Central banks typically do two things. They issue currency and, as a banker to the banking system, they effectively run the banking system’s clearing house. Thus, a central bank will issue notes (liabilities of the central bank that are matched on its balance sheet by government bonds of the same value – central bank assets) and it will also accept deposits from banks (the deposit is a liability to the central bank and an asset to the bank) that can be transferred from one bank to another as a way of settling (or clearing) banks’ positions. So for example, if you are in Australia, and you write a cheque for $100 drawn on the ANZ bank that gets deposited at the Commonwealth Bank, then, at the end of the day, the ANZ will owe the Commonwealth $100. This outstanding debt can be settled by transferring $100 from the ANZ’s account at the Reserve Bank of Australia to the Commonwealth’s account. Typically, at the end of an average day, the two banks’ positions will more or less net out given the huge volume of transactions in both directions. So there is not much need to literally transfer central bank deposits, and even when there is an outstanding position, banks will often simply lend other banks the any cash they owe, so long as the bank that is lending them has good collateral (such as a deposit at the central bank). Thus, in practice, the central bank is rarely called upon to transfer large sums from one bank to another and the size of banks’ deposits with the central bank is typically only a small fraction of the total value of all the banks’ deposits.
As the runner of the clearing house and issuer of currency, the central bank is also well positioned to go beyond its clearing house role and lend money directly to a bank that may come up a bit short of what is needed to meet its obligations with other banks. In such circumstances the central bank may have to act as a lender of last resort to the bank in difficulty. So when the Queensland Metropolitain Building Society experienced a rumour-driven run and a rapid loss of deposits to other banks, it was forced to borrow from the Reserve Bank of Australia (via a trading bank) to settle its positions with the rest of the banking system. Typically, this is just a temporary intervention by the central bank.
The ECB is not much different from other central banks except the ECB also acts as banker to the various euro area central banks (which in turn act as banker to the banks in their own jurisdictions). TH admits that he doesn’t understand this particularly well at all – part of the point of this post is to figure this out – but think of the euro area as consisting of a central bank that clears the positions of 17 euro area central banks (the country-level central banks such as the Bank of Greece), each central bank having an account with the ECB and the clearing process between the euro area central banks being the Target 2 system. Typically, the accounts of these banks with the ECB would not be large and would be just enough to settle payments between the banking systems of various countries that could not be facilitated through the usual system of interbank borrowing and lending. But when one country’s banking system experiences a large loss of deposits that it cannot replaced by, say, issuing paper to other banks, then it will need to make up the difference by borrowing from its own central bank, which in turn must borrow from the ECB. If the central bank didn’t go to the ECB, then it would be forced to let its banks go bankrupt. This is what happened in Greece.
There is another way of looking at this. Imagine that the Bank of Greece had a typical fixed exchange rate system when the banking system suffered a loss of deposits to the rest of the world, then to maintain the fixed exchange rate, the central bank would have to have run down its foreign reserves, or if it could borrow them from another central bank (via a swap line) or borrow then from the IMF.
Chart 1 shows that between March 2010 and March 2011, euro area monetary and financial institutions (MFIs or, in this case, the ECB) transferred 20 billion euro to the Bank of Greece and another 20 billion since. This is roughly equivalent to 10% of Greek GDP per year! In turn, the ECB lent about one quarter of this money to Greek commercial banks. It has not been sufficient to make up for the 30% loss of deposits since March 2010.
Now we said that, as a clearing house for financial transaction, central banks were well placed to make these last resort loans. The problem here is that what this lending is doing is financing a run down in deposits. Although the data is not as clear cut, Greek lending to the non-bank private sector has remained pretty much stagnant over the last two years, but deposits at Greek banks have fallen. The difference has been made up by the lender of last resort loans. This essentially means that the ECB has been lending money to the Bank of Greece, which keeps some and lends some to Greece banks. The depositors at Greek banks have, in turn, withdrawn the money (about 11 billion euro, see Chart 2) and deposited it elsewhere (other euro area and Swiss banks). This could be a pure run, but should Greece exit the euro by suddenly converting all banking system amounts into new drachma, then these depositors will make a tidy sum and the losers will be the central banks of Greece and the ECB.