Central Bank Balance Sheet Used to Deposit Financial Losses

Central Bank Journal of Law and Finance, No. 2/2015 1
Final Deposition of Losses through the
European Central Bank's Balance Sheet as a
Financial Stability Policy Tool
Max Danzmann*
Abstract
The central bank has an extensive set of tools to grant financial stability. Its unlimited
potential to create money and its ability to indefinitely stave off insolvency, enable it to
act as a "Bad Bank". This can be implemented by using the central bank’s balance sheet
to permanently deposit financial market participants' losses which would otherwise
jeopardise financial stability (final deposition function). While final deposition of losses
is used as a policy instrument to establish financial stability, it also has a number of
economic effects, such as redistributive effects, misdirected incentives and inflationary
dangers. Against the backdrop of the central bank's independence and the instable
financial condition of the European Monetary Union, these consequences raise questions
as to the member states' sovereignty.
Keywords
Financial Stability, Final Deposition, European Central Bank, European Monetary Union
JEL Classification:
E52, E58, F45
* The author holds a doctor’s degree in economics and works as finance lawyer for an international law
firm in Frankfurt, Germany

Final Deposition of Losses through the European Central Bank’s Balance Sheet
2 Central Bank Journal of Law and Finance, No. 2/2015
1. INTRODUCTION
While financial liberalisation has increased the importance of financial affairs for macro-
economic developments, an actual shift in financial policy competence has been
prompted by the strong influence that the central bank has on the financial industry and
financial policy measures. This shift is illustrated by the phenomenon of financial
instability. This is due to the fact that the central bank is effectively the only player who
has the required tools to protect the financial system during times of financial instability.
The potential need for stabilisation by the central bank is unlimited due to the inherent
instability in the financial system. It will not be possible to eliminate financial instabilities
from the financial system over the long term since financial relations between economic
players can always differ from what the parties wish or intend. However, financial
instabilities that have the potential to affect the functional operability of the financial
system, have only recently started to appear since some individual financial relations have
reached magnitudes which represent a potential for harm for many other financial
relations.
Since then, it has been the objective of financial stability policy to identify and isolate
financial instabilities. This is carried out in order to attain their definitive (dis-)solution.
Such a process – if feasible at all under the relevant circumstances – entails financial side
effects, i.e. losses, which may be channeled into something that could be described as final
deposition. If the final deposition concept is not only applied to physical substances, as in
environmental policy1, but also to social phenomena. It is also (semantically) possible to
finally deposit losses caused by certain assets (i.e. obligations and ownership rights). For
such purpose, the central bank's balance sheet can be used to finally deposit financially
destabilising losses more effectively than any other financial stability policy tool. In a final
deposition scenario, the central bank ascribes a financially destabilising effect to specific
obligations and ownership rights (assets) and extracts them from the financial system by
transferal to the central bank. By neutralising financial losses through final deposition in
the central bank's balance sheet, destabilising obligations and ownership rights (assets)
will be rendered harmless for the financial system and financial instabilities will be
minimized, if not altogether eliminated.
The final deposition of losses on obligations or ownership rights (assets) posing a risk for
financial stability would generally be subject to three prerequisites: (i) the impossibility to
dissolve such financial instabilities by other reactive instruments, (ii) the assignment of
such financial stability risks to specified obligations or ownership rights (assets) and (iii)
the final depository must be separated from the remainder of the financial system in such
a manner that there is no risk that the finally deposited losses cause further

