Home > Eurozone: The Secret System That Blew Another Hole In The Euro (FXE, EUO, IEV, VGK, VWO)
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Eurozone: The Secret System That Blew Another Hole In The Euro (FXE, EUO, IEV, VGK, VWO)

April 26th, 2012

Martin Hutchinson: According to financial consultant David Marsh, writing in CBS Marketwatch, the Bundesbank’s net Target-2 assets ballooned to 615 billion euros ($800 billion) in March, while the Banco de Espana’s net liabilities rose to 252 billion euros and the Banca d’Italia’s to 270 billion euros. 

Don’t forget: the Italian and Spanish central banks can no longer print money to satisfy their obligations; that is the function of the European Central Bank. 

Thus the Bundesbank has taken on around $800 billion of credit risk against the weaker economies of Europe. 


Since the German taxpayers would have to bail out the Bundesbank if it got in trouble (again, it cannot print money) the lawsuit looks reasonable. The amount involved is, after all, about $10,000 for every German man, woman and child.

This may sound arcane and boring, but I promise you it’s not.

What I’ve learned will blow yet another hole in the already shaky euro. 

It begins with Bernd Schunemann, a law professor at the Ludwig-Maximilian University in Munich. He has sued the German Bundesbank over its participation in the Eurozone “Target-2″ settlements system. 

Now I’ll be the first to admit that yes, my eyes do glaze over when thinking about settlements systems-and I used to be a merchant banker.

But looking at the details of the case I had something of a banker’s moment of clarity.

I realized that Schunemann was claiming that the settlements system had saddled German taxpayers with a potential liability of 615 billion euros, over $800 billion, in exposure to Greece, Italy, Spain and Portugal.

After all, who would have to bail out the Bundesbank if it became insolvent?

What’s more, when you un-glaze your eyes and look closely, the risk is entirely unnecessary. It is yet another huge botch-up job by the EU bureaucrats.

Here’s what I mean…

The Euro and the Target-2 Settlement System

The Target-2 settlement system was introduced in 2007, as a replacement for Target (Trans-European AutomatedReal-time Gross Settlement Express Transfer System).

The first Target was the large-scale payments system between central banks that had been introduced with the euro in 1999. 

Under the system, when a Greek makes a large euro payment to a German, his Greek bank makes a payment to the Greek central bank, which in turn makes a payment to the Bundesbank. Once it reaches the German central bank, it pays the German bank, which pays the German.

For ordinary trade transactions, that’s all fine and good. Greek exports to Germany are balanced with German exports to Greece. 

If, however, there’s a big trade imbalance between the two countries, then gradually an imbalance grows up between the central banks. As it develops, the Bank of Greece ends up owing the Bundesbank more and more money. 

Even more serious is when Greek citizens rush to get their money out of Greek banks and put it in German banks. Every million euros Greek citizens remove from their banks is a million euros by which the Bundesbank increases its exposure to the Bank of Greece. 

You can see how this could be big problem-especially since that’s the arrangement all around the Eurozone. 

Unnecessary Risk for the Euro

At first sight, this just seems like one of the costs of the Eurozone

However, when you think more carefully and look at the U.S. example, you realize this mess is entirely unnecessary. 

If an Alabama depositor of $1 million doesn’t like the prospects for Regions Financial Corp. (NYSE:RF) and decides to transfer his money to JPMorgan Chase (NYSE:JPM) his $1 million moves directly from Regions to JPMorgan Chase. In the process, it sets up an interbank liability of $1 million owed by Regions to JPMorgan Chase. 

There’s no Alabama Central Bank or New York Central Bank getting in the middle of the transaction. There’s no need for one, since Alabama and New York use the same currency.

In the U.S. case, it means no possibility whatsoever of a huge imbalance building up in the payments system. 

If all the Regions depositors start transferring money to New York, eventually the JPMorgan Chase “line” for Regions gets exhausted, or close to it. At that point, payments don’t bounce; the correspondent banking relationship officer from JPMorgan Chase calls his counterpart from Regions and tells him Regions needs to pay down its line. 

Regions then goes out and borrows some money, from another Alabama bank or maybe from the Fed, pays JPMorgan Chase, and everybody’s happy. 

If all the Alabama banks find money has gotten tight and nobody will deposit with them, they reduce their lending and raise the rates they pay on interbank deposits. Thus any shortage of cash is quickly alleviated, although local Alabama businesses find their loans have got more expensive.

This system could perfectly well have been used in Europe, with Greece as Alabama and Germany as New York. The Deutsche Bank and Commerzbank undoubtedly have (or at least, had) interbank lines with National Bank of Greece and Piraeus Bank, so payments could have been organized in the Eurozone just as they are in the United States. 

As imbalances built up with Greek overspending after 2001, the Greek banks would have had to pay down their obligations to German banks and Greek interest rates would have risen. The Greek bubble would have been choked off earlier than it was, and at less cost, and there would have been only modest amounts owed by the Greek banks to the German banks – probably very modest, as the German banks would have seen which way the flows were going, and would have reduced their credit lines to Greek banks.

Pious Euro Nonsense

However, the bureaucrats had to get involved, and set up Target/Target-2, making all payments go through the national central banks which were otherwise pretty redundant, once the ECB was set up. 

But if you read the Wikipedia article on Target-2, it’s full of pious stuff about “Supporting the implementation of the Eurosystem’s monetary policy and the functioning of the euro money market; Minimizing systemic risk in the payments market; Increasing the efficiency of cross-border payments in euro.” 

In reality what Target-2 did was take the credit monitoring out of the system. 

By giving national central banks something to do and allowing them to deal with each other, it allowed the system to pretend that Eurozone central banks would never default and that payment imbalances were not a problem. 

The credit risks of the payments system, which would have been handled by the banking system, were transferred to central banks and allowed to grow to their current monstrous size. 

And the normal local money tightening that would have been generated by persistent payment imbalances never happened, so Greek overspending and Spanish dodgy real estate loans grew unchecked.

It’s another huge weakness in the euro system, which will cause endless trouble in the years ahead. 

And it was all completely unnecessary. Too bad someday it will help sink the euro.

Related: iShares S&P Europe 350 Index (NYSEARCA:IEV), Vanguard European ETF (NYSEARCA:VGK), ProShares UltraShort Euro ETF (NYSEARCA:EUO), CurrencyShares Euro Trust (NYSEARCA:FXE), Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO).

Written By Martin Hutchinson From Money Morning

Martin is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor  to the Korean conglomerate, Sunkyong Corp. In February 2000, as part of  the Financial Services Volunteer Corps, Hutchinson became an advisor to  the Republic of Macedonia, working directly with Minister of Finance Nikola Gruevski (now that country’s Prime Minister). The nation had been staggered by the breakup of Yugoslavia – in which 800,000 Macedonians lost their life savings – and then the Kosovo War. Under Hutchinson’s guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what  they’d lost – to the tune of about $1 billion. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.

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