Target2 - the cross border settlement system

Target2 - the cross border settlement system

by Pininvest Analysis

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Poorly understood, and rarely discussed, Target2, the cross border settlement system between the central banks of the Eurozone, may soon provide fodder for self-serving headlines

It is true that fast growing and very large imbalances have a way of quantifying the rift between core EU countries (foremost Germany) and the Southern periphery (Italy and Spain)

But the European Central Bank (ECB) definition is a clear reminder of the central purpose of Target2 : countering the fragmentation of the shared monetary infrastructure

The fundamental objective of the T2S project is to integrate and harmonize the highly fragmented securities settlement infrastructure in Europe
It aims to reduce the costs of cross-border securities settlement and increase competition and choice among providers of post-trading services in Europe
It is therefore a critical step forward in the creation of a true single market for financial services in the EU


In sum, Target2, covering all cross-border transactions, goods and services, needs to be understood in its own right before jumping to conclusions about assets and liabilities


Based on the network of the European Central Bank (ECB) and the National Central Banks (NCBs), Target2 is an integral part of the decentralized Eurozone monetary union

Target2 imbalances are inherent to such a decentralized union because banks may and often do have central bank accounts spread across different central banks

  • In case of a payment by a bank customer to a beneficiary in another Eurozone country, the financial transaction is recorded in the account of the NCB of the country initiating the payment, as a liability at the ECB
  • The deposit, and resulting credit in the bank account of the beneficiary translates in an asset in the accounts at the ECB on behalf of the NCB at the receiving end of the transaction


Since payments accounting for cross-border transactions within the Eurozone result in positive (assets) and negative (liabilities) entries on behalf of National Central Banks (NCBs) in the books of the European Central Bank (ECB), Target2 imbalances have been diversely qualified as

  • a record of the massive liquidity creation by the ECB – resulting in inevitable imbalances
  • debt of non-core Euro members (Italy and Spain), balanced by assets held on behalf of core members (mainly Germany) – debt which should be recognized as such by Italy and Spain (and is not…)
  • true measure of capital flight from the Southern non-core Eurozone members
  • stealth bail-out of non-core banking systems

None of these assertions is completely false but causality is usually twisted and key determinants must be reweighted over time

And because Target2 nets all movements of the balance of payments accounts of the Union member countries, it appears possible to identify the main drivers of the liability build-up in Italy or in Spain

The ‘explanations’ or ‘justifications’ assigned to these drivers obviously lend themselves to various interpretations

We argue in this note that the Eurozone remains an imperfect construct of a stable currency union

And in a forthcoming analysis, we will seek to prove that the fairly recent blow-out increase in liabilities at the periphery flows from interest rate repression by the ECB, which will most probably be reversed


A stable currency union

The principles of a stable currency union, as laid out by Robert Mundell in a 1961 article, are well understood

At the macroeconomic level, a union can be expected to operate smoothly, and economic imbalances between union members will be avoided, if all their economies move in harmony over an economic cycle

  • This assumes reasonably similar economic structures, open foreign trade and properly diversified economies
  • If any – or all – of these principles are violated, the union remains exposed to ‘asymmetric shocks’ causing financial imbalance : only closer integration can hope to counterbalance these shocks, as the European Union has endeavored to achieve

As a disequilibrium, reflected in one-way financial flows, builds up, adjustments have to be brought forward, by aligning national fiscal policies for the greater common good and by rebalancing factor allocation with free movement of labor and capital

Ultimately, transfer payments should be viewed as a backstop, because they net all movements of the balance of payments accounts of the Union member countries

This is precisely how the IMF Balance of Payments and International Investment Position Manual (2009) defines intra-currency balances (page 280 / 371)

A3.46 – Currency Unions

Transactions and positions corresponding to claims and liabilities among Intra- Currency Union National Central Banks and the Currency Union Central Bank (including those arising from settlement and clearing arrangements) are to be recorded for the central bank under other investment, currency and deposits or loans (depending on the nature of the claim) in the balance of payments and International investment position (IIP) of member economies


Cumulative imbalances – in Target2 accounts – imply that union integration has been at best fitful, which does not suggest that the EU has not put forward major structural programs, often with success

  • Over time however, economic integration has not followed the monetary lead, at least not to the extent hoped for, fiscal policies hardly harmonized and labor movements from one country (or region) to another remained (unsurprisingly) constrained
  • The Great Recession has laid bare the relative frailty of banking institutions at the periphery, compelling the ECB to take action
  • By replacing inter-bank lending, the ECB’s successful ‘nonstandard’ monetary easing has unintentionally facilitated the retrenchment of core financial institutions

Considered in sequence, and in a nut shell, these events led to the subsequent build-up of imbalances at the ECB

  • the core (German) banking system devolved the financing of the Southern periphery (and the associated risk) to the ECB while collecting overabundant liquidity
  • the retrenchment of financial institutions in their respective backyards has been all the more tempting to secure their status as national champions

With growing imbalances between Core and South, the ECB has to confront what is becoming a self-fulfilling prophesy

  • because of its structural imperfections, the monetary union is prone to doubt
  • the necessary quantitative easing is fostering a fragmentation the Central Bank is justly on a mission to contain


Our follow-up note will discuss the systemic vulnerability of increasing Target2 imbalances for the Eurozone, the underlying factors of imbalance and the most likely actions the ECB will initiate