By Marshall Auerback, a hedge fund manager and portfolio strategist. Cross posted from New Economic Perspectives
Hans-Werner Sinn, president of Germany’s Ifo Institute and the director of the Center for Economic Studies at the University of Munich, has taken to the pages of the NY Times to explain why Berlin is balking on a further bailout for Europe. Amongst the points that Sinn makes against German sharing in the debt of the euro zone’s southern nations is a legal one:
For one thing, such a bailout is illegal under the Maastricht Treaty, which governs the euro zone. Because the treaty is law in each member state, a bailout would be rejected by Germany’s Constitutional Court.
Sinn also argues that Germany’s counterparty credit exposure already exposes the country to immense credit risk:
Should Greece, Ireland, Italy, Portugal and Spain go bankrupt and repay nothing, while the euro survives, Germany would lose $899 billion. Should the euro fail, Germany would lose over $1.35 trillion, more than 40 percent of its G.D.P.
Let’s leave aside Sinn’s broader rhetorical points (“Has the United States ever incurred a similar risk for helping other countries?” Umm, yes, it did – there was that little matter of World War II). Levity aside, professor Sinn does raise a huge potential conundrum as far as Germany and its broader relationship to the Eurozone’s institutions go. In fact, recent German Constitutional Court rulings on bailouts could well blow apart the European Monetary Union. This is because the potential unlimited liabilities to which Germany is exposed under Target 2, the ELA, and various other lender of last resort facilities adopted by the European Central Bank do on the face of it run afoul of the court’s ruling, which argued that any future bailouts had to be limited and subject to the democratic consent of Germany’s Parliament. What happens, for example, if someone in Germany were to challenge the very legality of Target 2 on those grounds?
This is not the first time in which Sinn has expressed concerns in regard to Germany’s exposure via “Target 2”; indeed, he was to our knowledge one of the first to raise this issue in a number of scholarly papers (see here).
So what exactly is “Target 2”? Target 2 refers to Trans-European Automated Real-time Gross Settlement Express Transfer. It is the euro system’s operational tool through which the national central banks of member states provide payment and settlement services for intra/euro area transactions. Target 2 claims can arise from trade and current account transactions as well as from purely financial transactions.
Recently financial transactions have become dominant. Funds have been taken out of banks on Europe’s periphery and have been deposited in banks in the north of Europe, principally in Germany. The bank receiving the deposit places those funds with the Bundesbank (or other recipient national central banks); in doing so it has its funds delivered through the Bundesbank (or other recipient national central banks), which in turn deposits with the ECB. Via the ECB the funds then go to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction. The so-called Target 2 outstanding balance is the net position of such claims between two European countries. The ECB in effect acts as the hub through which these transactions are mediated.
Target 2 has taken on heightened relevance in the past year as a consequence of the Eurozone’s silent bank run. As deposits have fled the periphery banks – Greece, Portugal, Ireland and Spain – these banks have become increasingly reliant on Target 2 to overcome funding problems.
As an aside, it is also worth noting that banks can also borrow under the emergency liquidity assistance (ELA) program. Such assistance is extended by single national central banks to their banking systems. The risk is borne at the national level. The collateral requirements imposed upon a commercial bank for obtaining ELA funds is less than the collateral requirements needed for obtaining Target 2 funds. The national central bank in a country like Greece with commercial bank deposit runs ultimately funds its ELA financial assistance to its commercial banks from the ECB. That ECB funding for ELA is above and beyond Target 2 funding.
The ECB also conducts repo operations with banks in the system. Recently these repo operations (e.g., LTRO’s) have also been funding banks in the periphery that have been experiencing deposit runs. It has been widely believed that LTRO funds received by Italian and Spanish banks went entirely into purchases of their government’s bonds. Some of these funds did go into purchases of national government bonds, but only in part; some of those LTRO funds financed deposit losses.
So where is the money ultimately coming from? To some extent there is a circular quality attendant with the banking crisis. Money leaves, say, a Greek bank. A wealthy Greek ship-owner is worried about the solvency of his country (or a concern that he might actually have to pay taxes), so he quickly withdraws the sums from a Greek bank and redeposits the money with a German bank. The German bank now might find itself flush with billions of euros which it can’t use, so it re-deposits the money with the Bundesbank, which in turn places it with the ECB. The ECB then might turn around and extends funding (via Target 2, or the ELA) back to the Greek banks and in effect closes the financial circuit created in the Eurozone when a citizen of one country chooses to move his deposit from a domestic bank to a bank domiciled in another euro area nation.
