18 April 2012

VoxEU: Eurosystem TARGET balance deviations call for cautious changing of the EU banking landscape

Since the start of the crisis the Eurosystem balance sheet has grown significantly. This column by Ossi Leppänen from the Finnish Ministry of Finance argues that these balances signal a need for change and restructuring in the eurozone banking sector.

In the monetary policy analysis, only the consolidated balance sheet of the Eurosystem is relevant. In a decentralised central banking system, individual national central banks’ balance sheets are relevant when assessing banks’ short-term financing needs vis-à-vis each of the national central banks. Apart from this, the decentralised system also opens the tricky issue of intra-area (TARGET) balances.

The eurozone central banks manage the TARGET system, which is an online real-time payments settlement system of the Eurosystem. According to the balance-of-payment terminology, the system registers current account transactions as well as the balancing financial account transactions. Thus, the Eurosystem decentralised financing operations and the TARGET settlement systems replace the need to use currency reserves as the final balancing source for the balance of payments inside a currency union. The settlement system is a central arrangement in the eurozone and is not a source of troubles as such. On the other hand, if large and permanent balance deviations in the intra-area accounts do occur and prevail for a longer period, they indicate important market tensions that need to be analysed and cautiously corrected.

Before 2007, the TARGET balances were well within a narrow €100 billion range. The deviations caused by the cross-border flows were mainly balanced through interbank transfers without difficulties. A significant change happened during the 2008, however, and again towards the end of 2011. The change was due not so much to national level current account differences between the EU countries but rather to problems stemming from financial items; partly from difficulties in banks’ own funding and partly from changing funding practices inside the EU banking sector.

We must also recognise that the TARGET deviations can be balanced in different ways. A properly functioning interbank market is the first natural alternative, but it requires full credibility and trust among banks. The other more permanent alternative would be to transfer assets and loan packages from ailing banks to more stable banks with full market-value compensation. For this type of transfers to succeed it would require appropriate trading platforms or resolution mechanisms that do not exist in the EU today. Thirdly, one must also note that administrated bank liquidations would also align the TARGET balances but this would only come at some expense to central banks’ profits through the loss-sharing arrangements between the eurozone central banks.

The longer the funding bias continues, the more central bank funding is needed. The ECB’s three-year longer-term refinancing operation (LTRO) funding will temporarily alleviate banks’ funding situation but is not a lasting solution. The risk is that the public-sector responsibilities will be exacerbated if both the funding and capital become dependent on public-sector back-ups.

If large dislocations on banks’ shorter-term funding and in TARGET balances become a permanent feature in the eurozone, this signals a need for structural changes in the eurozone banking sector. Permanent funding biases can be corrected if banks and the banking sectors, especially in the so-called periphery countries, can deleverage and also cautiously shrink in the longer run. In addition, administrated transfers of bank assets and loan packages from struggling banks to more stable banks would do the same, representing a sort of permanent interbank transfer.

Whichever method is used, if the changes are market-led or can happen over time in a managed way this would not threaten the flow of credit to the whole eurozone. Persistent deviations in the TARGET balances roughly indicate the amount of restructuring needed in the eurozone banking sector. If, however, structural changes and restructurings are not allowed to happen, the troubled banks will undoubtedly need continued central bank and/or other public-sector support.

Full article

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