Financial Plumbing: Europe and the Fed's Interdistrict Settlement Account

One of this blog's most recurrently popular posts is a 2012 ditty entitled the Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. The Interdistrict Settlement Account, or ISA, is a highly esoteric "plumbing" mechanism that lies at the centre of the Federal Reserve System. After a century of being ignored, it suddenly became a popular topic for discussion in late 2011 and 2012 as the breakup of the euro became a real possibility. Groping for a fix, European analysts turned to the world's other large monetary union, the U.S. Federal Reserve System, to see how it coped with the sorts of monetary problems that Europe was then experiencing.

Here's a short explanation of the ISA. Consider that there is no such thing as a unified Federal Reserve dollar. Rather, both the paper dollars that you hold in your wallet and the electronic reserves that a private bank holds in its vaults are the liability of one of twelve distinct Federal Reserve district banks. Thanks to the convention among these Reserve banks of accepting each others dollars at par, a 1:1 exchange rate between each of these twelve U.S. dollar brands prevails. This gives rise to the useful mental short cut of assuming that there is one homogeneous dollar brand. But to do so ignores the heterogeneity at the core of the system —we can imagine worlds, for instance, in which one district's dollars, say those of the St Louis Fed, are considered to be so inferior to the rest that the other Reserve banks will only accept "St. Louis's bucks" at a discount.

All inter-district flows between Reserve banks must be settled, which is where the ISA comes into the picture. The ISA is a ledger that tracks the various imbalances that accrue between Federal Reserve banks. Each April that imbalance is settled by a transfer of assets from debtor to creditor Reserve banks, so that if St. Louis is owing and San Francisco is owed, then bonds will flow from the former to the latter, reducing each district's respective ISA balance (or increasing it) to a sufficient level.

I'm happy to say that my ISA post was useful to a number of researchers, including Karl Whelan (pdf), Kevin H. O’Rourke and Alan M. Taylor, and most recently, Alexander Wolman (pdf), who all made reference to it in recent papers. I like to think that this demonstrates the second purpose of the econblogosphere. The first purpose, of course, is to swarm over polished work by those like Piketty and Reinhart/Rogoff searching for chinks in the armour. The second is to act as an advance scout of sorts. When a completely new problem crops up, a blogger can quickly pump out a few posts, establishing a beachhead from which the main army—academics with time, money, and resource—can begin to launch a larger-scale attack.

While scouts can provide useful hints on where to launch initial sorties, they will always make a few errors, and I want to draw attention to one error I made in my ISA post. I speculated that the Federal Reserve banks may not have bothered to settle the ISA in 2011. Given a visual inspection of the various imbalances that had arisen between several of the Reserve banks, it appeared that the Richmond Fed in particular had been allowed to carryover a large deficit while the New York Fed (FRBNY) was stuck with an outstanding credit. Luckily for the small group of folks interested in the ISA, Federal Reserve researcher Alexander Wolman has recently provided some clarity on this issue.

Wolman has written the definite explanation of how the ISA functions and it is well worth your time if you want to discover how this fascinating mechanism works. (In defense of my old Idiot's Guide, note that I did manage to incorporate the destruction of the Death Star scene into it — I doubt Alex's editors would let him get away with that). He also goes through the data to show how the ISA settled in April 2011. I had originally focused on the New York Fed's ISA balance as the basis for my suspicion that settlement may not have occurred—the FRBNY's ISA balance had not fallen by the proper amount over the settlement month. But if you look at the FRBNY's securities balance on its balance sheet, you'll see that it rose by $100-$150 billion, an amount sufficient to settle the debts that other Reserve banks owed it. If you care to explore more deeply, Alex deals with this on page 135 of his article. I'm tickled pink that he managed to "settle" this bit of trivia since it has been a recurring topics on this blog. (See here and here).

I should point out that the 2011 episode interested me because if non-settlement had occurred, then the ISA would impose very weak constraints on payments imbalances arising between the various district Reserve Banks. European analysts, who were looking to the U.S. for inspiration, needed to know whether the ISA imposed stern limits on imbalances or lenient ones.

Like the Fed, the ECB is composed of a number of member banks, or national central banks (NCBs). Each issues their own brand of Euro while accepting all other Euros at par, thereby ensuring a smooth 1:1 exchange between the various Euros. Unlike the Fed, the ECB has no settlement mechanism. Imbalances that arise between member banks can continue growing perpetually. This is what appeared to be happening between 2008 and 2012 as European depositors, wary of a break up the Eurozone, fled the GIIPS banking systems for safe havens like German and Dutch banks, resulting in the emergence of massive deficits and credits between the various member NCBs. The chart below illustrates the size of these imbalances, which have since shrunk.

