Collateral is key for target debate

In my letter of June 8 2011 to the FT, I had argued that the lack of collateral will limit flows of the eurosystem to the periphery and thereby limit target 2 balances. This has now somewhat been addressed by a growing recourse to Emergency Liquidity Assistance and Long Term Refinancing Operations that include a substantial expansion of the collateral pool. Jens Weidman of the Bundesbank has started a debate on exactly this link between target balance and the collateral pool. In his letter, he raises doubts about the quality of the collateral posted. So have we reached the limit of the target imbalances? Should the eurosystem ask for better collateral? Should the collateral be actually posted at the ECB and not just at the national central bank? Let me make four remarks.

1)      The central role of the Eurosystem is to provide unlimited liquidity in case of a confidence crisis. Only if investors trust that this unlimited liquidity can be provided, it is possible to prevent a confidence crisis from deepening. The ECB is rightly providing these large amounts of liquidity to the banking system of the periphery. It was therefore counterproductive to have the letter by Weidman to Draghi made public.

2)      It is necessary to broaden the collateral base in order to be able to provide this liquidity. In extremis, it may become necessary to substitute the entire funding of banks with ECB liquidity. As a consequence, it may also become necessary to lower the collateral standard so much as to be able to accept virtually all assets as collateral. This would mean that target balances would grow much more.

3)      Jens Weidman nevertheless raises a valid point. The Bundesbank has started to make a loss provisions in its latest financial statement because it assess that there is a material risk of losses resulting from low quality collateral according to the FAZ. In other words: if we accept the notion that the Greek financial system is insolvent and the value of the collateral is lower than the liquidity it receives, then the Bank of Greece and the eurosystem has a real credit risk on its books. If the risk materializes in the future, the eurosystem will incur losses. The Banque de France, the Bundesbank as well as all the other central banks will de facto engage in a transfer operation to Greece. So it might be natural for the eurosystem to provision at least a portion of those potential losses.

4)      The eurosystem would then have underestimated a solvency risk as a liquidity risk. It is very difficult to assess to what extent the collateral could cover up for the potential loss (and remember, there is a large haircut imposed). Ultimately, this assessment can only be made by those who know the collateral in detail.

In practice, it is difficult to distinguish liquidity from solvency risk and good from bad collateral. In a true fiscal union, this does not really matter as central bank losses would fall back on the sovereign. In the euro area, this sovereign is however missing.

That is why national central bank governors get cold feet and start worrying about the quality of collateral and the target balances. Accepting lower quality collateral means that the monetary system is used to do fiscal transfers. This is not its task and instead a larger fiscal programme or proper transfer should be agreed by governments. Jens Weidmann should, however, worry in private because public worrying risks undermining the integrity of the monetary union. I expect target balances to continue rising as long as the confidence crisis in the viability of euro area’s banking and financial system persists. And these target balances will only meaningfully decline when the interbank market is functioning again and when fiscal insurance becomes available. This why the debate about a fiscal union remains essential as we have described here.