More on the comparison of the Federal Reserve and ECB settlement mechanisms

Michiel Bijlsma and Jasper Lukkezen have a very good article on the Bruegel blog that deals with the question: why is there no Target2 debate in the US?



On a purely technical note, they bring up an interesting point that Interdistrict Settlement imbalances can arise not just from capital outflows from one district to another, but from the daily redistribution of SOMA assets bought on behalf of the other Reserve banks by the New York Fed. I hadn’t previously considered this mechanism and consider it to be a good addition to understanding the debate.

More controversially, they maintain that ISA imbalances primarily arise from SOMA redistribution and that regional capital flows contribute fewer imbalances. Perhaps, but that’s an empirical question.

Continuing on a purely technical note, Bijlsma and Lukkezen note that when the FRBNY purchases

from a counterpart with a depository account at one of the FRBs, this particular FRB then credits the counterpart’s depository account, which increases the liabilities of that FRB. This increases the FRBs ISA balance, while the ISA balance of the FRBNY is decreased. ..If more assets are bought from banks registered in Dallas, the Dallas Fed has larger bank deposits (liabilities) and a larger, positive ISA balance (asset) to compensate.

Technically, the FRBNY conducts open market purchases through primary dealers who have accounts at the FRBNY. These dealers are not banks. So in adding to SOMA, the FRBNY never deals directly with banks registered in Dallas. Mind you, that doesn’t mean they don’t deal indirectly with them. For instance, in selling bonds to the FRBNY, the primary dealer could have originally purchased these bonds from a Dallas-based bank. This would have required an ISA inflow to the Dallas Fed, compensating for the ISA outflow from the Dallas Fed to the FRBNY to settle the SOMA adjustment.

But this is less a criticism of Bijlsma and Lukkezen than an addition to their points on how SOMA purchases and redistributions by the FRBNY can create ISA imbalances.

On a more substantial basis, Bijlsma and Lukkezen note that:

As a result of this decentralized system and in contrast with the US, the quality of collateral held can differ across National Central Banks.

This relates to one of the underlying tensions in the Target2 debate. The Eurosystem is not balancing. Were settlement to be attempted, the quality of assets held in some of the NCBs is inferior to the assets held in other NCBs, preventing any possibility of a quid pro quo. Distributional issues arise: who pays for whom? Bijlsma and Lukkezen point out that in the US, the quality of collateral held in SOMA is uniform so that no regional Fed holds inferior assets. This homogeneity, it might be presumed, helps contribute to a lack of controversy in the US over Fed imbalances.

While it is true that each Reserve bank’s SOMA portfolio is homogenous, not all Federal Reserve liabilities (notes and reserves) are created by SOMA-related open market operations. Individual Reserve banks also create reserves by lending to their private member banks upon sufficient security. These loans are evaluated by the respective Reserve bank, not by the central Federal Reserve Board. Thus in addition to its SOMA allocation each district Reserve bank has its own unique portfolio of securities to back the loans it has made. These holdings are not amalgamated into a larger Fed-wide portfolio and shared.

To illustrate, were a bank run from the Atlanta Federal Reserve district to New York banks to begin, the Atlanta Fed would meet this with huge loans to its member banks. In return it would require that colletaral be submitted by its borrowing members. Atlanta’s ISA debit to the FRBNY would mount . As the run on Atlanta continued, private Atlanta banks would begin to stump up increasingly inferior types of collateral to the Atlanta Fed. What would Atlanta ultimately use to settle with New York? Well, it could use its SOMA portfolio, but once that was exhausted all that would remain are the inferior collateral, and this might not be sufficiently valuable. All of this resembles the Greek situation, in which private Greek banks are submitting inferior collateral to the Greek central bank.

The upshot is that the asset mixes held by each Reserve bank are not of the same quality. Yes, the SOMA mix is homogenous, but the mix of assets held as collateral for loans are very different. In this respect, the Federal Reserve System is more similar to the ECB than Bijlsma and Lukkezen might think. Imagine that the Atlanta Fed to declared itself insolvent because the collateral submitted by member banks caused large losses. Next, say that the Federal government were to recapitalize the Atlanta Fed. This would amount to a subsidy provided by all US taxpayers to the banking system of one US region. I don’t think this would be much different from some of the worst-case scenarios making the rounds in Europe. Say that losses arising from collateral submitted by Greek commercial banks to the Greek central bank forced all Euro nations to recapitalize the Greek central bank. Non-Greek taxpayers would effectively be financing a bailout of the Greek banking system. Is this any different from non-Atlanta taxpayers bailing out the Atlanta banking system?

That being said, the question Bijlsma and Lukkezen ask is very important: why is there no Target2 debate in the US? I think the answer has to do with the fact that the Federal Reserve System is the world’s oldest and most successful monetary union. All the controversy surrounding the union of the Reserve banks, and surely there was plenty, dissipated decades ago. Any American pundit who dares float the idea of the system breaking up would be laughed off the air. The Eurosystem, on the other hand, is not even fifteen years old. Because the union of the European central banks is so fresh in everyone’s mind, and because it remains a controversy in many circles to this day, it’s still politically acceptable to discuss the opposite, the disbanding of the union. It’s only because so many Europeans already have the prior belief the union can or should disband that imbalances become a hot button issue. When the survival of the union is the unspoken consensus, as in the case of the Federal Reserve System, then imbalances and the way by which they are settled are relatively unimportant.

Note: My previous posts on the Federal Reserve Interdistrict Settlement Account are here, here, and here.