Source: Euro Crisis Monitor, Osnabrück University

A number of analysts, led by Hans Werner Sinn, felt that a U.S.-style ISA settlement mechanism should be grafted on to the European payments system. In theory, this would impose strict discipline on NCBs and prevent imbalances from emerging. Many, including myself, felt that this sort of discipline might be a bad idea.

But a better rebuttal of the proposed European ISA is that the Federal Reserve ISA was never the stern mechanism that folks like Sinn made it out to be. Though my point about 2011 non-settlement is false, other features of the ISA provide for long settlement delays, including the "rediscounting mechanism" that I mentioned in my Idiot's Guide. However, the best person to learn from on this topic is economic historian Barry Eichengreen who, in the video that I've linked to below, provides a definitive historical overview of the ISA.

While the whole video is worth watching, I'm going to draw attention to a chart that Eichengreen shows at around minute 14-15 which I reproduce below.

Source: Federal Reserve Bulletin, 1922

During 1920 and 1921, large and persistent imbalances between Federal Reserve banks emerged, much like the imbalances that have plagued the Eurosystem since the credit crisis. It would seem that the Fed, just a young pup at the time, faced the very same problem that the ECB began to face just nine years after its debut and, much like the ECB, it chose to handle it by allowing for non-settlement. Eichengreen (and Mehl, Chitu & Richardson) has an upcoming paper that explores the long history of Reserve bank "mutual assistance", although for now you'll have to be content with the video.

The European payment imbalances debate (or Target2 debate) has long since died out. Germany's ever-growing creditor position halted in 2012 and has been shrinking ever since while debtors like Italy, Spain, and Greece have seen their negative positions return towards zero. No one talks about intra-Eurosystem imbalances or Euro breakup anymore, at least not on the blogosphere. But I have no doubt that somewhere in the ECB's deepest catacombs a group of European monetary architects are debating if, how, and when to import an ISA-style settlement mechanism into Europe. Let's hope that they are very careful in their approach and consider the softest possible solution.

Central banks that trade on the stock market

Most people don't realize that the central banks of Belgium, Japan, Greece, Switzerland, and South Africa are all publicly-traded. In times past, central clearinghouses were typically privately-owned while the issuance of bank-notes was the domain of competing banks. The fact that a few central banks still retain traces of their former private nature is a good reminder that centralized banking isn't necessarily the domain of the public sector.

The Swiss National Bank, for instance, was founded in 1907 to take upon itself the issuance of national bank notes, hitherto provided by private banks. According to Hübscher and Kuhn (pdf), efforts to establish a wholly government-owned central bank were defeated in an 1897 national referendum. Opponents of the plan drew up an alternative proposal for a privately owned bank the structure of which would, according to Bordo, "not allow for state socialism or the public control of credit policy." One fifth of the new bank's capital would be given to the private banks to compensate them for the loss of their power to issue notes.

Nowadays, SNB shares trade on the SIX Swiss Exchange. The original 100,000 shares are still outstanding, with 2,185 private shareholders owning about 37% of the float. Another 53% is owned by the cantonal governments and cantonal banks and the last 10% by other public institutions. The Swiss Federal council (Switzerland's federal government) doesn't own a single share, a contrast to most central banks which are 100% owned by their federal government. The largest private investor is Theo Siegert, who owns 5.95% of the float. The SNB provides all breakdowns here.

Though the shareholders of the five central banks may to some extent "own" their nation's central bank, they don't exercise the same degree of control over their company that regular shareholders do. Here are some of the drawbacks to owning central bank shares:

1. Capped dividends: The SNB's dividend is capped at 6% of the company's paid-up share capital. Because the SNB was originally capitalized with CHF 25 million, a large amount a hundred years ago but today a minuscule slice, aggregate dividend payments to all shareholders are limited to a mere CHF 1.5 million a year (around US$1.6 million), or CHF 10.50 per share. At today's stock price of CHF 1115, the shares yield just 1% or so.

This is a stable dividend. The SNB has paid it going back to at least 1996 (the last annual report I could get my hands on). But unlike the typical common share, there is no chance of this dividend growing.

2. Profits siphoned away: Nor will the profits that are not distributed to shareholders stay with the Bank. The lion's share of the SNB's remaining profits go to the state. Specifically, two-thirds of earnings are paid to the cantonal governments, and another third to the Federal council. In 2011, for instance, the SNB earned CHF 4.9 billion. A tiny CHF 1.5 million sliver was paid to shareholders while the various governments received CHF 1 billion (the balance was held over as reserve for the next year).

