Euro crisis

Rule disparity

How should the ECB account for the claims to and from NCBs, which it has now accepted as principal? International Accounting Standards (IAS), which the ECB is not obliged to follow, suggest that balances with separate counterparties cannot be netted (IAS32, Financial Instruments: Presentation – paragraphs 42 and 49) ie, the ECB should disclose each balance between itself and each individual NCB.

In practice, and contrary to IAS and best practice, the ECB nets down the respective receivables and payables, and simply discloses the net balance in its financial statements. The Eurosystem’s legal framework for accounting and financial reporting is set out in a guideline issued by the ECB’s Governing Council (ECB/2010/20). In Annex IV, sections 9.5 (assets) and 10.4 (liabilities) specifically state that treatment for TARGET2 balances/correspondent accounts of NCBs should be ‘the net figure of claims and liabilities’.

It is unclear how this treatment reconciles with Article 3, which sets out the basic accounting assumptions including a requirement that the ‘accounting methods and financial reporting reflect economic reality, be transparent… Transactions shall be accounted for and presented in accordance with their substance and economic reality, and not merely their legal form’.

As of 31 December 2011, ECB TARGET2 total asset balances by NCB amounted to approximately €842bn (£674bn), and liabilities approximately €793bn. The ECB disclosed only the net balance of €49bn in its balance sheet.

Does any of this matter? Was anyone harmed by a different approach to accounting adopted by the ECB? Before the crisis, the balances between the NCBs were not significant at January 2007.

The banks funded themselves through the interbank market privately. However, following the crisis, these private sources of funding dried up and the banks in sovereign states on the periphery (the GIIPS - Greece, Italy, Ireland, Portugal and Spain) could only raise funds via the TARGET2 system.

The TARGET2 balances began to rise after 2007 but this was not noticed because of the opaque accounting treatment adopted by the ECB. As of April 2012, the NCBs of the GIIPS had borrowed over €850bn from the rest of the system, principally funded by Germany (€644bn) and the Netherlands (€155bn).

Worryingly, these negative balances have arisen despite public money inflows such as European Union-International Monetary Fund loans, which eventually end up in the banking systems. These balances represent massive transfers of wealth - Germany’s balance represents 23% of its annual GDP.

This transfer happened without any political accountability or democratic process – just through the automatic function of the monetary union. It is worth comparing this complete absence of political process with the attention and scrutiny associated with the European Financial Stability Facility (EFSF), which was recently increased to €780bn.

Who knew?

In the absence of standard accounting practices, or at least disclosure by the ECB, nobody knew what was happening. It was only in 2011 that two enterprising economists, Hans-Werner Sinn and Timo Wollmershäuser, found a way of sourcing the full data from the IMF databank and were able to present the full picture.

The ECB responded that the TARGET2 system was working as it was intended to, and cannot be capped since a euro must be worth the same in all parts of the currency area, and freely transferable as well. Some official voices have even suggested that the size of these balances is only a problem if the public know about them.

The debate, indeed outcry, in Germany about these balances shows that the full implications of monetary union were not properly understood by the vast majority of citizens, even though there were references to the possibility of this type of event in academic literature.

It is noteworthy that the recently released 2011 ECB annual report has finally provided some further information on TARGET2, if not adopting IAS in its treatment of individual NCB balances.

Concern is particularly high now because if Greece were to leave the monetary union, it would not be in a position to repay the €100bn odd euros that its NCB owes the rest of the Eurosystem. Of course, the whole edifice was set up without any limitations on TARGET2 balances, wholly on the basis that no country would ever leave the euro.

Although this remains the official position of the ECB, in practice we have now seen politicians speak openly of this as a possibility. The second Greek election on 17 June 2012 should clarify further the likely outcome. If the ECB were to suffer from an NCB not meeting its obligations on TARGET2, a Greek exit would wipe out the capital of the ECB which has capital and reserves of approximately €31bn. This would require the other NCBs, which collectively own the ECB, to contribute capital in proportion to their capital keys, shown below.

The contributing countries would be forced to pay out taxpayer monies with little or no democratic accountability. We are witnessing historic events in the eurozone and may even see the retreat of the euro to a hard currency zone in the north of Europe.

The causes of such a break-up are outside the scope of this article but the absence of proper accounting for these balances deprived the public of a sign of the balance of payments crisis developing within the eurozone after the credit crunch and angered many taxpayers that they were not deemed suitable recipients of information concerning the use of public funds.

Author

Travis Taylor is a director with Navigant Consulting, responsible for valuations, and Hugo Watson Brown is a director with Navigant Capital Markets Advisers