The Remarkable Eurozone Clearing House

The ECB’s Target 2 clearing system is currently the only thing preventing the Euro system from collapsing — as it was designed to do. In fact, what is happening at the ECB is a remarkably interesting look into the role central banks play in the workings of the monetary system via their function as a banking system clearing house.

The Target 2 system is a clearing system for banks in the Euro area. When a bank in one part of euro system receives a deposit from a bank in another part, say in the form of a cheque, the receiving bank has an effective claim on the issuing bank, which has to be settled (i.e the banks’ positions have to be closed out). Don’t know the exact numbers, but it is likely that there are millions of such transactions every day, which are quickly and effectively settled via the Target 2 clearing system.

If banks trust one another, they will settle their positions between themselves with no need for the ECB to get particularly involved. For example, suppose a German bank receives a deposit, electronically transferred from, say, a Spanish bank, but the Spanish bank lacks the cash to immediately close out its position with the German bank. In normal times, the two banks would clear their positions with the Spanish bank offering to issue a short term IOU to the German bank until it had the cash to permanently close its position. But when the German bank isn’t so trusting of the Spanish bank, it may refuse the IOU (perhaps the Spanish bank is making losses and it doesn’t have enough collateral to back the IOU). In this case, the Target system can act as the intermediary between the two banks by essentially allowing the Spanish bank to borrow from the ECB and depositing the proceeds into the German bank’s ECB account. Instead of the German bank having an outstanding position with the Spanish bank, it ends up with cash from the ECB and the ECB accepts the Spanish bank’s IOU. The German bank ends up with a positive Target 2 balance and the Spanish bank ends up with a negative balance.

Strictly speaking, commercial banks (e.g. Deutsche Bank) from each country deal with their own national central banks (e.g. the Bundesbank) and the national central banks represent their commercial banks at the ECB with the ECB acting as an intermediary between the two national central banks. Because of this, the Target 2 system is not only a clearing house it is actually what makes the euro area a common currency area. To see why, suppose that the ECB did not offer to automatically settle the positions between the German central bank and the Spanish central bank. Then, when there was a net transfer of funds that banks didn’t settle between themselves, the Spanish central bank would have to bid for funds to transfer to the German central bank. This would drive up the price of German deposits relative to Spanish deposits. The value of money in German banks would start to fluctuate against the value of Spanish deposits and the two countries would effectively have a floating exchange rate. Thus, because the ECB stands ready to automatically clear any net positions between the two central banks, deposits in German banks have the same value as deposits in Spanish banks and vice versa. Essentially the ECB is fixing the price of deposits between the two banking systems by mopping up any excess supply of or satisfying any excess demands for one country’s deposits relative to another’s.

When all is well and banks trust one another, the net Target system balances should normally be fairly small; but when there is banking system stress, the target balances can become quite large. And right now, they are huge. Check out the Chart, which shows each euro area member country’s target balance as a share of national GDP and how much it has changed in the last year. Thanks to this handy dandy Euro crisis monitor at the University of Osnabrueck in Germany  (

The numbers are disconcerting, to say the least. Banks in Cyprus, Ireland, Greece, Portugal and Spain depend on the Target system for deposits to the order of more than 30% of GDP. This means that over the last year or two, the periphery country banks have experienced huge amounts of capital flight.

These bank deposits have been flooding into core Euro area countries. German banks are now holding around 25% of German GDP at the ECB – Finnish banks have about 30% of Finland’s GDP on deposit at the ECB. This is not normal. The European banking system should clear without the ECB. So when it isn’t (and by such incredibly large amounts), you should be worried (and grateful that the whole thing is holding together).

So what does all this mean? Well, firstly, this reveals just how effective the TARGET2 system has been.  It is doing exactly what it is supposed to do: prevented banks in the periphery from losing access to euro liquidity.  This is incredibly important because if that did happen, as explained above, then a fall in demand for periphery assets would require price of the nominal value of those assets to float against the price of nominal assets in the core and the fixed exchange rate element of the euro system would, for all intents and purposes, be broken.

It also means that the ECB has effectively taken on much of the periphery banking system risks which used to be borne by periphery bank depositors.  These depositors resided in both the periphery (Spanish households and so on) and in the core (Germany had large surpluses that were effectively deposited at periphery banks), and they have now withdrawn their funds, deposited them at German and Finish and other core banks. These funds have then been re-lent to the periphery via the ECB, which bears the risk. Ultimately, these risks are redistributed back to the Euro area governments — each government’s central bank is liable for losses according to its shareholding in the ECB.

TH might be wrong here, but it seems that the ECB is now shouldering a good chunk of the future losses of Europe’s banks. Indeed, it could be argued that euro area crisis management is now being conducted by the ECB.  The reasons are simple. First and foremost, Europe’s political and economic policy institutions (other than the ECB) have failed to do anything of substance. On the other hand, the ECB has a well defined governance structure, it has a well designed set of rules that appropriately and clearly redistribute loses to its members (i.e. it can take on losses from one part of Europe and share them across the euro area), it has the power to tax via the inflation tax, and it can provide subsidised lending to states and banks.  In short, the ECB is the Euro area’s federal fiscal agent – its treasury if you like.  Soon, it will become the euro area’s banking supervisor as well.  TH wonders when they boys and girls in Frankfurt find time to set monetary policy.

3 thoughts on “The Remarkable Eurozone Clearing House

    1. Danke, Robert. Your website is the finest and most complete listing of works related to the European System of Central Banks’ Target system. A fantastic resource. Thanks for the link.

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