Much like the SNB, the Bank of Japan (BOJ) pays a fixed dividend. The BOJ, established in 1882, trades on the JASDAQ for around ¥46,500 a share. The Bank is not permitted to pay more than 5% of its  ¥100 million in paid-up capital to shareholders. As is the case with the SNB, this was a large amount back in 1942, the last time the BoJ was capitalized, but today its amounts to just ~$10 million. The upshot is that the BOJ can only provide shareholders a piddling ¥5 million in aggregate dividends a year, or  ¥5 a share. This equates to just US$50,000 in aggregate dividend payments, or around 5 cents a share. Considering that total profits earned by the BOJ in 2011 amounted to  ¥503 billion (around $5 billion), the shareholders are getting peanuts.

3. Minority position: Unlike the SNB, the Japanese federal government owns 55% of the Bank's shares. This puts private shareholders at an even larger disadvantage since they must play second fiddle to a dominant shareholder at all shareholder meetings.

4. No residual claim: The Bank of Japan Act stipulates that should the Bank be dissolved, shareholders only get a return of initial paid-up capital. All residual assets belong to the national treasury. Thus shareholders get a mere  ¥100 million (around $1 million) back in case of dissolution, or around  ¥100 per share -- far less than the current  ¥46,500 a share. Genuine common shares would allow shareholders to get all residual assets.

According the the National Bank Act, SNB shareholders are also restricted in their ability to claim residual assets:

In case of a liquidation of the National Bank, the shareholders shall receive in cash the nominal value of their shares as well as reasonable interest for the period of time since the decision to liquidate the National Bank became effective. The shareholders shall not have any additional rights to the assets of the National Bank. Any remaining assets shall become the property of the new central bank.

This means that each SNB shareholder is entitled to CHF 250 a share upon dissolution, far less than the current CHF 1150 per share price.

4. Inability to select management. Even with their voting power, SNB shareholders have little influence over the composition of bank management. The supreme managing and executive body of the Bank is the three-member Governing Board. All three members are appointed by the Federal Council upon recommendation of the SNB's Bank Council. Here shareholders do exercise some power. They have the ability to vote 5 members of the Bank Council. But the remaining 6 are appointed by the Federal Council, which means that the Federal Council can always stack the deck to ensure that its people get appointed to the Governing Board.

In the BOJ's case, it appears that shareholders have no ability whatsoever to select BOJ officials.

5. Voting limitations: The SNB limits non-public shareholders to a maximum of 100 votes. Even though Theo Siegert owns 5,950 shares, he only gets 100 votes. Most common shares carry the privilege of one share, one vote.

The South African Reserve Bank (SARB) also imposes artificial limitations on shareholders. No single shareholder is allowed to hold more than 10,000 of the 2 million shares outstanding. This limits the ability of individuals shareholders or blocks of shareholders to exercise voting control, a key element of modern shareholder activism.

The SARB was established in 1921 and, much like the SNB, replaced the existing network of private bank-note issuers then operating in South Africa. Its shares currently trade for about R7.00 on a SARB-hosted OTC market rather than the local Johannesburg Stock Exchange from which the shares were delisted a few years ago. The market is thin, although according to the bank's records there are over 600 shareholders. Like the SNB, the federal government does not own a single share of the Bank.

Similar to the SNB and BOJ, the SARB can only pay a fixed dividend of 10% on paid-up capital. With just R2 million in paid-up capital outstanding (about $225,000), the Bank only distributes R200,000 a year, or R0.10 a share. Compared to the R53 million in central bank profits paid to the government in 2011, shareholders get next to nothing.

Because the return on all three central bank shares so far discussed is calculated on a nominally fixed amount of paid-up capital from a bygone era when a few million dollars was still a large amount of money, they trade more like perpetual bonds than stocks. But this isn't the case for our fourth publicly-traded central bank -- the Bank of Greece (BoG). In 1927, the private National Bank of Greece waived its right to issue bank-notes in return for handling the IPO of the new Greek central bank. The BoG currently has some 19,000 shareholders and trades on the Athens Exchange for around €16.

What makes the Bank of Greece unique is that it pays a fixed 12% dividend on paid-up capital and an additional dividend based on remaining profits. Whereas the first payment is fixed relative to paid-up capital, the second is floating, thereby allowing shareholders to get exposure to continued growth in the Bank's business. The floating dividend also exposes shareholders to declines in the Bank's business, which is what has happened over the last few years:

Due to the euro crisis, the floating portion of the dividend has collapsed from over €40 million to zero. The upshot is that BoG shares are much more volatile than the shares of their fixed-rate cousins the BOJ, SNB, and SARB. Below is the share price of the BoG, which seems to trade much like a regular bank common share:

The National Bank of Belgium (NBB) falls in the same mold as the BoG. The NBB was founded in 1850 as a limited liability company, with shares distributed to private banks who in exchange agreed to forgo the privilege of issuing bank-notes. The Belgian government subscribed to 50% of the shares in 1948. The Bank's constituting articles specify a minimum 6% dividend on paid-up capital and an additional dividend to be paid after the reserve fund has been topped up:

Article 32. - The annual profits shall be distributed as follows:
1. a first dividend of 6% of the capital shall be allocated to the shareholders;
2. from the excess, an amount proposed by the Board of Directors and established by the Council of Regency shall be  independently allocated to the reserve fund or to the available reserves; 
3. from the second excess, a second dividend, established by the Council of Regency, forming a minimum of 50% of the net proceeds from the assets forming the counterpart to the reserve fund and available reserves shall be allocated to the shareholders;
4. the balance shall be allocated to the State; it shall be exempt from company tax.