Of course, some of this money goes outside the euro zone (Swiss banks, US banks, London property, gold, etc) and it is almost certainly the case (even though the ECB would never admit it) that some of this funding (perhaps most of it) comes the ECB actually creating new net financial assets. To get a sense of how big the ECB’s exposure is, it is worthwhile looking at its “loans to other monetary financial institutions”, which is one of the line items buried in its balance sheet. That the ECB creates new euros in itself is hardly problematic from an operational standpoint: as the sole issuer of the euro, the ECB is free to provide as many euros as is needed to keep the funding system in place. It cannot go broke.
To reiterate, a private bank needs capital – clearly because there are prudential regulations requiring that – but because it can become insolvent. It has not currency-issuing capacity in its own right. While the ECB has an elaborate formula for determining how capital is from the national member banks, at an intrinsic level, it has no need for capital. It could operate forever with a balance sheet that if held by a private bank would signal insolvency.
The point is that there are no comparable concepts for a currency issuer and a currency user in terms of solvency. The latter is always at risk of insolvency, the former never, so there is no OPERATIONAL risk or limit per se implied in the ECB’s actions.
Although it might well assert to the contrary, the ECB has massively expanded its lender of last resort facilities, in many cases in violation of the Maastricht Treaty. As Professor Wilhem Buiter has argued in a recent paper:
[T]he European Central Bank (ECB) has been acting as lender of last resort (LoLR) for the sovereigns of the Eurosystem since it first started its outright purchases of euro area (EA) periphery sovereign debt under the Securities Markets Programme (SMP) in May 2010 (see de Grauwe (2011b), Wyplosz (2011, 2012) and Buiter and Rahbari (2012a)). The scale of its interventions as LoLR for sovereigns has grown steadily since then and its range of instruments has expanded. We interpret the longer-term refinancing operations (LTROs) of December 2011 and February 2012 as being as much about acting, indirectly, as LoLR for the Spanish and Italian sovereigns by facilitating the purchase of their debt by domestic banks in the primary issue markets, as about dealing with a liquidity crunch for EA banks. A future third LoLR instrument will be indirect lending by the Eurosystem to periphery sovereigns. This will be achieved through national Central Banks lending to the International Monetary Fund (IMF) and the IMF lending to the Spanish and Italian sovereigns, once these sovereigns have come under suitable troika (IMF, European Commission and ECB) programmes. If and when the European Stability Mechanism (ESM) gets a banking licence (becomes an eligible counterparty of the Eurosystem for the purpose of repos or other forms of collateralized borrowing), the ECB will have a fourth mechanism through which it can act as LoLR for sovereigns.
Which gets us back to the issues raised by Sinn: Reflecting mounting German concerns about the country’s growing counterparty exposure risks to the periphery, Sinn has proposed limiting Germany’s Target 2 exposures. From a German legal perspective, Sinn is on very solid ground. In May 2010, when Germany’s Parliament voted to provide financial aid to Greece to prevent it from insolvency and to approve the €440 billion ($620 billion) European Financial Stability Facility, with €147 billion in loan guarantees, this was challenged in Germany’s Constitutional Court. At the time, Germany’s highest court ruled that the parliamentary criteria had been adhered to when the government agreed to those specific bailout measures.
At the same time, the court said the Bundestag had not ceded any of its authority in budget decision-making with its approval of the legislation. Furthermore, the judges ruled that future aid package resolutions could not be automatic and should not infringe on the future decision-making rights of Germany’s parliament. Aid packages, they argued, would have to be clearly defined, and members of parliament would have to be given the opportunity to review the aid and also stop it if needed.
Under the terms of the German court’s ruling, then, Target 2 itself would appear to be unconstitutional, even though Target 2 itself was one of the features incorporated in the Treaty of Maastricht. But the problem with Target 2 is that it involves an open ended indeterminate exposure of the German people to losses involved in the bailout of the periphery. The German parliament has no say in the disbursements. That this is unconstitutional would appear to be very clear on the basis of Germany’s Constitutional Court rulings. Logically, it should extend to the other Lender of Last Resort financings that have been undertaken by the ECB, cited in the Buiter article above.
So consider the following: imagine that there is a Constitutional Court challenge of the Target 2 and other ECB lender of last resort financings. The day this occurs and becomes public the bank run will accelerate greatly. To be sure, the court might well rule that ECB agreements amongst the member states take precedence over the earlier ruling expressed in the wake of the 2010 bailout for Greece. But it would be hard to square that argument with the clear meaning expressed by the German court at that time. And if the Constitutional Court rules that ECB lender of last resort bailouts are unconstitutional the banks on the periphery will have to close and suspend payment on requests for withdrawals. So Germany’s court could well become the instrument of the euro’s destruction by frustrating the ECB’s capacity to operate as lender of last resort.