Max Danzmann
contamination or harm. Therefore, in order to be suitable as final depository for losses
from financially destabilising assets, the central bank's balance sheet must be completely
isolated from the rest of the financial system.
Whereas losses will be permanently disposed of, reducing the central bank's equity
position, it must be noted that not the assets causing financial instability, but the losses
resulting from the obligations and ownership rights (assets) recorded in the central bank's
balance sheet, are subject to final deposition. The assets will only be held temporarily and
after a certain time either be resold or become extinct, e.g. by expiration, termination,
fulfilment or waiver (in each case writing-off the losses subject to final deposition, if
any)2. Unlike obligations and ownership rights (assets), the losses themselves cannot,
however, be dissolved or extinguished (except through currency changeover) because they
became effective in the past. Likewise, the consequences of losses cannot be neutralised
within the central bank's balance sheet with future effect since every balance sheet is at
any given time an update of the results of all prior balance sheets. Generally speaking, the
central bank's balance sheet is a cumulative reflection or summary of all monetary actions
of the central bank in the past. Inevitably, the economic consequences of money issuances
and quantitative easing (such as redistribution effects) will have continuing effect even
though tailing-off over time.
After all, it has only after abolishment of the gold standard – from a material point of view
– become possible to replace non-performing debt and loss-incurring ownership rights
(i.e. loss-making assets or finances) by money and thereby support financial stability in
general3. In doing so, the central bank becomes a vehicle for final deposition of financially
destabilising losses incurred by financial market actors, which can neither be utilised nor
dissolved by the financial system without jeopardising its own viability. The central bank
then acts as a public winding-up agency, commonly known as a 'Bad Bank'4.
2. FINAL DEPOSITION TOOLS
Among a variety of tools for final deposition of financial instabilities in the central bank's
balance sheet, the assumption of destabilising finances by the central bank is the most
direct tool. All tools have in common that the central bank uses central bank money and
quantitative easing strategies to extract financial instabilities from the financial market by
isolating, and thereby neutralising, financially destabilising losses from the rest of the
financial market in the central bank's balance sheet. In this regard, the tools for final
deposition in principle represent an inexhaustible stabilisation source, considering that
the central bank has the infinite ability to absorb losses and can indefinitely create central
bank money. When taking losses into the final depository, the central bank not only acts

as lender of last resort, but also provides the financial system with solvency assistance to
avoid over-indebtedness by way of ultimately assuming losses incurred by other financial
market players.
2.1. Assumption of Financially Destabilising Losses by Asset Purchase
Losses subject to final deposition are caused by loss-incurring assets. Final deposition is
the manifestation of the central bank's ability to assume financial stability risks by
purchasing assets which are destabilising the financial system. Such assets include
obligations and ownership rights (assets), such as, but are not limited to, loans, credit
derivatives, securities (including (government) bonds and loan securitisations), derivative
instruments with securities as underlyings, currencies and insurance policies. The assets
are purchased by the central bank at prices exceeding the (then current) financial market
value, so that private financial market players selling such assets are not required to
record balance sheet loss write-offs, which might jeopardise financial stability. By making
excessive purchase price payments with central bank money generated for this purpose,
the financial stability risk is transferred from the seller to the central bank.
While obligations are usually purchased on secondary markets, losses can also be
assumed by central bank interventions in the primary markets with subsequent debt
relief. The latter will basically have the effect of a donation of capital for solvency
assistance purposes and is particularly appropriate where the cause of the beneficiary's
financial instability is ambiguous, i.e. financial instability cannot be assigned to a specific
asset. Final deposition is, however, impossible where financial instability cannot, lege
artis, be timely discovered. In addition, due to the intense interference with competition,
it can be expected that this final deposition tool will, if at all, only be used for the benefit
of one's own government.
Such financial stability policy operations do not necessarily entail central bank losses.
Where financial stability risks from certain assets do not materialise, the central bank can
avoid losses either by performance on the purchased obligations, or by enjoyment of
benefits of the purchased ownership rights, or by the sale or transfer of such obligations
and ownership rights (assets). Contrarily, if the assets purchased do not (or not fully)
perform or if the purchased ownership rights decline in value as anticipated, the central
bank will incur losses. The exact timing of the write-offs of losses depends on the relevant
accounting standards, i.e. on the question of whether the asset is recorded at market value
or at purchase price which in turn may depend on the question as to whether or not the
asset is held until maturity5.

