Disentangling the nature of Italy’s capital flights

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna


Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks' accounting method continues to prove elusive. Even the same ECB is explicitly warning not to infer bold assumptions from analysis of these data since simplistic explanations could lead to wrong conclusions.

Some academic research on the importance of Target2 balances has progressed considerably from the seminal but disputed work of Sinn (2012). The Sinn research has the merit in attracting attention on the relationship between the current accounts and the Target2 balances of Eurozone countries. A surplus in the current account should lead to a positive Target2 net balance, and vice versa. In this perspective, the Sinn research considers the Target2 balances in terms of a “stealth bail-out” of peripheral countries by the creditor central banks. According to Sinn, in the case a “debtor” central bank would leave the Eurosystem, the Target2 net balance would become immediately payable. A subsequent default of the debtor central bank would turn into a net loss for the Eurosystem to be absorbed jointly by all the remaining members (risk mutualisation or risk-sharing). Whelan (2012 and 2014) contested this view in many papers, pointing out that any central bank can always operate with “negative equity” (in other terms it could offset losses "printing money", without fiscal transfers from the taxpayers).  Now it seems understood (Szécsényi, 2015) that Target2 assets and liabilities could eventually lead to losses in case of a Euro break-up, but these should be a lot less than the raw net imbalances suggest.

At the present, a large part of the financial community seems to acknowledge that diverging net balances in the last two years are driven by purely financial transactions.  The current accounts of Eurozone countries are mainly in surplus (see Figure 2) due to the depreciating Euro and the compression of the level of prices and wages in the periphery (i.e. a phenomenon also known as internal devaluation). Hence, it could be inferred that the intra-European trade between Germany and the periphery (the Sinn hypothesis) is not the leading factor in explaining Target2 net balances.

Figure 3.

Digging deeper, it’s interesting to highlight also the strong correlation between the size of the ECB balance sheet and NCBs Target2 numbers. When the ECB inflates its accounts via expansionary measures, newly created money flows towards Eurozone banks that use it to regulate different kinds of transactions. When they are settled and accounted, these operations produce variations in the Target2 net balances. Let’s investigate the Italy’s case. As Figure 4 clearly depicts, Italy’s Target2 net balance and central bank balance sheet show a 96% correlation between 2011 and 2016.

Figure 4.

In the pursuit to understand movements in Italy's Target2 net balance, a detailed decomposition has been calculated by exploiting financial account data from the balance of payments (see Figure 5). The reconstruction has a good degree of precision, with little unexplained residual flows (the orange bars).

Figure 5.

In 2011 and 2012, core Eurozone banks sold significant amounts of Italian government bonds on the secondary markets because of an augmented perception of Italy’s credit risk (the green bars grew quickly). Those bonds were then purchased by Italian banks, which increased their exposure to national public debt. At the same time, German banks were deleveraging from long-term commercial credit exposure to Southern Europe. Net borrowing by the Italian banks on the Euro area interbank market also decreased markedly, due to the substantial reduction of deposits abroad and the missed renewals of existing loans. These phenomena (together with a progressively higher cost of financing) were signaling stress on the Italian banking sector’s funding practices  (the yellow bars). Together, this led to large capital outflow from Italy to the Eurozone core (denoted with a positive sign in core Target2 accounts; vice versa for Italy). The ECB’s LTROs and other unconventional measures have supplied over € 1 trillion to the Eurozone banks (€ 270 billion to Italy alone) that have been employed to finance the capital flight and transfer risk from the German banking system to the ECB.

When LTROs repayments began in 2013, the ECB balance sheets gradually deflated along with the Target2 net balances. Foreign investment in the Italian public sector resumed, though it did not reach previous levels. The missing amounts were partially compensated by a positive influx of foreign money in the private sector (sky blue bars). The divergence returned in June 2014 when Mr. Draghi launched the new T-LTROs in an effort to revive the sluggish Eurozone credit growth. In March 2015, PSPP’s launch accelerated the growth of ECB assets and had widened the spread between Target2 net balances.

New money flows (TLTROs loans and revenues from the selling of government bonds) reached Eurozone banks but only partially were employed to increase the exposure on national government bonds. A new source of capital flows has emerged and become the primary driver of Italy Target2 negative net balance: a shift in Italy’s private non-banking sector from government and banking bonds to foreign shares and mutual funds.  Looking closer at Figure 6, one can infer that the Target2 net balance (blue line) was only affected by the sell-off and the subsequent repurchase of Italian government bonds (green line) until June 2014. Afterward, foreign investment by the non-banking sector (red line) played a larger role in dragging down the Target2 balance. Moreover, the last few months of decline could be attributed to a renewed – albeit moderate – flight from government bonds.

Figure 6.