In 2011, the bank earned €900 million. Of this, a healthy  €61.6 was paid out to shareholders, with €225 and €618 allocated to the reserve fund and government respectively. The first dividend, it should be noted, amounts to a mere €600,000 a year, since it is based on a percentage of legacy paid-up capital from the 1800s. The second dividend provides pretty much all of the returns. Thanks to the floating nature of the second dividend, the NBB's dividends have appreciated nicely over the last decade:

Despite this stability, its shares, which trade on Euronext Brussels, have been volatile, falling from over  €4,000 per share in 2010 to under €2,000 last year:

Compare the NBB and BoG variability to the relative stability of the SNB, with its fixed coupon:

According to the SNB's 1997 Annual Report, the massive 1997 price spike was anomalous and due entirely to speculation surrounding the effects of the Bank's planned marking-to-market of their gold holdings:

The rise was apparently due to recommendations made in various broker reports, which were based on hopes that the planned revaluation of the gold reserves would generate additional earnings for the National Bank’s shareholders. However, the authors of these recommendations failed to note that the law earmarks for public use any profits in excess of the maximum dividend of 6%.

A sure example of the EMH not working.

It mystifies me why BOJ shares are so volatile. They promise a fixed and stable dividend, yet have collapsed from over ¥170,000 a share to ¥30,500 over the last few years. What happened in September 2005 that caused the shares to almost triple in value? Shares have recently rallied on the news that the BOJ will target 2% inflation, which is odd, since as a bond-like investment, the shares should fall with the promise of more inflation, not rise:

Below are the five central banks with their respective dividends and market capitalizations:

The NBB has the largest market cap, and justifiably so since it pays an attractive floating second dividend and, unlike the BoG, is a relatively stable institution. I find it amusing that the entire SARB can be bought for a mere $1.5 million. You can own a nation's central bank for the price of a large house!

What is even more odd is the terrific valuation being put on BOJ shares. In aggregate, BOJ shareholders earn a miserable $53,763 a year in dividends, only twice what SARB shareholders earn in aggregate. Yet the Japanese market is putting a value of $500 million on that cash flow, or 500x more than the value that shareholders put on SARB cash flows. BOJ shareholders have absolutely no claim on residual assets. What are they thinking?

Which one would I buy? Gun to my head, I'll take BoG shares. When things get back to normal they'll be paying a  €3 dividend which you can buy now for  €16 or so. But if you're going to take any profit from this post, hopefully its because it gives you another perspective from which to view centralized banking.

Mutilated money and central bank breakage

Mutilated Bank of Thailand baht notes

A couple of years ago Mike Sproul and I worked on a short project. Mike wanted to know what portion of outstanding central bank notes are actually held by the public and what percentage has been lost, destroyed in fires and foods, buried, and misplaced. The implications are that if a large percentage of notes have been destroyed over the years, then the central bank holds significant "free" assets in its vaults for which a corresponding liability no longer exists. If you're interested in what backs "money", then this amount is important.

This is a similar concept to the idea of a "breakage". Businesses that sell gift cards, which are really just liabilities of the issuer, would prefer if those cards were lost and never redeemed. After all, the issuer will no longer be on the hook for anything and can book a pure profit. Gift card liabilities that are never redeemed are called breakage. The loyalty point industry also makes use of the term breakage. Around 18% of points that loyalty point issuers sell to their partners will never be redeemed—which is huge breakage. (That statistic come from this publicly-traded loyalty point issuer.)

The term breakage also pops up in Breaking Bad which, I should add, is one of the most realistic TV shows out there from a moneyness perspective. In the fifth episode of season two, Walt gets angry at Jesse for losing money:

Walt: So you're saying that your guy got robbed--or rather you got robbed--but it doesn't matter.
Jesse: Dude, it's called breakage, okay? Like Kmart. Shit breaks.
Walt: And you're thinking this is acceptable?
Jesse: It's the cost of business, yo. You're sweating me over a grand?

Unlike Jesse and Walt, any business that issues bearer liabilities (like central bank notes, gift cards, and loyalty points) isn't afraid of breakage—they want breakage. Specifically, they want people to "break" ie. lose/forget their cards and points.