Max Danzmann
2.2. Eligibility of Inferior Assets for Monetary Policy Refinancing
Financial stability risks – i.e. destabilising risks of loss – can also be transferred to the
central bank by collateralisation under monetary policy refinancing operations. In its
monetary policy refinancing operations, the central bank generally protects itself against
the insolvency of its debtors by taking collateral and setting eligibility criteria for loan
collateral6. To avoid central bank losses, strict criteria are applied by the central bank to
the eligibility of assets providing protection upon insolvency of the borrowing bank7.
Collateralisation mostly involves either the granting of a pledge or lien over a borrower's
asset or the security assignment of a borrower's claim. But loan collateral is provided to
the central bank only for realisation purposes, so that not the asset will be permanently
deposited as a loss, but rather the difference between an outstanding claim and the
proceeds from realisation of the pledged or transferred asset. Hence, the central bank will
not record a loss in its balance sheet before the loans, for which insufficient collateral was
provided, go into default8.
As many bank assets decline in value in times of financial instability, the number and
volume of eligible assets will also decrease. Overall, the availability of loans – and
consequently the liquidity of credit institutions – will deteriorate as a consequence of
financial instability9. The central bank can, however, redress liquidity deterioration of
credit institutions by easing the eligibility requirements for certain assets, thereby
increasing the scope of potentially eligible assets and thus ensuring solvency of these
credit institutions through central bank refinancing operations. In doing so, the central
bank escalates its own risks of loss upon insolvency of its counterparties because
collateral provided does not provide sufficient cover for the claims outstanding10. It is
possible to ensure liquidity of any credit institution at the cost of the central bank's risks
of loss, if only the requirements are lowered enough and the scope of monetary policy
refinancing transactions is raised sufficiently.
Upon insolvency of a bank, losses are transferred from a bank to the central bank’s
balance sheet making the collateralisation of refinancing loans a final deposition tool.
Unlike the transfer of financially destabilising assets, such collateralisation cannot be
qualified as direct solvency assistance, but only as a loan. Solvency assistance is only
provided to a bank indirectly by enabling them to liquidate assets not required for
collateralisation of central bank lending and to use the proceeds to repay debt, thereby
avoiding over-indebtedness. In this manner, creditors can be paid off while the central
bank's default risks rise (as a consequence of lower-quality assets).
However, where a beneficiary bank does not use refinancing loans to improve its own
solvency, but instead to expand its lending activities (for example by purchasing sovereign
debt to maintain government solvency), the central bank's loss risks increase even

further. In the event of the insolvency of such bank, the central bank is then required to
also compete, without sufficient collateral (i.e. on a pari passu-basis), with the unpaid
creditors for the insolvency estate. Ultimately, upon default (resulting in insolvency),
credit expansion is at the expense of the central bank's balance sheet, which serves as
final depository.
2.3. Central Bank SPV Assumes Final Deposition Function
It is also conceivable to permanently deposit financially destabilising losses through a
vehicle specifically established for that purpose (special purpose vehicle, SPV). The SPV
would generally be required to write-off its final losses immediately, depriving it of the
possibility to stabilise the financial system since this would result in its own over-
indebtedness. Therefore, legal provisions would be required providing that the SPV is to
be established as a public-law entity and therefore cannot be declared insolvent – just as
the central bank11. Under such condition, the SPV, like the central bank, could record a
negative equity position in its balance sheet.
Such SPV, however, can only assume a final deposition function in co-operation with the
central bank. If an SPV is granted the status of a counterparty to monetary policy
refinancing operations by the central bank, such SPV can participate in monetary policy
refinancing and receive liquidity from the central bank. The central bank can then provide
the SPV with exactly the amounts of central bank money which are required for financial
stabilisation in each case. Instead of the central bank, the SPV would purchase the assets
jeopardising financial stability in accordance with the first method of final deposition and
have them transferred to it. Moreover, the central bank should not require the SPV to
provide collateral for refinancing loans at all or restrict such provision of collateral to the
assets which were taken on by the SPV and cause financial instability (e.g. low quality
sovereign debt). This final deposition instrument thus constitutes a combination of the
first two final deposition methods.
By derogation of the previous instruments, rather than the central bank's balance sheet,
the SPV's balance sheet serves as final depository for the financial instabilities.
Functionally, the SPV is a central bank vehicle, because it is used by the central bank to
provide financing without (or with insufficient) collateral, thereby enabling the central
bank to finally deposit losses outside of its balance sheet.
The practical problem of this tool, however, will be repayment of the central bank's
refinancing loans by the SPV at the end of the agreed term, because the SPV will record
losses on the investments made with the money from these loans. The central bank
should therefore either grant such refinancing loans to the SPV indefinitely, whereby they
would lose their loan characteristics and require loss write-offs by the central bank (which