As of the beginning of 2016, over € 180 billion has shifted from Italy towards mutual funds located in Luxembourg, Netherlands and Germany. Only 20% of them can be traced back to Italian entities (i.e. round trip funds). The hunt for yield in a unprecedently low-interest-rate environment can only explain part of this sustained capital flight towards Northern Europe. Subtle but persistent redenomination risk (the risk that a euro asset will be redenominated into a devalued legacy currency after a partial or total Euro break-up) affecting Italian assets. Moreover, the fear of adverse effects of the bail-in regulation that came into effect in January 2016 may have had a meaningful role in explaining this massive portfolio readjustment by the private non-banking sector.
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References and Further Readings:

Publication of TARGET balances (2015) https://www.ecb.europa.eu/pub/pdf/other/eb201506_focus04.en.pdf.

Minenna et al. (2016 - forthcoming) “The Incomplete Currency: The Future of the Euro and Solutions for the Eurozone”, Wiley.

Sinn H.-W., Wollmershäuser T. (2012b), “Target balances and the German financial account in light of the European balance-of-Payments crisis”, CESifo Working Paper No. 4051, December.

Szécsényi P. (2015), “Nature of TARGET2 Imbalances”, https://www.asz.hu/storage/files/files/public-finance-quarterly-articles/2015/a_szecsenyip_2015_3.pdf

Whelan (2012) “TARGET2: Not why Germans should fear a euro breakup”, http://voxeu.org/article/target2-germany-has-bigger-things-worry-about

Whelan K. (2014), TARGET2 and central bank balance sheets, Economic Policy January 2014

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Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:

Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.

There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research

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Spain's banking system bleeding contained for now

Spain's banking system continues to struggle, with Bankia reporting more losses and tapping the government's bailout vehicle.

The Guardian: - Spain's answer to RBS – Bankia – published the worst results ever seen by a Spanish corporation, racking up 2012 losses of €19.2 bn (£16.6bn) as the nationalised bank drowned in a sea of toxic real estate left over from the country's burst housing bubble.

The figures confirmed the dire fortunes of a bank formed out of a merger of seven of Spain's ailing savings banks in 2010 as the government made a futile attempt to save them from disaster. Client flight during 2012 helped bring a 13% fall in total deposits.

Bankia became the focus of Spain's banking crisis last year after auditors refused to sign off on the accounts presented by company president Rodrigo Rato, a former finance minister from prime minister Mariano Rajoy's People's party (PP) and one-time head of the International Monetary Fund. It is now taking €18bn in bailout funds from the country's Frob bank restructuring fund, which had to borrow the money from the eurozone's bailout fund as part of a €40bn rescue of several struggling banks.

2012 has been particularly difficult for Spanish banks who relied on domestic deposits. Panicked depositors moved cash to Germany or even out of the Eurozone altogether to Switzerland. That forced the banks to tap the ECB's long and short-term lending programs for most of their funding needs.

But there may be some good news on the horizon. Some deposits are returning to Spain - cash flows recently turned positive. The flow data has a great deal of noise due to the effects of recent tax deposits as well as the issuance of commercial paper (pagares). The adjustment for pagares is shown below.

Source: Credit Suisse

Whatever the case, the "run on banks" taking place in Spain a year ago seems to have stopped - for now. That in turn slightly reduced banks' reliance on the ECB, particularly in the short-term funding program (MRO).

And as discussed before (see post), this reversal of flows should reduce Spain's TARGET2 liability - which is exactly what happened.

Clearly, both of these measures are highly elevated relative to historical levels, but nevertheless the "bleeding" has been contained.

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TARGET2 replacing other sources of funding for Bank of Spain

Kostas Kalevras posted his update for Bank of Spain's (BdE) balance sheet this morning. Once again, both lending to banks and TARGET2 liability rose sharply.

Bank of Spain lending to banks vs. TARGET2 liability

It is clear that lending to Spanish banks is now funded entirely via TARGET2 (borrowing from the rest of the Eurosystem) rather than with deposits. In fact deposits at the Bank of Spain by the Spanish government and Spanish banks (excess reserves) have been declining since the second 3y LTRO. These sources of funding have since been replaced by TARGET2, as the Eurosystem outside of Bank of Spain is now fully supporting the Spanish banking system .

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Desperate for more ECB funding and running out of collateral, Spain is creating a new type of covered bonds

Spanish banks are running out of collateral that can be pledged at the ECB. The ECB no longer permits banks' own bonds guaranteed by their government (beyond what's already been pledged) to be used as collateral (see the document in this post).

What about using more covered bonds? Unfortunately with unemployment pushing 25% and housing declining quickly, demand for mortgages has dried up.

Changes in demand for loans to households (seasonally adjusted, source: Bank of Spain)

That means mortgage-backed covered bonds (Cedulas) can no longer be issued. These bonds were quite popular in the Eurozone during the bubble years, but are now mostly sitting at the ECB as collateral.

