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Whelan has revised and updated his paper on TARGET2. The new paper adds more information and (he thinks) explains many of the issues better than the original draft that he circulated last November.
The balance sheet of the Central Bank of Cyprus showed Intra-Eurosystem liabilities relating to TARGET2 of €8.9 billion at the end of January. It is likely that this figure increased over the subsequent period up until this week’s closure of Cpyriot banks.
Since the ECB acts as the “middleman” in the TARGET2 system, it would be likely that a decision by Cyprus to unilaterally repudiate its TARGET2 liabilities would lead to the ECB booking a loss and such a loss would wipe out most of, or possible more than, its level of capital.
Now before people go getting too excited about this, I suspect Cyprus would continue honouring its TARGET2 obligations even after an exit by paying the required low interest rate on euro-denominated liabilities. Also, the ECB is not the same thing as the Eurosystem. The balance sheet for the whole Eurosystem (including all the national central banks) shows almost half a trillion euros in capital and revaluation reserves. So people who worry about the Eurosystem needing to have assets that back its liabilities (not me, as you can see if you read the paper).
Still, some people (again not me) would wring their hands about the need for the national central banks to recapitalise the ECB and there would likely be a big media kerfuffle about this. Even though a default by Cyprus on its TARGET2 asset wouldn’t matter much in the grand scheme of things, I suspect this is an issue that senior staff at the ECB are very sensitive about. An unwillingness to let this TARGET2 balance get much bigger than current levels may be playing some role in the ECB’s decision-making on Cyprus."
TARGET2 and Central Bank Balance Sheets: New Draft, March 17, 2013