A Greek exit from the eurozone would be a social, political and economic cataclysm. It would also make a mess of the Eurosystem, the carefully constructed central-banking arrangement that underpins the 19-nation currency union. What would happen to it if one country fell out? We’ll step through the implications, including for Target2, the transnational payment system that has caused a huge fuss in Germany.


How are central banks set up in the eurozone?

What we think of as the European Central Bank is really the “Eurosystem”: the 19 central banks of eurozone countries plus the ECB itself. The vast bulk of ECB’s balance sheet—its assets and its liabilities—is held by the national central banks. They function as sort of branches of the broader ECB. This is a consequence of Europe’s imperfect union: All the eurozone countries retain their own central banks and their own banking systems, even though the system’s policies and rules are set centrally.

In normal times, this is a distinction without a difference. But when one country is on the cusp of leaving, it starts to matter.

How do commercial banks operate in the eurozone?

They interact and transact with the central bank of their home country.

Commercial banks have their own deposit accounts with the local central bank. When they need central-bank loans, they turn to the local central bank. That means that, say, Piraeus Bank (a Greek bank) gets funding from the Bank of Greece.

A customer’s deposit in a commercial bank is simply an amount the bank owes the customer. When a customer of Piraeus Bank transfers €1,000 ($1,117) to another Piraeus Bank customer, Piraeus notes in its ledger that it now owes €1,000 less to Customer A and €1,000 more to Customer B.

When the Piraeus customer transfers €1,000 to a customer of Alpha Bank (another Greek bank), the Bank of Greece gets involved.

Just as a customer deposit with Piraeus is an amount Piraeus owes the customer, Piraeus itself has a deposit account with the Bank of Greece that shows how much the Bank of Greece owes it.

In the transfer from a Piraeus customer to an Alpha customer, the Bank of Greece notes in its ledgers that it now owes Piraeus €1,000 less and Alpha €1,000 more. Piraeus notes that it owes its customer €1,000 less and Alpha that it owes its customer €1,000 more.

(This, incidentially, is why electronic transfers within Greece are permitted by the capital controls.)
OK, so what happens if a Piraeus customer transfers €1,000 to, say, an account in Germany with Deustche Bank?
Well, the customer can’t anymore because of capital controls, but let’s go back to a time when he or she could.

Piraeus deals with the Bank of Greece and Deutsche Bank with the Bundesbank, Germany’s central bank. That makes the transfer more complicated. The central banks themselves don’t have a “master” central bank with which they both have deposit accounts. Instead, the Eurosystem operates a system called Target2 to handle the payment.

The €1,000 transfer works like this: Piraeus notes that it owes the customer €1,000 less. The Bank of Greece notes that it owes Piraeus €1,000 less. The Bundesbank notes that it owes Deutsche Bank €1,000 more. Deutsche Bank notes that it owes the customer €1,000 more.

In between the Bank of Greece and the Bundesbank sits Target2. The Target2 system notes that the Eurosystem owes the Bank of Greece €1,000 less and the Bundesbank €1,000 more.

Target2 operates every business day; over time these credits and debits add up, and every central bank has either a positive or negative balance toward the Eurosystem.

How big are these balances?

In precrisis times they were pretty small. That’s because banks in the eurozone used to lend money to each other quite readily. If a Piraeus customer transferred €1,000 to a Deutsche Bank customer, that might have been offset by a loan from Deutsche Bank to Piraeus (or another German bank to another Greek bank)—which is money moving the other way. Thus the Target2 flows cancelled each other out.
How about now?
Now, not so much. Greek banks have been cut off from international markets for months; in order to get €1,000 to transfer to a German bank, a Greek bank would’ve had to borrow it from the Bank of Greece. The outgoing flows have not been offset by incoming flows, and so the Bank of Greece’s Target2 balance has ballooned. It was minus €100 billion at the end of May. By contrast, the Bundesbank’s balance was positive €526 billion at the same time.
So Germany is lending money to Greece through the central banks?
Not exactly.

Let’s get philosophical. We need to understand the nature of a euro.

Where do euros come from?

Banks make them. Loans create deposits. If the bank lends you €200,000 for a mortgage, it notes in its ledgers that it you owe it €200,000 (that’s an asset to the bank) and credits your deposit account with €200,000 (that’s a liability for the bank). Voila, some new euros are born. You transfer them to the house seller, and off they go into the financial system.

Banks can’t make euros like this infinitely: Regulatory constraints bind how much risk they can take (a loan is risky), and the central bank requires that they hold an amount equal to a certain fraction of their loans as deposits with the central bank.