In a desperate attempt to create more covered bonds in order to extract additional lending from the ECB, the Spanish government is about to authorize a new type of securitization structure:

Reuters: - Spanish banks are hoping that the new structure - Cedulas de Internacionalizacion (CI) - will extend this funding lifeline by allowing collateral, previously excluded, to be used.

Under the terms of the new law, export finance credit from high quality financial institutions or guaranteed public sector entities can be used to back a new issue.

This would have the added benefit of lowering issuers' funding costs because covered bonds benefit from lower haircut valuations compared with securitisation, Moody's said.

The ECB accepts self-issued covered bonds as collateral, but not self-issued senior unsecured debt, it added.

Spanish banks are already borrowing €337bn from the ECB (in practice the banks are borrowing from the Bank of Spain who is funding all that lending via TARGET2 loans from the Eurosystem). With these new bonds in place the central bank lending will increase further. Over time the nation's whole economy will in effect be funded by the central bank and any private credit that can be packaged into covered bonds will be pledged as collateral.

Spanish banks' borrowing from the ECB

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Germany's reluctance to deal with the crisis decisively created "back door" exposure

Here is an excellent quote from BNP Paribas on the Eurozone crisis. They point out Germany's false belief that the nation avoided extensive periphery exposure by limiting decisive crisis fighting measures. Instead Germany became exposed via the "back door" channels.

BNP Paribas: - ... We believe the German approach has been one of false economy. The mutualisation of country risk has occurred through the back door, but with far worse consequences for market dynamics than had sufficient resources been committed earlier.

Why do we say this? One euro too little, one day too late has always been a formula for mutating and strengthening the crisis. It’s a bit like a course of antibiotics – too low a dose, administered for too short a period, results in a more resilient and more difficult strain to beat. Isn’t that what we have now? At one stage, EUR100bn was a serious amount of money that bought serious relief in the market. Now, EUR100bn for Spain’s banks is shrugged off in a day.

Because of the progressive worsening of the crisis, the hidden costs of failure have mounted. These can be counted in two ways: first, the increase in the size of the ECB’s balance sheet, accompanied by a worsening of the quality of credit it takes as collateral, and second, the increased size of the TARGET2 balances, now exceeding EUR 900bn.
...
Germany’s reluctance to commit funds to resolve the eurozone crisis has resulted in it having greater exposure than it would otherwise have had – but through the back door rather than the front.

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Germany's growing exposure

With the latest summit "agreement" (assuming it gets off the ground) Germany will continue to increase its exposure to the Eurozone periphery. The nation's exposure will grow via its share of the ESM as well as the ECB who will be buying Italian bonds. That's in addition to what is already committed via the EFSF and its share of the IMF. There are also large direct exposures via the bilateral loans pooled by the European Commission (such as loans to Greece). And then there is the exposure that the media doesn't like to talk about because of the ongoing "debate". It is the Bundesbank's TARGET2 exposure, which just hit a record of about €700bn.

Bundesbank's TARGET2 exposure (€bn)

So what does 700 billion really mean in the context of Bundesbank's balance sheet? The balance sheet has grown as the exposure increased, right? But the reality is that TARGET2 is becoming an increasingly dominant component of Bundesbank's balance sheet. Almost two thirds of the central bank's assets are now tied in this "debated" exposure. And as funds flow out of the periphery states, the proportion is only getting larger.

In fact it is beginning to dwarf all the other assets. So here is a question: if you were Jens Weidmann or the the Bundestag or Angela Merkel or the German public for that matter, and you were looking at the chart below of Bundesbank's assets, what would you think? But no need to worry because these are just accounting entries and as long as the Eurozone stays intact there is no risk.

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The TARGET2 circle of life

Kostas Kalevras, who diligently watches central banks, today observed an increase in Bank of Spain's TARGET2 liability for the month of May. In fact this number has been climbing every month for the past year.

Bank of Spain TARGET2 liability

There are multiple questions that keep coming up on this topic as we see these balances grow. It's worth addressing two of them here.

1. How is it that TARGET2 continues to grow so rapidly even after the LTRO program? The answer is that depositors in Spain are moving money out of Spanish banks, while Spanish banks in turn replace their deposit funding with the MRO short-term funds from the central bank (Bank of Spain). The central bank provides this MRO loan by crediting the Spanish bank and debiting the Eurosystem (increasing the MRO on the asset side, offset by TARGET2 increase on the liability side). And so goes the TARGET2 "circle of life" - see the diagram below. If it turns counterclockwise, the Bank of Spain TARGET2 liabilities rise. If the flow changes direction, the liabilities fall.

2. Who cares? Why do these balances matter at all? The best way to answer this is to address some of Felix Salmon's commentary called Don’t worry about Target2 (ht Advisor Overheard).

Certainly a Greek exit would be small enough not to worry about at all. Greece has a negative Target2 balance of about €100 billion. What that means is that Greek banks owe the Bank of Greece €100 billion, which is fully collateralized; and that in turn the Bank of Greece owes the ECB €100 billion on an unsecured basis. If Greece were to chaotically devalue and default, then it’s entirely reasonable to assume that the Bank of Greece would default on those obligations to the ECB, and would keep the Greek banks’ collateral for itself, to help prop up as much as possible the nascent drachma.

