ECB’s TARGET2 system vs. Fed’s interdistrict settlement account

A nice analysis on TARGET2 account by Richmond Fed econs – Thomas A. Lubik and Karl Rhodes.

They say TARGET2 is not a cause but symptom of the Eurozone crisis. My research on the same was also on similar lines.  I am not going into Target2 discussion as have pointed to many articles etc in the past.

This bit on comparison of ECB’s Target2 system (t2) and Fed’s interdistrict settlement account (ISA) is really interesting. The comparison basically started when Herbert Sinn (who kickstarted the T2 debate) said the settlements between Eurozone central banks should be as done in Fed’s case:

Sinn also suggests that the ECB should limit TARGET2 balances or settle them periodically as the Federal Reserve does with interdistrict settlement account (ISA) balances among the 12 regional Reserve Banks.  

In April of each year, the Board of Governors and the New York Fed calculate the average daily balance (positive or negative) of each Reserve Bank’s ISA during the preceding year. The New York Fed then increases or decreases each Reserve Bank’s ISA by the amount of its average daily balance in exchange for an off setting decrease or increase in each Reserve Bank’s securities holdings in the System Open Market Account. This annual rebalancing generally pushes each Reserve Bank’s ISA closer to zero, but it does not reset the accounts to zero because the accounting exercise uses an average daily balance instead of the balance on settlement day in April.

It was all fine till the crisis came in 2008. The balances at regional Feds  diverged much like seen in Eurozone T2 as well:

In the years leading up to the fi nancial crisis of 2008, ISAs at all 12 Reserve Banks stayed relatively close to zero. The New York Fed account occasionally strayed into negative territory, but the April rebalancing procedures brought it back in line. (See Figure 3.) Beginning in fall 2008, however, ISA balances at  the Richmond Fed and the New York Fed diverged quickly and sharply from zero as the Federal Reserve System engaged in foreign currency swaps and other liquidity operations to help stimulate and stabilize domestic and international fi nancial markets.

Those actions had a disproportionate eff ect on the New  York Fed because it carries out transactions for the  entire system. In addition, the international operations had a  disproportionate effect on the New York  Fed and the Richmond Fed because the resulting foreign currency denominated assets were allocated to Reserve Banks based on their member banks’ paid in capital. New York and Richmond rank first and second, respectively, in that category. Rebalancing in April 2009 and April 2010 moved both banks’ ISAs closer to zero, but then the New York account soared to positive $368 billion and the Richmond account plunged to negative $149 billion by early 2012, mainly due to large-scale asset purchases in 2010 and 2011. (ISAs at other Reserve Banks also moved farther from zero, but Richmond and New York were by far the most volatile.

However, unlike concerns over T2 balances there are no fears here:

In the context of the TARGET2 debate, these unusual fluctuations prompted some economists to speculate that the Federal Reserve had suspended its April rebalancing procedures in response to the financial crisis.5 But that was not the case. Rebalancing in April 2012 brought the accounts at the Richmond Fed and the New York Fed close to zero (briefl y), but the fact remains that in early 2012, the Richmond Fed was “borrowing” $149 billion from the Federal Reserve System, and the New York Fed was “lending” $368 billion to the System. These large positive and negative balances did not represent a “stealth bailout” of the Richmond Fed and its member banks in the Fifth District, nor did they impede the New York Fed’s ability to lend money to financial institutions in its district.

Apart from this, there are real differences between the 2 systems:

There are fundamental diff erences, of course, between the Federal Reserve System and the Eurosystem. Most notably, Reserve Banks are owned by their member banks, and they serve one country with one national economy and fi scal policy. The NCBs of the Eurozone are owned by their respective countries, each with its own national economy and fi scal policy.  These diff erences create diffi cult challenges for the ECB, but TARGET2 does not cause those problems. It merely refl ects the long-term lending and collateral policies of the ECB and the relative strength of national economies within the Eurosystem.

Placing arbitrary limits on TARGET2 balances at this stage would not solve anything. To the contrary, TARGET2 restrictions would unnecessarily constrain cross-border transactions and ultimately defeat the purpose of the EMU.

Useful stuff. Though, need to track these ISA balances closely to figure the whole thing..

The crisis has made you look at things which did not matter at all some time ago..

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