How much breakage do central banks enjoy? Mike's idea was to use conversion data from the pre-Euro currencies like the franc, deutsche mark, and lira. As a condition of the euro's debut, each nation's national central bank (NCB) was required to withdraw its existing note issues. Any one who owned legacy bank notes was given a horizon over which they could convert them into euros.

I've pulled the amounts of legacy bank notes not submitted for conversion from the financial statements of most European NCB's. This allows us to get a rough idea of how many notes may have been lost, burnt, or buried. I've focused on the Bundesbank, the Banque de France, De Nederlansche Bank, and Banca d'Italia—which should be a sufficient sample size. Below are the numbers in chart format.

As you can see, most legacy notes have been returned to their respective NCB. Italians and French lead the pack in returning francs and lira, with only 1.23% and 0.85% of the issue still outstanding. The Dutch and the Germans have been a bit lazy, with 2.44% of all deutsche marks and 2.79% of all guilders still unconverted.

What probably explains this discrepancy between the two groups is the horizon set for conversion. All lira had to be converted by December 2011, and all francs by February 2012. If you've still got lira or francs, you've missed the window. Guilders, on the other hand, can be converted into euro until January 2032. Deutsche marks have an even wider window—unlimited. If George Jetson still has some deutsche marks, he can take them in for conversion, assuming the euro still exists in 2062. These incentives (or lack thereof) no doubt explain some of the tardiness among the Dutch and Germans. Here is a list of time limits for redemption of each national issue of bank notes.

On the question of breakage, only ~1% franc and lira bank notes were never redeemed. A large portion of this 1% has probably been retained by the collecting community. Would it be reasonable to assume at least half? Both Mike and I were surprised that after decades of issuing currency, so little was lost to fires, flooding, rotting, misplacement, and whatnot. Maybe 0.3%-0.5%? Are people really that responsible and notes that indestructible?

One reasons for this low number is that damaged central bank notes can almost always be reclaimed. As long as more than half of the note remains, banks are required to accept it for deposit. If one-half or less of the note remains, it cannot be directly deposited. The Fed refers to this as "mutilated currency". But these notes aren't valueless since owners can send it to the Bureau of Engraving and Printing where it will be examined to determine its authenticity. A letter must be enclosed with the mutilated currency explaining why it was damaged. Presumably as long as all tests are passed, the owner of a small corner of a burnt US $100 bill will be issued a brand new bill by the Bureau.

The Fed provides a hyper detailed article here on the management of cash and mutilated currency. It's so precise that it's amusing. Learn how to properly stack, band, bag, strap, and bundle notes, and see pictures of burnt, liquid damaged, buried, and chemically damaged currency like the one below.

Examples from the Federal Reserve of mutilated currency

The Fed/Bureau of Engraving aren't the only institutions to adopt the policy of exchanging damaged currency—the European Central Bank does too. Perhaps these sorts of programs help explain the surprisingly low amounts of legacy European bank notes still outstanding.

The last question is this: who benefits from central bank breakage? The Banca d'Italia should be a good model for us since it just recently retired its entire issue of lira. One way for the Banca d'Italia to allocate breakage would have been for it to give the windfall to remaining bank note holders, say as a reserve fund to back the note issue going forward. Or each note holder might enjoy a special dividend if they provided evidence of their note holdings (could get complicated). Secondly, breakage could be distributed to central bank shareholders. Here is a list of Banca d'Italia's shareholders. Lastly, the Banca d'Italia could send the profits to the state. Here's what the Banca d'Italia actually did, taken from its 2011 annual report:

Accordingly, the Bank of Italy transferred the sum of €600 million to the Treasury, being the provisional balance of lira banknotes not yet presented for conversion by the deadline.

There you have it. Profits from breakage go to the state. And when we crunch the numbers, central bank breakage really doesn't amount to much.

Let the ECB capital key float

Bankers clear and settle with each other at a clearing house

Perry Mehrling had in interesting comment about how to settle the Eurosystem's Target2 imbalance problem.

If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System. More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.

Perry is talking about adapting the structure of the Fed's Interdistrict Settlement Account to Europe. To understand the ISA, check out my Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. In short, the 12 regional Reserve banks run up debts and credits to each other over the course of the year due to changes in payments flows. These debts and credits are settled each year by transferring securities that have been bought in open market operations from debtor Reserves banks to creditor Reserve banks.

The Eurosystem, on the other hand, doesn't require that the clearing debts wracked up by the various National Central Banks (NCBs) be settled. Which is odd. Not even Keynes's ICU would have allowed infinite debts, and Keynes was a forgiving sort of guy.

Perry's idea is that with the Eurosystem embarking on a program of Outright Monetary Transactions (OMTs), maybe the securities amassed will allow for a mechanism to settle intra-Eurosystem imbalances. Debtor NCBs like the Bank of Greece will have to transfer OMT securities to creditor banks like the Bundesbank. Perry specifically discusses the idea of having each NCB own shares in the OMT portfolio and have these shares transferable so as to facilitate settlement.