This description of the Bank of Greece exit form the Eurosystem is quite accurate. And the Eurosystem would indeed absorb this loss fairly easily. Nevertheless it is a loss. In the Eurozone, just as it is in the US, the central bank profits go back to the central governments - every year. This loss due to Greece would offset the profits and the central governments (and the taxpayers) would certainly feel it. (Of course there would be other much bigger losses from "Grexit".)

Now if Bank of Spain were to exit the Eurosystem, that loss becomes more than three times as much (as shown in the first chart above). Italy's exit would be even larger. Central banks can of course continue to operate with a large loss. As Felix points out they are central banks, so they can't officially go broke. But that lost money would need to be recovered before central banks pay "dividends" to their governments again. So the taxpayer will feel that loss for years to come (or in one shot, should the governments choose to recapitalize the central banks.) With enough central banks exiting, the remaining Eurosystem will end up operating with negative equity - and it can certainly do that indefinitely. But ultimately the taxpayer gets hurt.

As an example consider why the Fed is so concerned about having Maiden Lane loans repaid to it as quickly as possible. Clearly the Fed can take this loss and not go broke - the central bank can just go on functioning with smaller equity capital. But it doesn't want to take a loss because ultimately it's the US Treasury that will get hurt by having to recapitalize the Fed or via the reduction in the income the Fed is paying out.

Because the Eurosystem can "print money" some argue it can effectively "recapitalize itself". There is simply no mechanism for that. The ECB can buy assets with printed money (QE), but that will cause it to grow its balance sheet, NOT increase its capital base (equity).

Felix argues that in case of the euro breakup, Bundesbank will start fresh with the deutsche mark. It would expand the money supply, somehow recapitalize itself, and the taxpayers wouldn't be responsible for the TARGET2 loss. But remember the "circle of life" above. Right now Germany owes a great deal of money to those Spanish (and other foreign) depositors. And the Eurosystem owes Germany some trillion euros - much of it generated by those same deposits. If Germany were to lose what it expects from the Eurosystem, it is a real reduction in the wealth of that country - no matter how many deutsche marks it prints.

A default on TARGET2 is a loss to the creditor nation even if the legal creditor is a central bank. And when one nation defaults to another, the pain is spread to the citizens, whether the default is on bonds, loans, or TARGET2 liabilities.

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German taxpayers face re-denomination loss from TARGET2

As the risks of Greek exit from the EMU increased, the mainstream financial media began to pay attention to growing TARGET2 issues within the Eurosystem. A recent Bloomberg article did a good job in describing the situation. But strangely, rather than referring to it as TARGET2 - the technical term, they called it the German "bailout" (although they've written about the topic before).

Bloomberg: - Here’s how it worked. When German banks pulled money out of Greece, the other national central banks of the euro area collectively offset the outflow with loans to the Greek central bank. These loans appeared on the balance sheet of the Bundesbank, Germany’s central bank, as claims on the rest of the euro area. This mechanism, designed to keep the currency area’s accounts in balance, made it easier for the German banks to exit their positions.

Now for the tricky part: As opposed to the claims of the private banks, the Bundesbank’s claims were only partly the responsibility of Germany. If Greece reneged on its debt, the losses would be shared among all euro-area countries, according to their shareholding in the ECB. Germany’s stake would be about 28 percent. 

Let's help Bloomberg with the explanation here. To start with, this is the "tricky part" - it's actually fairly straightforward. The arrows point to the direction of claims.

And here is how the Bundesbank claims grew. Bundesbank refers to it as "BBK01.EU8148: External position of the Bundesbank since the beginning of EMU / Claims within the Eurosystem / Other claims (net)".  For those who have trouble finding it on the newly redesigned Bundesbank website, you can plot it using Bloomberg charts here (just extend the period to 5 years to see the full effect).

Bundesbank "other claims" on the Eurosystem

But Bloomberg has yet to take that extra step and describe what would actually happen with these claims should a periphery nation exit. The exit would simply result in a re-denomination of some claims and would look like this:

There is no other way to do this. As loans to Greek banks become drachma denominated, so will the claim on the Bank of Greece (BoG), with the central bank separating from the Eurosystem. The Eurosystem was never designed for an exit of a central bank, so this process would need to be cobbled together on the fly - sort of the way the Greek restructuring was done. The "exercise" may potentially set up a process for other nations exiting the EMU.

In this scenario the Eurosystem's asset (claim on the BoG) is denominated in drachma and the liability in euros. The resulting P&L from the drachma devaluation will hit the books of the ECB and will need to be shared by the remaining Eurozone partners (of which Germany is 28%). So as the Bloomberg article points out, even if Germany avoided a massive direct bailout of Greece and other periphery nations, this "backdoor bailout" exposure will sill end up on the doorstep of German (and other core nations')  taxpayers.

