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US Economics Digest US ECONOMICS
Let's Settle This: TARGET2 versus the Fed’s
Interdistrict Account We can draw several parallels between the Eurosystem and the Federal Reserve.
In normal times, for example, flows of money to settle banking transactions between
the euro area’s National Central Banks (NCBs) resemble those between the Fed’s
12 District Banks. But the debt crisis has exposed significant dissimilarities.
Flows between NCBs are cleared via the ECB’s TARGET2 mechanism. Flows
between Fed District Banks are cleared via the Fed’s Interdistrict Settlement
Account (ISA). While there are many similarities between the two accounting
processes, it is important to recognize their fundamental differences:
Bilateral balances between pairs of Fed District Banks are settled once each
year, resulting in zero (or near-zero) net balances. But the outstanding net
balances between NCBs have been permitted to keep growing over time.
TARGET2 liabilities are claims on the ECB, and a claim on the ECB is
ultimately a claim on each nation according to that nation’s percentage
ownership of the ECB. But ISA liabilities are claims on other District Banks.
And claims on District Banks are (in principle) ultimately claims on the private
banks that own them, not on the government.
Interdistrict capital flows in the US are motivated by normal commercial flows
of money from a bank account in one district to a bank account in another,
whereas capital flight and loss of confidence in banks in some countries seem
to have prompted much of the recent flows in the euro area.
Exhibit 1: Growing Imbalances in TARGET2 Claims (€ bn)
Note: Peripheral NCBS: Central banks of Greece, Ireland, Portugal, Italy, Spain Source: Credit Suisse, National Central Banks, IMF
31 May 2012
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31 May 2012
US Economics Digest 2
Let's Settle This: TARGET2 vs the Interdistrict Account
Two months before his eight-year term as European Central Bank president ended, Jean-
Claude Trichet addressed the Kansas City Fed's August 2011 Jackson Hole conference.
Trichet compared the euro area with the US, arguing that economic diversity within the two
were similar:
“It is often assumed that the US economy would be significantly more homogenous than
the economy of the euro area … Looking more closely at the regional dispersion across
US regions and euro area economies does not confirm this ... The dispersion of many of
the key indicators is surprisingly similar.”
This may be accurate, but more structural reforms are needed before the euro area can
function comfortably like the US – with a single currency and monetary policy rate. The
crucial difference is clear: The federal legal and fiscal systems under which the 50 united
states operate do not have supranational counterparts in the euro area; each system in
the euro zone is still controlled by the region’s 17 individual sovereign countries.
Several other “compare and contrasts” can be drawn between the Eurosystem and the
Federal Reserve System. In normal times, for example, flows of money to settle transactions
between the euro area’s National Central Banks (NCBs) resemble those between the Fed’s
12 District Banks. But in times of financial stress, the very diversity of which Trichet spoke
exposes significant dissimilarities in flows within these two economic blocs.
Flows between NCBs are cleared via the European Central Bank’s TARGET2 mechanism.
Flows between Fed District Banks are cleared via the Federal Reserve System’s
Interdistrict Settlement Account (ISA). While there are many similarities between the
two accounting processes, it is important to recognize their fundamental differences:
1. Bilateral balances between pairs of Fed District Banks are settled once each year,
resulting in zero (or near-zero) net balances. But the outstanding net balances
between NCBs – and between the sovereigns that own them – have been
permitted to keep growing over time (Exhibit 1).
2. TARGET2 liabilities are ultimately claims on the ECB, and a claim on the ECB is
ultimately a claim on each nation according to that nation’s percentage ownership
of the ECB. But ISA liabilities are not claims on the Federal Reserve Board; they
are claims on other District Banks. And claims on District Banks are in principle
ultimately claims on the private banks that own them (not on the government).
3. Nationwide banking and deposit insurance in the US suggest that interdistrict
flows tend to reflect nothing more than normal commercial transactions. In
contrast, the persistence in the main of country-by-country banking in the euro
zone means that some (large) fraction of flows among NCBs may reflect capital
flight and loss of confidence in the underlying banks.