I like this idea and think it can be twinned with the already existing ECB capital key. What is the capital key?

All NCBs have an ownership stake in the overlying ECB. The relative amounts held by each are determined by the capital key. The key's weights are based on relative population and GDP. Germany for instance, has been given an 18.9% weighting in the capital key. Greece has been given a 1.96% weighting.

The ECB holds a unique set of assets on its balance sheet (see year-end 2011 statements). These have been transferred to it from the NCBs. First, it holds 16 million ounces of gold, worth around €21b. It also holds around €41 in forex reserves denominated in yen, dollars, and more. Lastly, it holds a few assets purchased during previous open market campaigns. Also worth considering is that the Eurosystem's total profits are paid out according to the capital key. This means that the profits yielded by assets held by the Bank of Greece don't necessarily get paid out to the BoG... they get amalgamated with all NCB profits and then allocated to each individual NCB according to the capital key. So having a big weighting in the capital key is definitely worth something.

Say that going forward all OMT purchases are conducted through the ECB and not the NCBs. That means that in addition to its gold and forex position, the ECB gets even bigger, and shares in the capital key are rendered more meaningful.

You can then institute a Fed-style settlement program by letting each NCB's weighting in the capital key float. Each year debtors get their share in the capital key lowered. Creditors get their's increased. That adds some quid pro quo to intra-Eurosystem balances. What happens if a central bank's representation in the capital key were to fall below zero because of persistent capital flight? Then the national government would have to recapitalize their respective NCB's contribution to the ECB so that it's portion of the key rises back to 0%. Or you could soft-pedal the whole thing and institute some sort of broad system of reforms a country has to initiate once it falls below 0%. Either way, the system is redesigned to have a tendency to equilibrate.

Is such a tendency necessary? I leave you with some words from Keynes's Proposals for an International Currency (or clearing) Union, February 11, 1942:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.

The Interdistrict Settlement Account finally settles

Last year and earlier this year, debate concerning the Target2 mechanism in Europe and its growing imbalances shed some light on the equivalent institution in the US, the Interdistrict Settlement Account (ISA). The argument has been made to import the ISA structure into Europe, in particular, the yearly settling of accounts between district Reserve banks. If the ECB were to operate this way, the idea goes, then there would be some sort of quid pro quo on Target2 imbalances - European national central banks (NCBs) would not be able to accumulate debts to each other ad infinitum.

The observation was made that contrary to what one might expect, the ISA at the time did not seem to be balancing. Thus the idea that adoption of the Fed model would impose "firm limits" on intra-Eurosystem credit is invalid, since the Fed doesn't seem to always impose settlement on district Reserve banks. This April, though, the ISA seems to have been settled, as the charts below will illustrate. Nevertheless, the point still stands that the Federal Reserve System may choose to constrain itself by requiring interdistrict settlement or it may choose to forego that restraint.

Greece is no Argentina

Paul Krugman compares Greece to Argentina. Devaluation in Argentina surely helped, and so would it in Greece. But there's a problem. See my comment:

The comparison to Argentina is a poor one. Argentina's central bank was a fully-operational currency issuer when it lifted its peg, and the peso already circulated along with dollars.

Greece's central bank is currently in-operational as a currency issuer; drachmas simply don't exist.

Should the Bank of Greece try to relaunch itself, will its drachma liabilities be voluntarily accepted as mediums of exchange? Probably not, for the same reason its bonds are worthless. Like the Greek government, the BoG simply has no credit. Compounding this is the fact that already-existing euros circulate in paper form, and the fact that so many Greeks have accounts in German banks they can use for payments. Given this broad array of payments choices, the free drachma will be stillborn.

Nor can drachmas be forced into circulation. A country that can't enforce tax laws can't enforce legal tender laws. No, the drachma won't be reappearing any time soon.

Krugman assumes that the euro is like a glove. You can put it on and take it off easily. In actuality the Euro is more like a Chinese finger-trap. It's easy to put on, but once you're in, getting out is well night impossible. As attractive as devaluation is, that's not the core issue. There simply is no way to get from here to there.

Greece will either stay in the Eurosystem, or will try to leave and end up with euro anyways. The latter is informal euroization.

On the problem of ensuring the acceptability of a new fiat money, see George Selgin.

More on the comparison of the Federal Reserve and ECB settlement mechanisms

Michiel Bijlsma and Jasper Lukkezen have a very good article on the Bruegel blog that deals with the question: why is there no Target2 debate in the US?

Target2 and the Federal Reserve Interdistrict Settlement Account

Perry Mehrling wrote an interesting post called Why did the ECB LTROs help?