Bloomberg: - In short, over the last couple of years, much of the risk sitting on German banks’ balance sheets shifted to the taxpayers of the entire currency union.

It’s hard to quantify exactly how much Germany has benefited from its European bailout. One indicator would be the amount German banks pulled out of other euro-area countries since the crisis began. According to the BIS, they yanked $353 billion from December 2009 to the end of 2011 (the latest data available). Another would be the increase in the Bundesbank’s claims on other euro-area central banks. That amounts to 466 billion euros ($590 billion) from December 2009 through April 2012, though it would also reflect non-German depositors moving their money into German banks.

By comparison, Greece has received a total of about 340 billion euros in official loans to recapitalize its banks, replace fleeing capital, restructure its debts and help its government make ends meet. Only about 15 billion euros of that has come directly from Germany. The rest is all from the ECB, the EU and the International Monetary Fund.

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Bank of Spain's latest balance sheet figures point to further deterioration

Kostas Kalevras, who's been closely monitoring the ECB and the national central banks in the Eurozone pointed out this morning that Spain's central bank (Banco de España) released the April balance sheet figures (see his analysis for more detail). Two things stand out:

1. Spanish banks are now borrowing record amounts from the Banco de España (the Eurosystem). The total is 1.15 trillion Euros. As discussed earlier a good portion of the collateral are the banks' own bonds guaranteed by the government.

2. Target2 liabilities of Banco de España continue to grow, indicating further flight of capital out of Spain.

With Greece in the backdrop and this latest news on banks borrowing record amounts, the markets responded negatively. The Spanish bill auction went quite poorly this morning and Spanish sovereign spreads blew out. The 10-year spread to Germany hit a new high (above the December highs).

Spain 10-year spread to Germany (Bloomberg)

Spain sovereign CDS also hit a record this morning.

Spain sovereign 5-year CDS (Bloomberg)

Given the state of the banking system the situation will continue to deteriorate without further LTRO funding from the ECB. As we've learned earlier this year, the central bank is the only institution that can create any material support for Spain's sovereign bonds at this stage.

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Italy's and Spain's central banks plugged a €131bn balance sheet hole, with TARGET2

There is still some debate out there about how Eurozone's TARGET2 imbalances increased so much last month. The answer is simple. The national central banks (NCBs) in the periphery used TARGET2 to plug the holes in their balance sheets generated by the second 3-year LTRO. We saw that the Bank of Spain plugged a €55bn hole with TARGET2. Bank of Italy did the same but their portion was materially larger. Not only did Bank of Italy have to fund the LTRO (to the tune of about €127bn), but the central bank also had a reduction in deposits from the government and a drop in bank reserves (another €10bn). That's about a €137bn hit to the balance sheet and here is how this outflow was "funded".

How Bank of Italy "funded" LTRO-II (€127bn), and other outflows (€10bn)

TARGET2 balance sheet plug for March alone represented €76bn, bringing the total "Other liabilities within the Eurosystem (net)" to €270bn - a bit of an increase from the last time we looked at Bank of Italy (when this number was €194bn).

On a combined basis Bank of Italy and Bank of Spain have plugged a €131bn balance sheet gap in March. Note that when the NCBs "borrow" from the Eurosystem, they do not post collateral (they hold on to the collateral that banks post to them under LTRO). There is a reason that the Germans are concerned.


For further detail, please see Bank of Italy Balance Sheet (end of March 2012)

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Coming up with €163bn to keep the Spanish banking system afloat

On Friday the Spanish sovereign CDS widened to a record and further risk aversion spread throughout global markets. Equity markets closed sharply lower. One of the factors that contributed to the market jitters was a massive increase in LTRO financing for Spanish banks last month - a total increase of €163bn, more than doubling the amount outstanding in February.

LTRO amount for Spanish Banks (€ million)

However this should not have been a surprise, given the ECB's €433bn LTRO program net increase (from €664bn in February to €1,097bn in March). Where did people think this money was going? Spanish and Italian banks grabbed a large share of this financing. But confusion still persists about the mechanics of how Spanish banks actually borrowed the money.

The ECB provides this financing via Banco de España, the Spanish central bank, which is part of the Eurosystem. The table below shows the changes in Banco de España's balance sheet.

Banco de España balance sheet changes (click to enlarge)

This table tells us exactly how Banco de España came up with the €163bn:

Financing  €163bn of LTRO for Spanish banks

A big portion was financed via the Banco de España's contribution to the ECB Deposit Facility (green - above). Spanish banks immediately deposited a portion of the LTRO funds back with the central bank in order to use the funds later to pay off their maturing unsecured bonds (it would have been a disaster without the LTRO). Some was financed via the reduction in the MRO, the short term central bank funding (blue).