A Tale of Two Structures – The Eurosystem and the Federal Reserve
In the euro area, the central banking system is structured as a combination of NCBs, such
as the Banque de France and the Bundesbank, under the coordination of the ECB.
Monetary policy (setting policy rates, conducting open market operations, etc.) is
controlled by the ECB, which has its own balance sheet and capital.
The euro zone NCBs, currently numbering 17, retain their individual identities, with each
also maintaining its own balance sheet and capital. The NCBs own shares in the ECB,
determined by the GDP and population of their respective nations (i.e., the “capital key’
formula). Profits (and losses) on ECB monetary operations are distributed to the NCBs in
proportion to their ownership of the ECB. In turn, the NCBs can pass any profits through to
their respective national governments (Flood and Garber, 2000).
31 May 2012
US Economics Digest 3
Exhibit 2: The Eurosystem
Source: European Central Bank, Credit Suisse
In the US, the Federal Reserve System is a network of 12 District Banks, functioning under
the administrative supervision of the Board of Governors in Washington, DC. The Fed Board
is responsible for monetary policy, but unlike the ECB, the Board does not have its own
balance sheet and capital. The Fed balance sheet that is released each week (the “H.4.1”
report) is actually a consolidated statement of the District Banks’ financial conditions.
The Board of Governors is a federal government agency, but each District Bank is owned
by its members – the private banks in its region. Each District Bank is apportioned an
ownership interest in the Fed’s System Open Market Account (SOMA). The securities
allocations originally were set by a formula but have evolved over time as money has
flowed among the 12 districts.
Exhibit 3: The Twelve Federal Reserve Districts
Source: Federal Reserve, Credit Suisse
31 May 2012
US Economics Digest 4
The income of the District Banks is derived primarily from the interest on their SOMA
securities. Other major sources of income are the interest on foreign currency
investments; interest on loans to depository institutions; and fees received for services
provided to depository institutions, such as check clearing, funds transfers, and automated
clearinghouse operations. After it pays its expenses, the Federal Reserve turns the rest of
its earnings over to the US Treasury.
Both the European System of Central Banks and the Federal Reserve System have
developed mechanisms to account for funds flowing between euro area nations and
between Fed districts, respectively. Europe’s TARGET2 system has been the subject of
recent market angst, while the very existence of the Fed’s Interdistrict Settlement Account
is virtually unknown by the public.
The TARGET2 Situation
Our Europe Economics team has written extensively about the euro area’s TARGET2
payment system, mainly in response to increasing market concerns about the increasing
size of its unsettled balances:
December 16, 2011, European Economics, Missing the TARGET
April 24, 2012, European Economics, TARGET2: I’m a euro, get me out of here!
Specifically, the German Bundesbank has accumulated €644bn of TARGET2 claims on its
balance sheet as of April 2012. At the same time the NCBs of the five peripheral
economies have TARGET2 liabilities of €855bn (Exhibit 4). This has led to suggestions
that the Bundesbank is lending to peripheral countries through the TARGET2 system and
is therefore putting its balance sheet at risk.
Exhibit 4: Growing Imbalances in TARGET2 Claims
€ billions
Note: Peripheral NCBS: Central banks of Greece, Ireland, Portugal, Italy, Spain Source: Credit Suisse, National Central Banks, IMF
In our view, these TARGET2 balances are symptomatic of the euro area’s problems, but
are not the problem themselves. In large part they are a balance sheet reflection of issues
market participants already understand: deposit flight from the periphery to the core and
consequent increased reliance on ECB liquidity support from banks in the periphery rather
than the core. The growth in these imbalances is also related to, and reflective of, the
growing size of the ECB’s balance sheet.
Like all balances, they only become a problem when one party tries to unwind, and the
other party doesn't have the resources to do so. (“A rolling loan gathers no loss.”)
31 May 2012
US Economics Digest 5
How TARGET2 Works
TARGET2 is the Eurosystem’s real-time gross payment settlement system, used to settle
cross-border payments between banks in the European Economic Area. The effect on the
NCBs’ balance sheets from these transactions can be illustrated in the example below, in
which the customer of a Spanish bank makes a payment to a customer of a German bank:
As euro area banks maintain accounts with their national central banks, when the
Spanish bank makes the payment, the TARGET2 system debits the Spanish bank’s
account at the Bank of Spain and credits the German bank’s account at the
Bundesbank.
