Thursday, September 13, 2012

Loss Sharing in the Eurosystem

Our Claim

Monetary policy operations are only shared pursuant to a capital key weighted majority vote.  

Loss Sharing between NCB’s

The amount of each national central bank's monetary income shall be reduced by an amount equivalent to any interest paid by that central bank on its deposit liabilities to credit institutions in accordance with Article 19.

The Governing Council may decide that national central banks shall be indemnified against costs incurred in connection with the issue of banknotes or in exceptional circumstances for specific losses arising from monetary policy operations undertaken for the ESCB. Indemnification shall be in a form deemed appropriate in the judgment of the Governing Council; these amounts may be offset against the national central banks' monetary income.

What experts say:

“The official legal statute governing the Eurosystem is quite vague about the implications for an NCB of losses incurred in monetary operations… In practice, the Governing Council of the ECB used the defaults by Lehmans sic and other banks in 2008 to clarify in a statement in March 2009 that losses should be shared in full by the Eurosystem NCBs in proportion to their ECB capital key shares.” 

“Losses and profits made by the ECB and the NCBs in the implementation of the common MCL policy are shared among the NCBs in proportion to their share in the ECB capital.” 

“The losses incurred by the Eurosystem are to be shared by all national central banks in proportion to their shares in the ECB's capital.” 

Our interpretation:

Based on the Protocol on the Statute of the European System of Central Banks and of the European Central Bank (the legal framework for the Eurosystem), losses borne by an NCB are not automatically shared; losses may only be shared pursuant to a capital-key weighted majority decision by the Governing Council.


1) Plain Reading: Paragraph 2 of Article 32.4 states that the “Governing Council may decide that national central banks shall be indemnified… in exceptional circumstances for specific losses” (emphasis added).

We are not quite sure whether the use of “exceptional” in Article 32.4 is intended to refer to a decision on loss sharing (meaning loss sharing only happens in exceptional circumstances) or whether it is descriptive (meaning losses themselves could only occur in exceptional circumstances). Under either interpretation the sharing happens only pursuant to a Governing Council vote. In the event of a large loss such mandatory vote could easily be anything but pro forma.

Article 10.3 of the Protocol provides that for any decisions taken under Article 32, inter alia, “the votes in the Governing Council shall be weighted according to the national central banks’ shares in the subscribed capital of the ECB.”

2) The One Public Decision to Share Potential Losses: Due to counterparty defaults in 2008, the Bundesbank, the Dutch National Bank and the Luxembourg Central Bank seized collateral of defaulting counterparties and faced potential losses on its disposal. The Governing Council voted that potential losses arising from these operations should be shared (it is unclear whether or not losses ever materialized.)

Karl Whelan claims that this decision “clarifie[d]… that losses should be shared in full by the Eurosystem NCBs in proportion to their ECB capital key shares.” But that understanding is hard to square with the ECB’s press release on the matter. The ECB made a specific decision in March 2009, and nothing in it supports Whelan’s argument that they took that opportunity to clarify Article 32.4. In fact the whole exercise suggests loss sharing is not automatic, but only enacted pursuant to a vote (as Article 32.4 requires) after making sure, for instance, that all rules were followed.  The press release discusses specific potential counterparties and losses; it does not contemplate any future events or decisions.

ECB Press Release:
5 March 2009 - Eurosystem Monetary Policy Operations in 2008
The year 2008 has been exceptional, also in terms of Eurosystem’s monetary policy operations. The intensification of the market turmoil and the changes to Eurosystem refinancing operations led to an increased level of activity by the Eurosystem to support the financial sector and, through it, the entire economy.

The Eurosystem income from monetary policy operations is expected to amount to some € 28.7 billion in 2008, higher than in 2007 (€ 23.2 billion). The income from Eurosystem monetary policy operations is redistributed among national central banks (NCBs) in proportion to their shares in the ECB’s capital. However, net results of individual NCBs follow different patterns, due to the historical structure of their balance sheets, some specific national responsibilities and national accounting practices. The aggregate net result of the Eurosystem NCBs, including the distribution of the net result of the European Central Bank (ECB) that they receive, is estimated to amount to approximately € 16.8 billion for 2008. The year before, the aggregate net result was € 15.2 billion. The result of the ECB itself for 2008 amounted to EUR 1.3 billion in 2008, compared with zero in 2007 (see today’s ECB press release on the ECB annual accounts for 2008).

At the same time, the specific circumstances of 2008 also implied higher financial risks in Eurosystem credit operations. In autumn 2008, five counterparties defaulted on refinancing operations undertaken by the Eurosystem, namely Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks, and Indover NL. The total nominal value of the Eurosystem’s claims on these credit institutions amounted to some €10.3 billion at end-2008. The monetary policy operations in question were executed on behalf of the Eurosystem by three NCBs, namely the Deutsche Bundesbank, the Banque centrale du Luxembourg and de Nederlandsche Bank. The Governing Council has confirmed that the monetary policy operations in question were carried out by these NCBs in full compliance with the Eurosystem’s rules and procedures, and that these NCBs had taken all the necessary precautions, in full consultation with the ECB and the other NCBs, to maximise the recovery of funds from the collateral held.
The counterparties in question submitted eligible collateral in compliance with the Eurosystem’s rules and procedures. This collateral, which mainly consisted of asset-backed securities (ABSs), is of limited liquidity under the present exceptional market conditions and some of the ABSs need to be restructured in order to allow for efficient recovery. Under current market conditions, it is difficult to assess when the eventual resolution will be achieved by the Eurosystem.
The Governing Council decided that any shortfall, if it were to materialise, should eventually be shared in full by the Eurosystem NCBs in accordance with Article 32.4 of the Statute of the ESCB, in proportion to the prevailing ECB capital key shares of these NCBs in 2008. The Governing Council also decided, as a matter of prudence, that the NCBs should establish their respective shares of an appropriate total provision in their annual accounts for 2008 as a buffer against risks arising from the monetary policy operations which were conducted with the counterparties mentioned above. The size of the total provision will amount to € 5.7 billion, and it is already accounted for in the net result figures stated above. The level of the provision will be reviewed annually pending the eventual disposal of the collateral and in line with the prospect of recovery.

3) No ECB decisions have codified that losses are to be shared in the future. Some decisions have referred to the sharing of monetary income and have periodically updated the calculation of monetary income.  In December 2009, the ECB decided that NCB’s should not suffer a hit to their monetary income when interest bearing loans to counterparties are transformed into non-interest bearing claims against the defaulted estate.