A portion was financed via the deposits from the Spanish government (purple). In the first quarter, the Spanish government had issued almost half of its 2012 borrowing needs - clearly more than it needs immediately. It had to do it while the markets were opened. Some of that extra cash got deposited with Banco de España to be used later (particularly in case Spain has problems auctioning new debt later this year, which is a real possibility). Other than a relatively small change in bank reserves and "fine-tuning reserve operations", the rest came by borrowing from the Eurosystem (orange) via TARGET2 (which went up sharply as expected.)

TARGET2 balances of  Banco de España (used to fund part of the LTRO for Spanish banks; € million)

That's what it took to keep the Spanish banking system afloat - for now. But was it enough? These banks will need all the help they can get as Moody's prepares for bank downgrades shortly.

WSJ: Concerns over Spain were exacerbated by a calendar published by Moody's Investors Service for the conclusion of its review of European banks. Traders are seeing the review-for-downgrades as a major potential negative catalyst for financials. The expected timetable kicks off with the review of Italian banks next week and Spanish banks the week commencing April 23.

Much of the government debt that Spanish banks bought with LTRO money ("encouraged" by their governments) is now under water as yields shot up. The banks are taking significant mark to market losses. With questions persisting about whether the ECB will resume supporting periphery bond prices (with Spain all but begging them to do so), the markets are in for more volatility.

WSJ: Remarks by ECB governing council member Klaas Knot soured sentiment further, dashing hopes for further bond buying of 'peripheral' debt by the central bank. Knot said the ECB hopes to never "use the bond-buying program anymore," and the positive impact of the ECB's longer-term refinancing operations or LTRO on banks and credit supply are still visible.

Update: Kostas Kalevras did a nice write-up on this topic.


Update: Spanish banks now trade materially below the November lows:

MSCI Spain Financials Index (Bloomberg)

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Bundesbank tries to cap periphery exposure as TARGET2 claims spike

As predicted a month ago, the Bundesbank balance sheet grew materially due to increases in TARGET2 claims against other central banks. Again, these imbalances are driven by LTRO financing provided to periphery banks. In an LTRO transaction the periphery National Central Banks (NCBs) credit the accounts of their nation's banks (who seek LTRO financing) and debit the Eurosystem account. The periphery banks then pay down secured loans from German banks (replacing them with LTRO), increasing Bundesbank's TARGET2 claims (as euros move from periphery to Germany). In effect Bundesbank partially finances the periphery NCBs via the ECB. Below is the latest snapshot of Bundesbank's balance sheet.

Deutsche Bundesbank

Explanations: * The balance sheet items for gold, foreign currency, securities, and financial instruments are revalued at market rates at the end of each quarter. The figures for the latest date are always to be regarded as provisional. Subsequent revisions, which appear in the following publication, are therefore not specially marked. Discrepancies in the totals are due to rounding. — 1 For the detailed composition of the Bundesbank’s currency reserves, see table "Official reserve assets and other foreign currency assets" (Statistics/Regularly up-dated economic data/Data Template on International Reserve/Foreign Currency Liquidity), which is updated on a weekly basis. — 2 Deutsche Bundesbank’s claims on and liabilities to non-Eurosystem central banks are not included, see also footnote 4. — 3 Excluding Deutsche Bundesbank’s claims on and liabilities to central banks of the Eurosystem, see also footnote 4. — 4 Deutsche Bundesbank’s claims on and liabilities to central banks of the European Union (i.e. central banks of the Eurosystem and non-Eurosystem central banks) are recorded on a net basis; the net position of the Deutsche Bundesbank vis-à-vis central banks of the European Union is included within the item "Other assets" ("Other liabilities") if it has a positive (negative) sign. — 5 According to the accounting regime chosen by the Eurosystem on the issue of euro banknotes, a share of 8% of the total value of the euro banknotes in circulation is allocated to the ECB on a monthly basis. The counterpart of this adjustment is disclosed as an "Intra-Eurosystem liability related to banknote issue". The remaining 92% of the value of the euro banknotes in circulation are allocated to the NCBs on a monthly basis too, whereby each NCB shows in its balance sheet a share of the euro banknotes issued corresponding to its paid-up share in the ECB’s capital. The difference between the value of the euro banknotes allocated to the NCB according to the aforementioned accounting regime, and the value of euro banknotes put into circulation, is also disclosed as an "Intra-Eurosystem claim/ liability related to banknote issue".

Note that in order to obtain the exact TARGET2 position of the Bundesbank, one needs to net the "other assets" with "other liabilities". There is also a relatively small amount of claims against EU central banks that are not part of the Eurosystem that should be taken out. For the purposes of tracking the general trend however, that component can be ignored.

Deutsche Bundesbank claims on NCBs

This would not be an issue if the Eurosystem is to stay intact. However should a nation exit the euro, its central bank may not have the ability to cover its TARGET2 liabilities. In that case the ECB and the member states would be responsible for parsing out the losses among the remaining states based on their share.

