Let the ECB capital key float

Bankers clear and settle with each other at a clearing house

Perry Mehrling had in interesting comment about how to settle the Eurosystem's Target2 imbalance problem.

If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System. More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.

Perry is talking about adapting the structure of the Fed's Interdistrict Settlement Account to Europe. To understand the ISA, check out my Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. In short, the 12 regional Reserve banks run up debts and credits to each other over the course of the year due to changes in payments flows. These debts and credits are settled each year by transferring securities that have been bought in open market operations from debtor Reserves banks to creditor Reserve banks.

The Eurosystem, on the other hand, doesn't require that the clearing debts wracked up by the various National Central Banks (NCBs) be settled. Which is odd. Not even Keynes's ICU would have allowed infinite debts, and Keynes was a forgiving sort of guy.

Perry's idea is that with the Eurosystem embarking on a program of Outright Monetary Transactions (OMTs), maybe the securities amassed will allow for a mechanism to settle intra-Eurosystem imbalances. Debtor NCBs like the Bank of Greece will have to transfer OMT securities to creditor banks like the Bundesbank. Perry specifically discusses the idea of having each NCB own shares in the OMT portfolio and have these shares transferable so as to facilitate settlement.

I like this idea and think it can be twinned with the already existing ECB capital key. What is the capital key?

All NCBs have an ownership stake in the overlying ECB. The relative amounts held by each are determined by the capital key. The key's weights are based on relative population and GDP. Germany for instance, has been given an 18.9% weighting in the capital key. Greece has been given a 1.96% weighting.

The ECB holds a unique set of assets on its balance sheet (see year-end 2011 statements). These have been transferred to it from the NCBs. First, it holds 16 million ounces of gold, worth around €21b. It also holds around €41 in forex reserves denominated in yen, dollars, and more. Lastly, it holds a few assets purchased during previous open market campaigns. Also worth considering is that the Eurosystem's total profits are paid out according to the capital key. This means that the profits yielded by assets held by the Bank of Greece don't necessarily get paid out to the BoG... they get amalgamated with all NCB profits and then allocated to each individual NCB according to the capital key. So having a big weighting in the capital key is definitely worth something.

Say that going forward all OMT purchases are conducted through the ECB and not the NCBs. That means that in addition to its gold and forex position, the ECB gets even bigger, and shares in the capital key are rendered more meaningful.

You can then institute a Fed-style settlement program by letting each NCB's weighting in the capital key float. Each year debtors get their share in the capital key lowered. Creditors get their's increased. That adds some quid pro quo to intra-Eurosystem balances. What happens if a central bank's representation in the capital key were to fall below zero because of persistent capital flight? Then the national government would have to recapitalize their respective NCB's contribution to the ECB so that it's portion of the key rises back to 0%. Or you could soft-pedal the whole thing and institute some sort of broad system of reforms a country has to initiate once it falls below 0%. Either way, the system is redesigned to have a tendency to equilibrate.

Is such a tendency necessary? I leave you with some words from Keynes's Proposals for an International Currency (or clearing) Union, February 11, 1942:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.