He visits the comparison of the Federal Reserve Interdistrict Settlement Account and the ECB Target2 settlement mechanism. I have also found this comparison in a number of other publications, see the list at bottom. Here is the comment I left at the Money View blog.

My reading of the Euro-system rules is that deficit national central banks (NCBs) never have to settle with surplus NCBs. These intra-system balances can grow ad infinitum. Thus, deficit NCBs don't have to worry about owning acceptable assets for settlement, since there is no ultimate day of reckoning. The result is that survival constraints for Eurosystem NCBs are far looser than the survival constraints faced by regional Federal Reserve banks, which must settle each year. In the old days this settlement was conducted by transfers of gold certificates amongst regional Federal Reserve banks. After 1975 the settlement medium was switched to securities held in SOMA. But in the case of the Eurosystem, there is no ultimate settlement mechanism or medium that I am aware of, neither gold nor securities. 

Merhling's co-blogger Daniel Neilson had an interesting reply in which he pointed out that it would appear that the Fed's April settlement seems to no longer be occurring:

Indeed the Federal Reserve System seems to have decided to let FRBNY accumulate a large claim on the other Reserve Banks. One can see why the various Reserve Banks might not feel the need to imagine a breakup of the United States in deciding on the makeup of their balance sheets.

The appearance of non-settlement is noticeable in Mehrling's chart. The reversion to mean that should be occurring each April settlement did not happen in 2011. Debts to the New York Fed from other regional Federal Reserve banks are, seemingly, being allowed to accumulate.

Whether in fact settlement rules are being ignored is a mystery to me. Here is my comment:

Odd that this is not mentioned in the Fed's financial notes. What is the resolution of the data in that chart? End of week? It might not give sufficient granularity for us to assess whether claims were allowed to accumulate, or were settled for a day or two before returning to trend.

Buiter explains why the constraint can be escaped:

"The Interdistrict Settlement Account must be settled once a year with gold-backed securities or Federal treasury bills. This would represent a constraint on inter-district credit flows only if the stock of Federal Treasury bills allocated to the individual Federal Reserve banks was exogenous. However, individual regional reserve banks can always buy Federal treasury bills from banks or other holders of the stuff in their own districts, financing this with an increase in base money. The Federal Reserve Board could then decide to undo this transaction or ‘sterilise’, it. However, an interest-rate-setting Fed will only undo this, if the regional Fed’s Treasury bill purchase and the associated increase in base money were to lead to an excessive divergence between the actual Federal Funds rate and the Federal Funds target. This is highly unlikely. Even when the Fed’s official policy rate is at the effective lower bound for the official policy rate and the Fed is engaged in QE, there is no effective constraint on the ability of regional Reserve Banks to settle the Interdistrict Settlement Account imbalances with Treasury Bills funded with base money issuance. The yearly settlement requirement in the Interdistrict Settlement Account procedure would thus not appear to be a constraint on persistent credit imbalances between individual Federal Reserve banks’ districts."

I am hoping to investigate this mystery a bit further.

There are a number of conflicting resources explaining how the interdistrict account is settled, and how binding this is.

1. The key source is pg 136 - 138 of the Financial Account Manual for the Federal Reserve.
2. The Buiter quote I mention above comes from a Citi report called Original Sinn.
3. Peter Garber's Deutsche Bank article The Mechanics of Intra Euro Capital Flight also touches on the comparison.
4. Citi prints Hans-Werner Sinn reply to Buiter here, giving his views on interdistrict settlement.
5. Here is Sinn's initial paper.
6. I got the reference to the 1975 settlement changes from Meltzer, A History of the Fed, Vol 1. "The diminished stock of gold and gold certificates and rising levels of reserves and deposits required a change in interbank settlement... In 1975 the operations staff recommended that monthly gold transfers cease. Reserve banks other than New York would change once a year. New York would pay for withdrawals and receive deposits from the Treasury. Once a year, the Interdistrict Settlement Fund would reallocate securities in the System Open Market Account to balance accounts. Gold remain as collateral for the note issue, but securities would be the principal collateral (memo, Maurice McWhirter and Alan Holmes to FOMC, Board Records, April 11, 1975). Step by step, gold lost its monetary role and main provisions of the 1913 Federal Reserve Act disappeared."

There are no other good sources that I've been able to locate on the Target2/interdistrict comparison.

Note: I have blogged more extensively on the Interdistrict account here.

ECB, NCBs, and arbitrage yet again

Tyler Cowen posts again on the theory that banks are using the ECB's new and broader facilities for arbitrage by buying risky sovereign debt, thereby driving interest rates down.