All else equal, that results in an increase in the liabilities of the Bundesbank, in the form
of a liability to the German bank. This is matched on the asset side of the Bundesbank’s
balance sheet in the form of a claim on the Bank of Spain – which appears on the
liability side of the Bank of Spain in place of the liability to the Spanish bank.
The settlement of such payment flows in central bank money creates bilateral balances
for each NCB that is connected to TARGET2. These bilateral balances are then
assigned to the ECB on a daily basis, leaving each NCB with a single net bilateral
position vis-à-vis the ECB only. So the Bundesbank’s claim is then with the ECB, while
the ECB then has a claim on the Bank of Spain. For the balance sheet of the ECB (or
the Eurosystem, more precisely) those bilateral claims between the NCBs and the ECB
are netted out to zero.
Although NCBs have usually displayed non-zero TARGET2 balances vis-à-vis the ECB,
the balances tended to be neutral on average. However, in the past few years some
countries have seen their TARGET2 liabilities increase (and others have seen their
TARGET2 claims increase). Exhibit 5 shows a six-fold increase in the sum of all positive
(or alternatively negative) TARGET2 balances of the euro area NCBs since early 2008.
Exhibit 5: Sum of All Positive TARGET2 Balances of Euro Area NCBs
€ billions
Source: Credit Suisse, National Central Banks, IMF
31 May 2012
US Economics Digest 6
Demystifying the Fed’s Interdistrict Settlement Account (ISA)
On the surface, the basic workings of the Fed’s Interdistrict Settlement Account resemble
those of TARGET2. This is no coincidence, as the ISA served as an inspiration for the
original TARGET system. The ISA is much the older of the two, tracing its beginnings back
to the Fed’s Gold Reserve Account of 1915.
The ISA is not involved in private bank transactions within Federal Reserve districts, but it
plays a role once those transactions cross district borders. The way the ISA works is best
illustrated by example (Koning, 20121):
Say that a customer of bank A in the Atlanta Fed district sends a $100 check to a
customer of bank C in the Cleveland Fed district. The check is deposited by the Cleveland
customer, whose account at bank C is credited. Bank C sends the check on to the
Cleveland Fed, and the Cleveland Fed credits bank C’s reserve account.
The Cleveland Fed then dispatches the check to the Atlanta Fed, which proceeds to debit
the reserve account of bank A. The check is sent on to bank A which now debits the
original check writer’s account. The net result of this chain is that the customers of the
banks have settled with each other, as have banks A and C.
The final debt has been transferred onto the books of the Fed District Banks. But this final
debt has yet to be settled. In crediting bank C’s reserve account, the Cleveland Fed
requires a balancing asset. This is an amount due from the Atlanta Fed. In debiting bank
A’s reserve account, the Atlanta Fed requires a balancing liability. This is an amount owed
to the Cleveland Fed. Basically, the Atlanta Fed now owes the Cleveland Fed $100.
Over the course of a business day, large volumes of interdistrict payments are processed
by the Fed’s District Banks. The total quantity of the resulting credits and debts among the
District Banks are cleared through the ISA. At the end of the day, a given District Bank is
either a net debtor to the other Fed Banks via the ISA, or it is a creditor to them.
Exhibit 6: ISA Balances for Selected Fed Districts
$ billions
Source: Credit Suisse, Federal Reserve
1 Portions of our ISA description are from an excellent blog post by JP Koning.
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31 May 2012
US Economics Digest 7
Before 1975 District Banks were required to deposit gold in the ISA and transfer it daily so
as to achieve final settlement. But starting in August of that year, shifts in the holdings of
the System Open Market Account (SOMA) became the settlement medium. Furthermore,
these settlements were scheduled to occur on a yearly basis, not a daily basis. Thus, while
the ISA would clear each day and allocate Fed District Banks amounts due and owed, it
would only require once-a-year settlement of these respective balances.