Clearly Bundesbank has become concerned about its exposure to periphery nations. The central bank reacted to this increase by limiting the types of collateral it accepts. In particular it will no longer accept bonds guaranteed by certain Eurozone states (several states bailed out their banks by guaranteeing bonds issued by these banks, allowing them to post such bonds as collateral for LTRO financing - see this post for more detail)

Bloomberg (ht Kostas Kalevras): The Bundesbank won’t lend to banks against bank debt guaranteed by Greece, Ireland and Portugal from May, the newspaper said, citing unidentified officials. The Frankfurt- based central bank currently has less than 500 million euros ($667 million) of those bonds on its balance sheet, FAZ reported.

These specific bonds constitute a relatively minor exposure for the central bank, but because of the massive claims against the NCBs, it is trying to cap the overall exposure. This highlights Bundesbank's concern about the stability of the Eurosystem in its current form. It is possible this concern will soon spread to other core central banks, creating further rifts within the Eurosystem.

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Another good paper (and some comments) on TARGET2 imbalances

Attached is another good reference paper on the Eurozone's Target2 imbalances (hat tip Kostas Kalevras, @kkalev). A few comments on the topic:

1. The paper correctly points out the issue of liquidity imbalances (discussed here). This creates a divergence of money stock growth between the core and the periphery and severely impedes ECB's efforts.

2. Awash with liquidity Germany is more likely to decouple from the rest of the Eurozone, while the periphery would be hit by both tight money supply (tight credit conditions) as well as the various austerity related cuts. This will create a tremendous wealth disparity (and related social consequences) within the Eurozone.

3. It is important to clarify that Bundesbank's €500bn of claims is not against other central banks (NCBs), but against the Euro-system - effectively the ECB. If for example Greece were to exit the Union, the losses from the €100bn claim against the Greek Central Bank would be shared by the whole of Eurozone. Germany's cut is some 28% of that.

4. However it is possible that some other Eurozone members may not be able to (or decide not to) cover their portion of the losses, making Germany's exposure materially greater than 28%. This is not just a hypothetical scenario because the probability of Greece exiting the Union continues to be quite high in spite of the PSI debt reduction deal.

Enjoy.

Target2- Monetary Policy Implications


A great overview of TARGET2 issues is also available here.

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The issue with LTRO-II is not the spike in Deposit Facility

The American Enterprise Institute blog has posted an article entitled "The chart that should terrify the ECB" by Daniel Hanson. It shows a massive spike in the ECB Deposit Facility.

The deposits, which pay interest at 0.25 percent, have largely been made with funds obtained through two rounds of long-term refinancing operations, which charge an interest rate of 1 percent. Basically, banks are hoarding cash and losing money on the deal—something that will surely be a problem for the European economy.

Well, here is some news for Mr. Hanson and the American Enterprise Institute. The spike in the Deposit Facility was entirely expected. Even if every last euro from the 3-year LTRO facility was lent to Erozone citizens and corporations or used to buy securities, the Deposit Facility would still grow by the same amount. The rise in excess reserves, the bulk of which are balances in the Deposit Facility, simply represents net new lending by the ECB.

EUR MM, source: ECB

As discussed before, when the ECB lends money to a bank (via the National Central Banks), it simply credits the bank's reserve account. In the latest LTRO facility, about 2/5th went to repay short term loans from the ECB (rolling them into the 3-year loans). The other 3/5th became excess reserves. And banks just moved much of the excess reserves to the Deposit Facility because it pays a better rate than what they get in the reserve account. Some, possibly a big part of this liquidity will be used to repay bonds issued by banks during "good times" that are maturing in 2012 (many of these banks can not roll their maturing bonds - there are simply no private buyers).

The reason the spike in excess reserves is higher now than it was after the previous LTRO loan (chart above) is due to the fact that a smaller portion of the recent facility (LTRO-II) was used to repay existing short term loans. This generated larger net new borrowings from the ECB, thus higher excess reserves. At this stage the bulk of the borrowing from the central banks in the Eurozone is in the form of 3-year loans.

The mistake people often make is assuming that if banks were to lend these new euros out, the euros would leave the Deposit Facility. But any euro "created" by the ECB (via net new lending) has to end up in some bank's excess reserves (like the game of musical chairs). It may not be the same bank that took out the loan from the ECB, but it is still a bank within the Euro-system. So one way or another (whether banks, lend to each other, to clients, or buy securities) some bank in the Euro-system will end up with the excess reserves (net new euros never leave the system).

The issue with LTRO-II is therefore not the spike in the Deposit Facility. It is with the fact that Eurozone periphery (plus French and Belgian) banks end up using far more of the facility than banks from the "core" (particularly Germany). That has three effects:

1. It increases TARGET2 imbalances, with periphery central banks owing Bundesbank more money (as discussed here).

2. It creates a further imbalance in M3 money stock. Periphery banks use up the collateral previously employed for secured interbank borrowing (repo) to now post with the ECB against the LTRO loans. The collateral effectively leaves the system (and gets "trapped" at the periphery central banks for 3 years). A decline in repo borrowing among the banks in the periphery reduces broad money supply in these nations.

