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The Secret System that Blew Another Hole in the Euro

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 Automated Real-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.

Join the conversation. Click here to jump to comments…

  1. CP | April 25, 2012

    This is all by design.

    • L. Grapentine | April 26, 2012

      Probably not by design. But likely for short term political advantage somewhere, and with no concern for the ultimate end result. The kind of thing sometimes called "gross negligence", because the folks who came up with it were so concerned with their goal they forgot to back off and look at the picture with a cold eye for costs and benefits.

  2. Gordan Finch | April 25, 2012

    Very interesting article Martin, I read something similar about Canadian citizens taking action against the UK Monarch and others, will send the info for your readers if I can find the document.

  3. Richard Russell | April 25, 2012

    Another own goal for the champagne socialists

  4. Tom Hegarty | April 25, 2012

    Just a note; The European Investment Bank (EIB) has quietly made arrangements to allow Greece, Ireland, Portugal and maybe others, to be able to pay back loans in Drachma, Punts and Escudos (?)
    Of course this DOES NOT mean that the Euro is in any way 'shaky.'
    You won't tell anyone, will you ?

    • Karen | April 25, 2012


  5. denaco | April 25, 2012

    Perhaps you should send a personalized copy to the Federal Reserve?

  6. Bertalan Vegh | April 25, 2012

    I can not figuere out the problem with the euro currency collapse ,but the American dollar is alreaydthere!!! Do you have any answer ???

  7. Sumant | April 25, 2012

    Excellent write-up. Arcane, but very, very relevant and could prove to be the weakest link if/when a payments crisis – a la Gestalt – arises.

    Thnaks, Martin.

  8. Joseph Sobry | April 25, 2012

    This is just another excuse for the German and Greek banks. I find it hard to believe that the banks did not know at all what was going on regardless of target 1, target 2 or target 3 for that matter .
    In any lending/borrowing transaction there are two parties involved. The lender should judge the ability of the borrower to repay the loan. The borrower should be aware that he has to be able to make the payments. There is responsibility on both sides. Both sides chose to ignore reality repeatedly allthough they were and/or should have been fully aware of that reality. Denial of reality on both sides of the transaction leads to disaster. End of story.
    The rest is clean up after the disaster.
    The above statements make it look like this is very simple. The fact of the matter is that it is extremely complex. Because the respective banks are part of the greater german and greek economies and of the even greater European economy and the even greater world economy the effects of the denial of reality proliferate through the entire system. That is why there has to be control of the banks and ALL financial institutions. We call it regulation and we do not like it.
    Because any regulation limits the freedom of the market we need to limit the regulation to the largest extent possible and still provide protection for the larger economic system. That is in fact the largest and most complex problem. We are learning this art and have been learning it for at least the last 800 years ever since the start of banking somewhere in Italy of all places . Perhaps, one fine day, we will master this art.

  9. Athanasios Pitsiorlas | April 25, 2012

    Again, an issue of size and its effects arise!

    I would welcome more this Article if it would include a balance of pros and cons of Target II system (goals and effects). That way, the reader would form a more stable view on the problem.

    Evidently, Target raises transaction costs. It would be useful to know if the established system has to do only with a beaurocratic logic (letting the national central banks something to do, after they would have lost hand over monetary policy) or whether any protection from a specific dynamic systemic risk was taken into account.

    In any case, many thanks to the author …

  10. V Niilus | April 26, 2012

    I'm no expert on the US Federal Reserve System but I suspect that the Alabama depositor is responsible for $1 million of the Atlanta Federal Reserve Bank's $44 billion ISA liability (December 2011) with the Federal Reserve.

    I don't think that the problem is in the way the EMU is structured as it resembles the US structure.
    In fact the structure is probably quite sensible as it would be easier to coordinate the operation of 17 central banks than introduce an entirely new administrative system.

    The real issue is pretending that the assets of each individual country central bank are the same quality. If the Federal Reserve Bank of Atlanta were an entirely independent bank it would be able to settle its ISA liability by transferring some of the $130 billion in US treasuries that it owns. Would Greek Bonds be acceptable?

  11. Werner | April 27, 2012

    Martin, your analysis is a good reminder of what might happen, but it has a major flaw. You appear to forget that Schuneman is roughly 40 years behind reality. In fact he should have put the same complaint about the Bundesbank having bought Dollars after Nixon took the gold link off. The same is true for A L L other central banks having boughtDollars, and as a Swiss I mainly think of Swiss National Bank, whose USD holdings (per capita of population) even exceed Chinese Dollar holdings.
    Greek may be a threat to the Euro, Spain too, but the biggest threat have been and still are the United States, whose government is simply unable and/or unwilling to face the sad truth of its demise. Besides that, Marsh is known as a visceral anti-Euro person, whose analysis is usually heavily biased.

    • european Europa Sustentavel | April 28, 2012

      thank you for your comment. finally someone who is not biased against everything european. although europe should make big changes. but this is very diferrent from scrapping europe and the euro. when something is brke we should fix it instead of breaking it in pieces into oblivion.

  12. Roger K | April 27, 2012

    This appears to be a case where the lenders & borrowers i.e. executives of both parties are in "cahoots".

  13. Michael O Donovan | April 28, 2012

    From a layman’s point of view it seems the ostrich effect has taken hold of the entire banking system. Joseph Sobry's point about (ir)responsible borrowing and lending is at the hub of the issue.

    On the one hand there is an idea that more money can be pumped into the financial system creating growth, thereby shrinking debt levels in real terms. There is no guarantee of growth for a variety of reasons; patronage, corruption and inappropriate investment often leading to a greater debt spiral, with the wealth being concentrated in even fewer hands.

    The other view would be to shrink expenditure, diverting funds to pay down debts. This is usually successful, initially, but the eventual lack of spending power and consequent drop in tax revenue will very often leads us back to square one; not to mention depleted services, mass unemployment and the greater impoverishment of the weakest elements of society.

    I feel the only workable solution is the one our political leaders and financial masters dare not speak. A more equitable and consequently fairer universal system of finance needs to be created from the top down. Cutbacks in public expenditure should be targeted primarily at reducing wages, on a sliding scale to levels below that of a country’s private sector, compensated by job security. This should be extended with even more severity to public sector pensions, with nobody receiving more than one pension, and not until a minimum age of 65. Additional savings could be made in amalgamating some councils and boards of management, where overlapping occurs, and the disbandment of politically appointed boards of patronage. With the above less wasteful system in place any investments could be targeted at capital projects, and job and wealth creating enterprises.

    Such a radical new departure in human behavior will only flourish in conjunction with a massive global financial dispensation, however. Debt write-down, planned default, call it what you will; it is the financial elephant in the banking room. Sadly I do not think any of this will happen as it runs completely against the grain. The wealthier and more powerful a person is the more s/he stands to lose in the short-term. I don’t think, as a species we have yet evolved to appreciating the value of the greater good. Maybe financial Armageddon would ultimately bring us to that realisation.

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