it sits on TARGET2 it blocks current flows. Thus the refinancing itself will restore the ability of TARGET2 to absorb temporary imbalances, and so restore normal functioning of the Eurosystem.
Good thing in itself. But a second consequence would be to free up collateral that is now frozen.
A LOT of interbank lending is required to support sovereign debts on the balance sheets where they now sit, and in current circumstance ALL of that interbank lending soaks up scarce collateral that is needed, and in normal times used, for other purposes. All the collateral freed up by the IMF intervention would immediately be free to support other activities of the financial system, such as market-making in securities, and non-financial lending.
Would that end the collateral crunch? Would it also end the price distortions caused by that crunch? Would it, pray God, maybe even reverse the payment imbalances that are the source of the interbank lending stresses in the first place.
While this action would be a considerable move in solving the collateral problem, Mehrling agrees it naturally won’t solve all of them.
Nevertheless, what it might do is finally induce some unsecured borrowing in the system — and that, above all else, is what the system currently needs the most:
Personally, I think there are other, more systematic reasons for collateral shortage–let me cite here the latest Pozsar and Singh working paper–and so expect it be a recurring problem. But the IMF trick is a start, and perhaps shows us the way. In sum, what the system needs is someone to do some unsecured borrowing. If it isn’t going to be the ECB, then maybe the IMF will do. For both the ECB and the IMF, ECB for the banking system and IMF for the sovereigns, the borrowing should probably be thought of as unsecured borrowing of last resort (UBLF?). The EFSF, and now ESM, seem intended to serve as first resort, but their success depends crucially on the backstop provided by ECB and IMF.
In other words, unsecured loans to save the day.
Related links:
Is there an ECB? – Institute of New Economic Thinking
How Germany is paying for the Eurozone crisis anyway – FT Alphaville
The decline of “safe” assets – FT Alphaville
The eurozone crisis as balance of payment problem - FT Alphaville