TARGET2 imbalances, again at the center of attention

Wednesday 27 June 2018

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TARGET2 imbalances, again at the center of attention

Recent political developments in Italy, in particular the presence of Eurosceptic members within the government, have again shone the spotlight on TARGET2 imbalances. In this note, we propose to explain simply how the TARGET2 system works and the stakes they represent for the various stakeholders.

What is TARGET2?

TARGET2 (Trans-European Automated Real-Time Gross Settlement Express Transfer System) is a payment system that enables the settlement of national and cross-border payments in central bank money. This platform is managed by the Eurosystem.

The TARGET2 balances of Eurozone National Central Banks (NCBs) correspond to their assets and liabilities on the ECB, which acts as a clearing house that settles transactions among NCBs in the TARGET2 system.

How are TARGET2 imbalances emerging?

Let's take an example. When a customer of a bank A makes a payment to a customer of a bank B (for example to pay a goods transaction or to finance the acquisition of a financial security), the customer deposits of the bank A are debited while customers deposits of bank B are credited:

in the case where banks A and B are registered in the same country, the deposits of bank A at the NCB is debited, while the deposits of bank B is credited and the balance sheet size of the national central bank is unchanged.
in the case where banks A and B are not registered in the same country, the NCB of bank B records an asset in the TARGET 2 system while the NCB of bank A records a liability in this system.

Important: TARGET2 balances are not collateralized

Before the bankruptcy of Lehman Brothers, banks facing a decline in their customer deposits could easily offset it by borrowing the corresponding amounts on the interbank markets, which explains why TARGET2 balances remained very limited until 2008. The widespread mistrust since 2008, particularly in the interbank markets, has reduced this type of operation and the banks have made greater use of the financing proposed by the ECB (in particular, there has been a sharp increase in LTRO operations). It has been the starting point of the rise of the TARGET2 balances in terms of amounts.

How are TARGET 2 balances remunerated?

TARGET2 balances are remunerated at the ECB refinancing rate. As a reminder, the refinancing rate is 0% since March 16, 2016.

The question of the remuneration of TARGET2 balances could become an issue in the event of ECB rate normalization. Assuming a refinancing rate of 1%, the Bank of Spain and the Bank of Italy should pay each € 4bn per year interest on their TARGET2 liabilities

...Find out more below.