ECB Balance Sheet Liabilities: some notes.

As promised in a previous post, I will analyze the other side of the ECB’s balance sheet: Liabilities.

Anyone who is interested in the information provided weekly by the ECB about its balance sheet can go to the webpage:

http://www.ecb.europa.eu/press/pr/wfs/2012/html/fs120612.en.html

First of all, this is the Liabilities side as of 1/06/2012:

Liabilities	01/06/12
Banknotes in circulation	884,88
Liabilities to euro area credit institutions related to monetary policy operations denominated in euro	1.091,70
Current accounts (covering the minimum reserve system)	94,02
Deposit facility	784,97
Fixed-term deposits	212,00
Fine-tuning reverse operations	-
Deposits related to margin calls	0,71
Other liabilities to euro area credit institutions denominated in euro	3,40
Debt certificates issued	-
Liabilities to other euro area residents denominated in euro	129,03
General government	118,09
Other liabilities	10,93
Liabilities to non-euro area residents denominated in euro	116,42
Liabilities to euro area residents denominated in foreign currency	5,49
Liabilities to non-euro area residents denominated in foreign currency	9,28
Deposits, balances and other liabilities	9,28
Liabilities arising from the credit facility under ERM II	-
Counterpart of special drawing rights allocated by the IMF	54,72
Other liabilities	222,88
Revaluation accounts	399,45
Capital and reserves	85,36
Total liabilities	3.002,59

As in the previous post we will analyze account by account (but just the most important ones) the BS, trying to understand what the ECB puts en each of them.

Banknotes in Circulation (884,88): In this account we can find the physical euro supply. 30% of the ECB’s balance sheet is made of banknotes, actual euros issued by the ECB. This is part of the base money supply, the other part is the reserves and deposits held by banks in the ECB’s accounts. Paper euros, therefore, are liabilities of the central bank that are supposedly backed by its assets. When the ECB wants to increase the money supply it buys assets to private banks (or lends them assets) and gives them newly created physical euros or newly created deposits that banks can use to lend to clients or buy assets to other firms or individuals. Lets see the second account because the first two parts of the BS can be analyzed together, given that together are called the Base Money Supply, a concept that we will discuss later.

Liabilities to euro area credit institutions related to monetary policy operations denominated in euro (1.091,7): More than 36% of liabilities of the ECB are liabilities to euro area credit institutions related to monetary operations denominated in euro, that is deposits held by private banks in the ECB. So 66% of the ECB’s balance sheet is made of banknotes and demand deposits, that we can call “no term” liabilities because they can be withdrawn anytime by private banks. As we said, these two accounts together form the monetary base, that is the amount of money issued by the ECB. However, this is not the total money of the economy because private banks can expand the money supply due to a special privilege called fractional reserve banking. In the following link brief explanation of the concept of monetary base and fractional reserve lending can be found (http://en.wikipedia.org/wiki/Monetary_base). There is usually a connection between the monetary base and the total money supply, because an expansion of the monetary base usually translates in an increase of bank credit through the process of fractional reserve banking. However, during an economic crisis and a period of deleverage, even if central banks try to increase the quantity of money an credit in the economy, private banks do not expand credit on top of the monetary base at the same peace because banks have a small capital base, no creditworthy clients and a lot of loan defaults and therefore do not lend. The process of money and credit creation will be the argument of another post, now I want only to stress the fact that these two accounts should be monitored in order to see the increase or decrease of the monetary base. Now we are going to analyze each account separately, because we can understand a lot of interesting stuff.

Current accounts covering the minimum reserve system (94,02): Usually when the central bank buys assets to expand the money supply, it creates deposits in favor of the private banks that sold those assets. Then those banks withdraw these deposits and use them to expand credit. However, banks cannot use all the deposit, they have to keep as reserve at least the minimum reserve requirement, fixed by the central bank. Let’s make a simple example. The ECB wants to expand the money supply by 100. To do this it buys an asset held in bank’s A balance sheet and it pays for the asset creating a deposit of 100, that is a liability of the central bank and an asset of bank A. Then, bank A withdraws the deposit and uses it as it pleases. However, if the central bank decides that the minimum reserve requirement is 10%, bank A can only withdraw 90 and must let 10 as a reserve. In this account we can find the required reserve that banks need to keep at the ECB.  