There is another explanation for the fall in rates, see my comment below:

The new ECB collateral rules dramatically increase the quantity of assets that banks can submit to the ECB in order to get ECB clearing balances. Bank loans are now allowed, so are lower quality ABS. This means that it is less likely that the national governments will have to guarantee local bank debt. This was a real problem in Greece and Ireland, for instance, for the local banks had run out of assets to submit to the ECB. Instead, banks were creating debts amongst each other and having the government guarantee these debts, before submitting them to the ECB as collateral.

Since private non-marketable debt can now be submitted to the ECB, governments will no longer be required to covertly bail out their banks by guaranteeing intra-bank debts. That means that euro government debt is now a lot safer, and explains why yields are falling. So you can use an ECB arbitrage theory to explain the data, but there are alternatives.

Interfluidity also chimes in on The Eurozone’s policy breakthrough? My comment below:

I think the ECB’s policy change is designed to stop the intra-European bank run currently in effect, and not to support various governments. The arbitrage bit that Cowen is writing about is either a red herring or simply incidental.

Because of the Eoro area clearing & settlement mechanism, banks subject to capital flight need to submit collateral to their NCB on a continuing basis to deal with a bank run.

By lending settlement balances for three years and, more importantly, accepting lower quality ABS and bank loans as collateral, the ECB is committing NCBs to averting all degrees of bank runs from member banks. Hopefully this flexing of its muscles is enough to stop the run.


See this older blog post too.

ECB and NCBs again

Tyler Cowen has another post on the ECB financing sovereign governments via loans... It is finally being recognized that the eurozone made a major policy breakthrough:

My thoughts:

I don’t think the key here is arbitrage and government monetary financing. It’s about a slow bank run that has been enveloping Southern Europe for a few years now. The mechanism which governs intra-Euro payments requires Greek/Italian etc banks to “solve” for the bank run by submitting collateral to their national central bank in return for settlement balances. Much of this is done overnight or on a weekly basis. By establishing 3 year operations, the ECB is telling the banks and the rest of the world that they will continue to meet the demands of anyone running on the Southern European banks for the next 3 years. That sort of commitment to the system might be large enough to stop the bank run.

It’s similiar to how, in the old days, banks suffering bank runs would often bring out all their cash and gold from the vaults and put it on display behind the bank teller so that depositors, seeing the actual backing assets, would turn away. The ECB is putting its cash on display.

Relevant link: see this older post

ECB, NCBs, collateral, capital key, Target2, and intra-eurosystem credit

Two comments on The Money View. One on Perry Mehrling's The IMF and the Collateral Crunch and the other on Daniel H. Neilson's Is there an ECB?

Neilson links to the erroneous Tornell/Westerman piece. My comments on this are in a previous post. In short, Karl Whelan's Worse than Sinn clarifies the issue. Sterilization by the Bundesbank is not happening. 

Merhling and me discuss the nature of the transactions conducted between borrowing NCBs and the lending ECB.

Perry, I can't find any explicit reference to whether intra-Eurosystem credits are collateralized or not.

But I still think not. Collateral is posted by a borrower to a lender to protect the lender should the borrower default. Then the lender can collect the collateral instead.

But ECB losses are dealt with in a specific way. See bottom of http://www.ecb.int/ecb/orga/capital/html/index.en.html

In short, if the ECB suffers a loss on a loan to an NCB then that loss is allocated to all NCBs according to the ECB's capital key.

The March 2011 Bundesbank report describes this:

"An actual loss will be incurred only if and when a Eurosystem counterparty defaults and the collateral it posted does not realise the full value of the collateralised refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it. The cost of such a loss would be shared among the national banks in line with the capital key."
So it would be redundant or unecessary for an NCB to post collateral to the ECB for ECB credit, since in the case of non-payment the ECB has a claim on all NCBs to make up the loss.

That being said, I don't think this necessarily changes the thrust of your post.

Target2, ECB, and Euro NCBs

Commented at FT Alphaville on How Germany is paying for the Eurozone crisis anyway:

There are some good bits in the VOXeu article, although I have a few quibbles.

"“that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem.”"

The Bundesbank doesn’t need to fund its loan to the ECB by selling off assets. Effectively, German banks are deserting the PIIGS banks in droves. Reserves are flowing from the accounts of PIIGS banks at their domestic PIIGS NCBs to the German reserve accounts at the Bundesbank . Thus the Bundesbank’s reserve accounts (a liability to its domestic banking system) are rising even as its credit to the ECB (an asset on its balance sheet) rises. This is more or less automatic. So in order to balance a rapidly increasing credit item to the ECB, the Bundesbank doesn’t need a declining quantity of assets to act as the balancing mechanism; increasing reserves held at the Bundesbank will do the trick. There is nothing to exhaust. They don’t have to sell their gold.


Note that I think Karl Whelan's rejoinder "Worse than Sinn" available here is the best rejoinder to the FT Alphaville post.