FT Alphaville " Getting one's head around TARGET2 Izy's had a go. Tracy's had a go. Neil C's had a go. Martin Wolf has had an epic go. And here, to add to the vexed mix, is more on the subject from Greg Fuzesi of JP Morgan. Full details in the usual place, but the bank's latest ready reckoner on imbalances across the Eurosystem includes this stylized look at TARGET2... Assume initially that the German and Greek banking sys- tems each hold €100 of reserves at the Bundesbank and Bank of Greece, respectively, in order to fulfill their re- serve requirements. Both banking systems borrow these amounts from their local central bank through repos. A Greek household then decides to move €100 of bank de- posits to pay for a German export or to the perceived safety of a German bank. To settle this transaction, a Greek com- mercial bank has to transfer €100 of reserves to a German bank. It does this via TARGET2. The balance sheets of the German bank balances because it has received €100 of re- serves (an asset) and deposits (a liability); the opposite oc- curs at the Greek bank. What about the national central banks? In Step 1, German banks now have €200 of reserves at the Bundesbank and Greek banks have zero at the Bank of Greece. As the repos (and collateral) have not been transferred, the Bundesbank receives a "claim" on this, while the Bank of Greece incurs a TARGET2 liability. In reality, the Bundesbank's claim is "indirect" - it is a claim on the ECB, who then has a claim on the Bank of Greece. At this stage, the German banks have €100 of excess reserves (given that their reserve re- quirement is increased only marginally by the deposit in- flow). In Step 2, the German banks can therefore reduce the amount they are borrowing from the Bundesbank via refis. In this way, they "destroy" the reserves. In contrast, the Greek banks need to top up their reserve account by borrowing an additional €100 through refis. This "creates" €100 of new reserves in Greece. In this example, the Bank of Greece's balance sheet has expanded by €100, while the Bundesbank's balance sheet has not increased at all (because the German banks were able to reduce their repos by an amount equal to the reserve inflow). In this case, the consolidated balance sheet of the Eurosystem will also be unchanged as (a) the TARGET2 positions net out to zero among the national central banks and as (b) the total amount of repos has not increased (only its geographic distribution has shifted to Greece). The Eurosystem balance sheet increases however if the German banks do not reduce their repos, for example, if the deposit inflow is so large that it exceeds the amount they had borrowed from the Bundesbank; this is what has happened. Related links: TARGET2 - ECB (includes video) Bundesbank Bark Is Worse Than Its Bite - Heard on the Street This entry was posted by Paul Murphy on Tuesday, March 6th, 2012 at 10:00 and is filed under Capital markets. Tagged with Eurosystem, JP morgan, Target2.