Deposit Facility (784,97): This is one of the most important accounts of the ECB’s balance sheet. It is one of the measures that show the level of stress in the economy and in the interbank market. When private banks use this facility they get paid just 0,25% on funds deposited. However, they could just use the money to lend to other banks or other clients and earn a higher return on the money. Why private banks prefer a lower interest rate instead of lending money and get paid much more for it? Because these banks do not trust clients or other banks and therefore they prefer put the money in a safe place rather than risk this money lending to someone else. In the graph below we can see the evolution of this account from the beginning of 2008 till now:

The first huge increase occurred when Lehman Brothers went bankrupt. It increase from almost zero to 200 billions. Then it came down again but it peaked again to 300 and almost 400 during 2010. During 2011 it came down again but in the end of 2011 and during 2012 it increased again to levels never seen before reaching 800 billions. This huge increase happened after the ECB implemented the two LTRO’s (long term refinancing operations) in December 2011 and February 2012 for a total amount between 600 and 1000 billions. The evolution of this account tells us that the monetary expansion orchestrated by the ECB did not reach the goal proposed: reactivate the economy. Instead, this account tells us that private banks took the money and, instead of loan it to clients, they deposited it again in the central bank. This is why this account is so important: it is a signal of the stress in the economy and a signal that central banks cannot decide exactly the level of money supply because if banks do not lend, the so called money multiplier does not work and the increase in the monetary base does not reflect in an increase in money and credit in circulation.

Fixed-term deposits (212): As in the previous account, this is money deposited by private banks in the ECB. The only difference is that these are time deposits while the others are overnight deposits that can be withdrawn whenever a private bank needs to.

The other accounts forming this section are much less important and I will skip them. However lets take a look to the following monetary base graph:

We can see how the monetary base increased from around 800 to 1.800 billions in just 5 years with the biggest increase in the last year (an increase of 800 billion, i.e. an increase of 80%). Remember that the monetary base is the sum of Banknotes and Liabilities to euro area credit institutions. Despite this huge increase, there was no beneficial effect in the economy and this is obvious because an increase in liabilities of ECB is not an increase in wealth and physical goods, it is only a redistribution of wealth. Moreover, banks, for the reasons discussed before, are not expanding credit on top of the monetary base expansion and therefore there is less impact of the monetary policy in the economy.

Liabilities to other euro area residents denominated in euro (129): Most of these liabilities are government liabilities (118), that is money owed by the ECB to EU member states.

Liabilities to non-euro area residents denominated in euro (116,42): These are liabilities that the ECB has with institutions that are located outside the euro area.

Counterpart of special drawing rights allocated by the IMF (54,72): The ECB owes almost 55 billions to the International Monetary Fund and this debt is recorded in this account.

Revaluation account (399,45): When the ECB considers that the value of some of its assets is higher than the value at which those assets are held in the balance sheet, it revalues upward these assets and recognizes this increase in its equity. Therefore these 400 billions are just the recognition that some of the assets have a higher value than initially recognized. For example, if the ECB has recorded its gold reserves at 1.000 euros per ounce and thinks that the price of gold will be stable around 1.500 euros per ounce, it can increase the value of its ounces in the balance sheet and recognize the 500 euros per ounce in Equity. Right now gold is valued by the ECB at 1250 euros approximately. This means that gold is almost marked to market because it is trading around 1250 euros per ounce. If gold price plummets to 1.000 euros (that is 20%, not a crazy scenario, even if improbable) and the ECB really marks to market gold, it would lose 86 billions in reserves.   

Capital and reserves (85,36): This is the equity of the ECB equivalent to 2,84% of total assets. It means that if ECB’s assets lose 3% of their value all the ECB’s capital would be wiped out and the ECB would be bankrupt. However, the ECB has also 400 billions of revaluation reserves that could be considered equity and therefore it could afford higher losses: 15% of assets. Nevertheless, probably these 400 billions in reserves reflect an inflated value of some assets, probably not market to market but marked to fantasy. All peripheral sovereign debt is valued at par and, in case of default of one or more countries, the ECB could face huge losses, even if bonds held by the ECB are ranked senior to privately held ones, as it was clear when Greece defaulted. Therefore, the financial position of the ECB is not that healthy given a leverage of 35 (Total Assets/Equity). Some people think that ECB’s financial position does not matter because it can just print money and bailout itself. However, we must consider that money is a liability for the ECB and it is not possible to decrease liabilities issuing more liabilities. Every time the ECB issues money, it increases its assets and liabilities and therefore the equity position is not affected. One way to recapitalize the ECB is to increase its assets while leaving its liabilities unchanged. This can be done, for example, by European states giving some of their sovereign debt for free, as a present. In this way assets would increase without a correspondent increase in liabilities. However, European states are already too much indebted and doing this would increase their debt burden and worsen the economic crisis.

I realize that this is not a complete discussion of the ECB’s balance sheet but I think it could be useful to understand this important institution. There are a lot of other considerations that should be done, like discussing in more detail how the monetary policy is implemented and which are the facilities used to implement it. Maybe I will do that in another post in the future.