Since the central bank controls how much of this central-bank money exists for these deposits, the central bank controls the ability of the commercial banks to make loans and create euros.

In effect, there are 19 systems creating euros—”French euros,” “Spanish euros,” “German euros,” “Greek euros” and so on. What makes all of these euros euros is that Target2 works: a euro in one place can be sent, through the central banks, to another place, where it is still a euro.
But don't the central banks make euros, too?
Yes, and it is this central-bank money that is “moved” between central banks via Target2. Central banks make euros the same way commercial banks do, by making loans. (They also buy bonds, as in quantitative easing.)

The central bank makes a loan to a commercial bank. It records in its ledger a loan to the bank (an asset) and a deposit to the bank’s account (a liability). In normal times, the central bank doesn’t need to do very much of this: banks can get loans from other banks if they need funds. But since the onset of the crisis, the ECB has let banks have as much funding from the central bank as they need, on generous terms, so long as they can put up some assets as collateral to secure the loan.

And in a pinch, the central bank gives emergency funding in this way—as the Bank of Greece has been doing for Greek banks—against less-secure collateral.

So have all the central banks been creating euros like this?

Some much more than others. The Bank of Greece, as of May, has created €116 billion through lending to its banks, both regular and emergency. The Bundesbank has created just €35 billion.

It is this outsized creation of euros that allows the buildup of the Target2 balance: In essence, the Greek central bank has been creating euros that its banks can send elsewhere.

Does the Bank of Greece 'owe' this sum to the Eurosystem?

In an accounting sense, yes. It pays interest on its Target2 balance, though it never has to be repaid. (A similar thing happens with banknotes; a central bank that issues excess banknotes pays interest to the Eurosystem. The Bundesbank is a big excess issuer of banknotes.)

So if Greece leaves the euro, does the Eurosystem have a €100 billion loss?

Not necessarily.

Let’s look at the Eurosystem’s balance sheet. Its balance sheet is the sum of all the balance sheets of the 19 national central banks and the ECB itself. The Eurosystem’s assets are mostly gold, foreign reserves, loans to eurozone banks and bonds it has bought under various bond-buying programs including quantitative easing.

Its liabilities are mostly banknotes and the deposit accounts maintained by eurozone banks.

Hidden in the Eurosystem’s balance sheet are the amounts that the central banks owe each other; they sum to zero. The Bank of Greece owes €116 billion (€100 billion for Target2, €18 billion for excess banknotes, minus €2 billion for other stuff it is owed). It has a liability of €116 billion.

Because all these claims balance each other out, the rest of the Eurosystem has an asset of €116 billion: a claim on the Bank of Greece. Thus, if the Bank of Greece were simply chopped out of the Eurosystem, the new Eurosystem’s balance sheet would record that claim as an asset.

But surely that asset isn't worth €116 billion?

Maybe not, but it possibly doesn’t matter. If the post-Grexit Bank of Greece repudiated that claim, the post-Grexit Eurosystem might have to take a writedown and book a loss. A loss would be shared among the central banks and could lead countries to recapitalize the system.

The economist Karl Whelan makes the point, in a comprehensive paper on Target2, that Greece wouldn’t necessarily have to, or want to, repudiate the claim. Being able to transact payments in euros is useful, and Greece could remain part of Target2 even if it exits the eurozone: several noneuro EU countries are part of it. “The claims can be honoured simply by making the necessary interest payments,” Prof. Whelan writes. At the current rate of 0.05%, the annual bill would be around €50 million.

What about the rest of the Eurosystem's balance sheet?

The imperfect union of Europe actually helps in a divorce: because all the Greek banks transact with the Bank of Greece, the Greek system could be more easily hived off.

One sticky point is banknotes. Greek banks’ electronic deposits with the Bank of Greece could be switched into drachma at the press of a button. But the euro banknotes it has issued to commercial banks can’t be pulled back. The Bank of Greece has issued €45 billion in banknotes—its regular allocation of €27 billion plus an additional €18 billion.

It’s not clear what would happen. One solution is to consider a post-exit Greece’s regular allocation of banknotes to be 0 instead of €27 billion—it’s not in the eurozone, after all.

Then, that €27 billion gets added to Greece’s excess issuance, and becomes part of its liability to the new Eurosystem, taking it from €116 billion to €143 billion.

Will it ever pay that back?

Maybe, eventually. Target2 liabilities and banknote liabilities don’t have to be repaid—they exist in perpetuity, fluctuating over time. But if Greece leaves the eurozone, its Target2 and banknote liabilities won’t soar again, because it can no longer print euro banknotes and it can no longer create euros by lending them to its banks.

THE WALL STREET JOURNAL

10 JULY 2015