This method of managing the ISA continues to this day. An average is calculated for each
district Fed's daily ISA clearing balance over the course of a year. Sometime in the first
week of April, the Board allocates SOMA holdings to District Bank so as to settle this
average yearly balance.
Note that the end of period clearing balance isn't what is settled, but only the average
yearly balance. Thus a bank which is owed $10bn at April settlement, but was only owed
on average $6bn in the 12 months prior, will receive $6bn in SOMA allocations in April, not
$10bn.
When the Fed was expanding its consolidated balance sheet via QE1 and QE2 (2009-11),
the bulk of new SOMA securities were allocated to the New York Fed by virtue of its larger
ownership share. In addition, subsequent interdistrict money flows headed to the New
York District, since it is the home District for most of the nation’s largest banks. As a result,
the NY Fed’s claims on the ISA ballooned in each of the past three years
Because annual ISA settlement is based on 12-month average balances (not on period-
end balances), the New York Fed's claim against the ISA only partly settled in the spring of
2010 and 2011. But as Exhibit 6 illustrates, the New York Fed’s claim on the ISA was
settled close to zero earlier this year. The other District Banks’ claims on – or liabilities to –
the ISA have settled nearly fully, as well (Exhibit 7).
Exhibit 7: Sum of All Positive ISA Balances of All Fed District Banks
$ billions
Source: Federal Reserve, Credit Suisse
31 May 2012
US Economics Digest 8
Comparing Recent Inter-NCB and Interdistrict Flows
As described above, a key difference between the TARGET2 and Interdistrict accounting
mechanisms is that bilateral balances between Fed District Banks are settled once each
year, which helps to constrain their sizes. But the outstanding net balances between NCBs –
and between the sovereigns that own them – have been permitted to keep growing over time.
If there were a desire to reduce TARGET2 imbalances within the euro area, the result
would likely be a reduction in the ECB financing of banks in the peripheral countries. That
would likely have negative economic and financial implications for both the peripheral
countries and their trading partners.
Outstanding TARGET2 balances could become an issue for the NCBs – and for
related sovereigns – in the disorderly event of a country leaving the euro area or a
full-blown euro break-up. In that respect, it is worth noting a second major difference
between TARGET2 and the ISA:
TARGET2 liabilities are ultimately claims on the ECB, and a claim on the ECB is ultimately a
claim on each nation according to that nation’s percentage ownership of the ECB. This
means that risk is shared among all the Eurosystem’s NCBs. (This is but one example of
how the costs of a break-up could fall disproportionately on some countries in the euro area.)
In contrast, ISA liabilities are not claims on the Federal Reserve Board; they are claims on
other District Banks. And claims on District Banks are in principle ultimately claims on the
private banks that own them (not on the government).
The final, and perhaps most important, distinction, is that interdistrict flows in the US have
been motivated in recent years by a very different set of forces from inter-NCB flows in the
euro area.
In the euro zone, the underlying factor driving the expansion of TARGET2 liabilities in the
periphery is that outflows of money have intensified since the crisis, while the willingness
of the private sector to finance these flows has decreased.
In the US, nationwide banking and a federal system of bank deposit insurance has nearly
eradicated the incidence of capital flight from one District to another.2 Despite the diversity
that arguably does exist between different Fed Districts (and among the 50 states, as per
Trichet’s observation last summer), regional economic performance does not prompt the
types of fear-driven money flows we've seen in the euro zone. Rather, the density of
money center banks in the New York Fed District is the main impetus for interdistrict flows.
* * *
Sources: Federal Reserve System, Financial Accounting Manual For Federal Reserve Banks, January 2012 Federal Reserve System, Purposes and Functions, August 2011 Flood, Robert and Peter M. Garber, “Is Launching the Euro Unstable in the Endgame?” National Bureau of Economic Research, January 2000 Koning, JP, The Idiot's Guide to the Federal Reserve Interdistrict Settlement Account, February 2012
2 The last documented example of capital flight from a Fed district that rendered it potentially unable to settle its ISA account was
related to the liabilities amassed by the New York Fed in 1933. In that episode, several other District Banks were required to rediscount with the New York Fed to help stabilize the district.
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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments. When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay purchase price only.
