(Disclaimer: this article is geeky. If you want to follow it, you should already know a bit about the European Target2 imbalances debate (here is a good intro) and have read my description of the US Interdistrict Settlement Account)
There is a tension involved in being a lender of last resort. Central banks are supposed to provide liquidity to solvent but temporarily illiquid institutions during a liquidity crisis. But they're not supposed to go as far as keeping bankrupt banks or governments alive. Hans-Werner Sinn’s proposal to import the Federal Reserve's Interdistrict Settlement Account (ISA) into the Eurosystem seems to me to be an attempt to impose on National Central Banks (NCBs) the discipline necessary to prevent them from crossing this almost transparent line.
But an ISA-type settlement mechanism in a European setting threatens to not only prevent NCBs from crossing the line; it could prevent them from fulfilling even their basic duty as lender of last resort. This would be dangerous. The very fear that an NCB is limited in acting as lender of last resort could lead to self-fulfilling runs on NCBs during crisis. Faced with the requirement of fulfilling its role of lender of last resort or meeting an ISA-type settlement requirement, it is likely that settlement will be sacrificed, resulting in an embarrassing loss of face and credibility to the Eurosystem as a whole.
Is the Federal Reserve’s ISA binding?
A large part of Sinn’s yearning for an ISA-style mechanism comes from the idea that “there is quite a penalty for District Feds that create and lend out more than their fair share of the monetary base. This is the reason why a TARGET-like problem has never arisen in the US to this day.” [source]
I disagree with him on his views on the ISA. While ISA settlement certainly imposes a constraint on district Reserve banks, it is a distant constraint. I call it distant because other “balancing” mechanisms (which I'll outline below) come prior to final settlement. As a result of these balancing mechanisms, district Reserve banks are unlikely to ever come close to settlement failure and therefore the ISA does not genuinely discipline them.
A hypothetical ISA settlement failure would happen if a district Reserve bank, in fulfilling its duty as lender-of-last resort, perpetually lent reserves to regional member banks facing crisis. If these newly-created reserves were to be moved to neighbouring districts, the district Reserve bank would be required to settle these capital outflows with ISA-permitted settlement media. In times past, gold was the settlement media, but nowadays it its System Open Market Account (SOMA) assets. All assets purchased by the Federal Reserve system in the open market are assigned to this account. Each district Reserve bank in turn receives an allocation of SOMA. Should the crisis be protracted and outflows continue, the district Reserve bank will eventually run out of SOMA assets and fail to settle its ISA debts.
But there is an important mechanism at work that prevents prolonged district Reserve bank loans to failing member institutions. In the US, insolvent banks are quickly shuttered and sold off by the Federal Deposit Insurance Corporation (FDIC). This is called bank resolution. Secondly, there are few regulatory barriers and certainly no cultural or linguistic boundaries to overcome when it comes to US bank mergers. A private bank in the Cleveland district can easily buy a weakened bank in the San Francisco district and vice versa.
Due to quick resolution and a relatively painless merger process, district Reserve banks need not lend to weak private member banks for extended periods of time. As a result, district Reserve banks don’t create the huge amounts of reserves that, when transferred to another district, might lead to an ISA settlement failure. Contrary to Sinn’s belief, the necessity of ISA settlement is only a distant constraint on district Reserve banks.
Potentially lethal problems with a European ISA
Sinn wants to graft an ISA-style mechanism onto the Eurosystem. The idea seems to be that if NCBs were to face a periodic day-of-reckoning that required the settlement of outstanding Target2 debts with real assets, then they would be dissuaded from incurring irresponsible debts in the first place.
I agree with Sinn on the idea of implementing some sort of Target2 settlement mechanism. Even Keynes, in devising his International Clearing Union, wrote:
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. Proposals for an International Currency (or clearing) Union, February 11, 1942But there is a certain danger in implementing an ISA-style settlement mechanism without the same balancing mechanisms we see in the US. This danger arises because the settlement mechanism interferes with the lender of last resort role of NCBs. Acting as lender of last resort is a duty that all central banks must be left free to exercise. The famous line from Bank of England Director Harman on the quelling of the 1825 crisis comes to mind:
We lent it [pounds] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.As long as US-style balancing mechanisms exist — both a quick resolution mechanism and the ability to freely merge banks — it is unlikely that an NCB, in discounting freely, will create the incredible volume of reserves that might lead to a European ISA settlement failure. But my understanding of European banking is that bank mergers are not easy (see pdf). Nor has a proper European wide resolution protocol been established. Perhaps readers can elaborate on this.
So let's imagine that Sinn’s plan to implement an ISA-style settlement mechanism is adopted without the balancing mechanisms I've previously mentioned. The next time a crisis hits, the NCBs will discount freely, as they should. They'll have to do a lot of it, since problem banks aren't being resolved, nor are they being merged. There will probably be capital flight from one country to another. This will bring the intra-Eurosystem settlement mechanism into play, requiring the transfer of settlement asset from debtor NCBs to creditor NCBs.
The problem is that as an NCB gets closer to settlement failure, depositors will flee ever faster to other European NCBs. Depositors will do this because they anticipate that settlement failure will lead to temporary inconvertibility of that NCB’s euroliabilities — better to get out while it's still possible, goes the thinking. This effect is perverse, since the very threat of settlement failure leads to the self-realization of settlement failure.
What does an NCB do when it hits Sinn’s settlement constraint? Does an NCB cease acting as the lender of last resort and settle? Or does it continue to lend and let settlement fail?
Relaxing the law is embarrassing
One of the lessons of monetary economics is that there are grave consequences to stepping aside as lender of last resort. Because of this, the most likely answer to the above question is that the law concerning Eurosystem settlement will be temporarily put aside to allow for continued lending.
There is a long tradition of setting law aside to allow for lender of last resort purposes. Peel’s Act of 1840 attempted to constrain credit creation by dividing the Bank of England into an Issue Department and a Banking Department. The Issue Department issued banknotes 100% backed by gold. The Banking Department issued deposits which were convertible into these notes. During a crisis, the Banking Department would be swamped with requests for notes. But Peel’s Act prevented the Issue Department from providing the Banking Department with bank notes. As a result, people grew even more anxious to withdraw existing notes from the Banking department, igniting a run. In order to save the Banking department from insolvency, during each crisis the government would issue a rather embarrassing public letter saying that the legal separation between the two departments was temporarily null. As a result, the Issue department could lend notes to the Banking department, and the crisis ended.
Much like the Bank of England of the 1800s, it would be embarrassing for the Eurosystem to adopt Sinn's ISA-style settlement mechanism only to have to publicly annul settlement each time a crisis hits and lender of last resort action is necessary. Far better to promote the emergence of strong balancing mechanisms like bank resolution and mergers, and only after that implement some sort of settlement mechanism. The former will dull the bite (and potential embarrassment caused by failure) of the latter.
PS. Karl Whelan is circulating a draft paper on Target2 and is looking for constructive criticism. I haven't commented on his paper in this post as I'm waiting for his final version. But drop by here to read & comment.
PPS. As a free banker, I don't support monopoly banking. I took off my free-banking hat to write this.