3. As more of the collateral, including retail and business loans (including ABS), that now qualifies for LTRO, is pledged to the ECB, any unsecured bonds that periphery banks still have outstanding will have zero recovery in case of default - since all the "good" assets have now been pledged (encumbered).

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Bundesbank’s balance sheet expands due to TARGET2 increases; will grow further after LTRO-II

Bundesbank’s balance sheet is continuing to grow at a fairly rapid pace. The January increase was driven by a rise in TARGET2 claims against other Eurozone central banks - a EUR 34bn claim increase in a single month (the liability side was increased via deposits by banks.) This is represented on Bundesbank’s balance sheet by "Other assets/Liabilities" (see table below):

Deutsche Bundesbank’s claims on and liabilities to central banks of the European Union (i.e. central banks of the Eurosystem and non-Eurosystem central banks) are recorded on a net basis; the net position of the Deutsche Bundesbank vis-à-vis central banks of the European Union is included within the item "Other assets" ("Other liabilities")

Bundesbank Balance Sheet (source: Bundesbank)

With the bulk of the EUR 523bn LTRO-II participants being non-German banks, the TARGET2 imbalances will increase further. Bundesbank’s balance sheet is expected to grow materially, with the bulk of the expansion coming from rising TARGET2 claims - on the asset side. The periphery central banks' balance sheets will grow as well, but with TARGET2 claims on the liability side. On a consolidated basis the ECB will show an increase in long term loans to banks on the asset side and a rise in deposits/reserves on the liability side.

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German people zero in on TARGET2 imbalances; may derail ESM increases

Let's for a moment continue with the topic of Google Search trends. One trend in particular indicates that the German people are becoming increasingly aware of and likely concerned with TARGET2 imbalances. The chart below shows a spike in global searches for the word "TARGET2". The bulk of those searches are coming from Germany, particularly from Hesse (likely dominated by searches out of Frankfurt).

Google search relative statistics for "TARGET2" 

The debate on the issue has sharpened as the public is becoming inpatient with the demands (at least from the German perspective) the currency union is placing on them. As one German newspaper points out, it is rare that an abstract ECB payment mechanism has attracted so much attention.

Frankfurter Allgemeine: Selten hat ein abstrakter Notenbankmechanismus in Deutschland so viel Aufmerksamkeit erregt wie die Target2-Salden des Eurosystems. Insbesondere Ifo-Präsident Hans-Werner Sinn schlägt Alarm. Ulrich Bindseil von der EZB widerspricht ihm fundamental.

The unease of the German people, many of whom perceive TARGET2 as a "backdoor" bailout, may end up derailing the Eurozone's ability to scale ESM to the desired levels.

MSN: Germany, however, has taken a tough public line on limiting public funds used for bailouts. A government official close to Chancellor Angela Merkel insisted on Sunday that there is already enough money pledged for the euro-zone's rescue fund, known as the European Stability Mechanism. Berlin has said it sees no need to combine the ESM with a temporary fund, the European Financial Stability Fund. "The German government's position is unchanged: we see no need to increase the upper limit of the ESM," said the official in Berlin.

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The new LTRO will boost TARGET2 imbalances - Bank of Italy example

As the ECB gears up for the LTRO-II program, one of the issues they ought to keep in mind is the increase in TARGET2 imbalances it will cause. With this additional borrowing by the periphery and French banks via their national central banks (NCBs), the balance sheets of the NCBs will grow further.

Consider Italy for example. The Bank of Italy balance sheet has grown dramatically in the last 7 months with the bulk of the growth coming from loans to Italian banks. These include short and long term (LTRO) lending. Notice in the chart below that the 3-year LTRO replaced some of the short term funding in December. The total lending to Italian banks reached over €200bn at the end of 2011.

Bank of Italy lending to Italian banks  (€ MM)

On the liability side of the Bank of Italy balance sheet, the debt to the Eurosystem has grown at a similar rate, also approaching €200bn. This is effectively how loans to Italian banks have been financed since mid-2011.

Bank of Italy liabilities to the Eurosystem (€ MM)

Now, with ABS and even corporate loans permitted as collateral for LTRO financing, banks will tap the facility to the fullest (leaving no unencumbered assets on their own balance sheets.)

The ECB:  ... national central banks will be allowed, as a temporary solution, to accept as collateral additional performing credit claims (namely bank loans) that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the national central bank authorising their use. 

Therefore making these new LTRO funds available to banks will grow the NCBs balance sheets further, increasing their liabilities to the Eurosystem. The periphery NCBs in particular will build disproportionate amounts of such liabilities in order to provide more financing to banks in their countries.

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