Is massive imbalance in Eurozone central banking system cause for concern?

Der Spiegel ran an interesting article that asks the question of 'is the massive imbalance in the Eurozone central banking system a cause for concern?"

The article focused on the fact that the German central bank has almost 500 billion euros of claims while the central banks of Greece, Spain, Portugal, Ireland and Italy owe over 600 billion euros.

How is the system suppose to work?

Here's an example: A Greek business buys a truck from a German company. The Greek company's local bank in Thessaloniki transfers the payment for the truck to the German company's bank in Stuttgart. 

Because the payment is carried out through the two countries' central banks, this creates a liability on the part of Greece's central bank toward the ECB within the Target2 system, while the German Bundesbank now has a claim from the ECB for the same amount. 

The balance evens out when money flows from Germany to Greece, as happened most years before the crisis: The commercial bank in Greece would borrow the money it needed for its loan to the Greek business, for example, from a German bank.

What gave rise to the current imbalance?

But in a financial crisis, they can potentially lead to catastrophe because the cash flow between banks suddenly falters. This is what has happened since 2007:

• Banks in all of the euro zone countries have had to hold onto their money. They withdrew from supposedly unstable countries, and loans that expired were not renewed.

• The fears of the wealthy also came into play: Concerned that their money might soon lose its value, they began to pull out of Greece, Ireland and Portugal, then later Spain and Italy as well. This left banks in those countries with a smaller pool of savings they could pass on as loans.

• The result of all this was that Greece and the other countries in crisis no longer had enough money to fund all of their imports. If Greek banks wanted to offer further loans, for example to pay for the purchase of German or Dutch products, they had to borrow from their central bank.

• The central bank, in turn, simply created money out of nothing, charging it to the entire euro zone as an outstanding claim within the TARGET2 system. "These countries simply pull money off the printing press," Sinn complains.

Even worse, the central banks also grew increasingly lax in the collateral they required for loans they made to banks in their country. Whereas in the past they accepted only government bonds with top-level credit ratings, now they began to accept second and third-tier securities. 

This can be seen clearly in the statistics: Just between 2005 and 2010, the volume of securities accepted by central banks rose from €8 billion to €14 billion -- and has likely increased even more since then. 

Especially those banks in crisis countries, which are already reliant on their central banks, now submit even their worst securities. Greek banks, for example, have primarily their own country's sovereign bonds on their books. No one on the free market wants these securities, but the Greek central bank continues to accept them as collateral, issuing new money to the banks in exchange. 

"Private cash flow is replaced by public cash flow," Sinn explains. 

This becomes dangerous if those securities ever need to be used, for example if Greece leaves the monetary union or declares bankruptcy. At that point, Greek bonds would be valueless, and the probability that Greece's central bank will be able to repay its debts to the euro system becomes miniscule.

Naturally, the article asks what happens if one or more of the countries with a central bank that owes money leaves the Eurozone.  Could Germany through its central bank lose 500 billion euros?

The real answer is it depends.

It depends on whether or not the individual central banks are enforcing the Eurozone central banking system's collateral requirements or not.

Specifically, when the Eurozone central banking system lends to a bank against its collateral the Eurozone central banking system does not advance as much as the collateral is currently worth.  In fact, there is a schedule for the haircuts applied to the collateral.

It is my understanding that after the loan has been made, in theory, if the value of the collateral declines, the borrowing bank is suppose to provide additional collateral. [This is done to protect the Eurozone central banking system from risk should the value of the collateral decline.]

But are the national central banks requiring the posting of additional collateral in practice?

If yes, even if a country leaves the Eurozone, its central bank should have adequate collateral to ensure that it can repay what it owes to the Eurozone central banking system.

If no, then the Eurozone central banking system is exposed to and could have losses should one or more nations leave the Eurozone.

What caught my attention about the imbalance in the Eurozone central banking system was here is a classic example of disclosure (we know which national central banks are creditors or debtors) without transparency (we don't have the information needed to know if there is adequate collateral available to minimize the risk of loss).