Max Danzmann
is exactly what was to be avoided by using the SPV as an intermediary) or the SPV would
need an additional investor, such as the government, which would eliminate its final
deposition function. Therefore, when it comes to the crunch, the SPV lacks the ability to
create money.
3. ECONOMIC EFFECTS OF FINAL DEPOSITION
That the central bank's balance sheet can be used as final depository does not necessarily
mean that stabilisation of the financial system should under all circumstances be sought
by using final deposition tools. It is rather necessary to weigh the consequences of final
deposition instruments against their financial stability policy benefits in each individual
case. Negative consequences may speak against the use of such instruments. Weighing the
consequences is a (financial stability) policy decision for which, due to the variability of
the overall financial system, a permanent universally appropriate solution cannot be
found.
3.1. Economic effects for the central bank
For most assets taken on by the central bank for final deposition, the central bank must,
lege artis, eventually record loss write-offs in its balance sheet in the event of impairment.
Accounts receivable may, however, be held until their due date to delay their write-down,
if the central bank records assets at purchase price rather than at their market value12. It
is also conceivable that, despite (large) value declines, assets which are non-depreciable,
must not be written-off at all, if the central bank does not intend to sell the assets.
Finally, deposited losses do not pose existential threats because, as a general rule, their
consequences are limited to the balance sheet. If, after taking into consideration the
financial year's revenues and provisions, the central bank still reports losses, the central
bank must revert to its reserves13. Where the amounts are not sufficient to cover losses,
the central bank must record a loss carry-forward in its annual financial statements until
the losses are offset by future profits14. Such losses may weigh heavily on the central
bank's net equity position, which may fall below the share capital or even turn negative.
However, as a general rule, neither a loss carry-forward nor a negative equity position will
have further consequences on the central bank's ability to act. The central bank is a
public-law entity and as such cannot become insolvent15 and can, in fact, not lose its
ability to pay due to its capability to issue (central bank) money. This capability, by law, is
only restricted by the price stability target which, in turn, is not clearly defined. Its
monopoly to create (central bank) money enables the central bank to fulfil any and all
payment obligations. As a matter of fact, the central bank does not need any equity capital
at all. Today, its equity capital has an idealistic function of displaying its independence

and autonomy. It is not designed to obtain the confidence of the public by its sheer
amount. Unlike commercial enterprises, where creditors are protected by provisions
relating to raising or maintaining capital, or by liability rules, holders of central bank
money as creditors of the central bank are protected by the central bank’s commitment to
achieve the target of monetary stability16.
The state as the owner of the central bank is not obliged to offset central bank losses by
injecting additional capital contributions, although a compensation of losses by the state
could, depending on the monetary policy or financial stability policy strategy, prove
expedient17. In the event of high loss carry-forwards, it is not altogether unimaginable that
the central bank will abandon its previous monetary policy targets and pursue a monetary
policy strategy aimed at profit maximisation. To effectively implement monetary policy,
the central bank depends on its credibility. This credibility could be impaired if private
economic actors expect the central bank to pursue a profit maximisation strategy. In view
of the principle of the central bank's financial independence, many economists believe
that the sovereign is factually obliged to offset the central bank’s losses in the event that
the amount and sustainability of loss carry-forwards justify significant doubt as to the
central bank's performance of its tasks18. Parliament might then have to approve and
provide sufficient fiscal funds in the budget.
An obligation of the sovereign to make additional capital contributions is at least not
required for the functioning of a central bank. If the central bank remains indifferent
towards its loss carry-forwards and negative equity capital positions, it may still be fully
able to focus central bank policy on non-profit-related monetary policy targets, regardless
of any losses19. It seems, however, possible that private economic actors’ expectations of a
central bank profit maximisation-strategy disappear over time if the central bank actually,
despite final deposition of losses, neither pursues a profit maximisation strategy nor a
monetary expansion strategy. As a consequence, if the central bank has, at an earlier
stage, pursued final deposition programmes without consequential strategies for profit
maximisation and neutralisation of the money supply injected into the market by final
deposition, it will not lose so much credibility that this jeopardises its ability to act. The
central bank could – to a certain extent – continue to pursue final deposition programmes
thereafter. As long as credibility is preserved, the central bank can operate in a loss-
making scenario over an extended period of time. This is evidenced by historical
examples, e.g. the Deutsche Bundesbank in the seventies and eighties of the 20th
century20.

Max Danzmann
3.2. Economic Effects for Fiscal Policy
Final deposition of financially destabilising assets not only affects the central bank, but
also fiscal policy. Asset write-downs reduce the central bank's profits from its monetary
policy transactions. Large write-downs may even eat up the profits of several subsequent
years. Since the central bank's net profits are transferred to the state at the end of the
year, losses caused by final deposition will weigh on state revenues in the amount of
central bank profits which would have been recorded without final deposition. In any
event, the detrimental effects on fiscal policy are limited to the revenues side of the
budget, since there is no obligation on the state to contribute capital – not even if the
central bank's equity capital were fully used up. Therefore, no charges will be posted to
the expense side of the budget.
Moreover, the central bank can support fiscal policy through final deposition instruments
by purchasing, or accepting as collateral for refinancing, sovereign debt of insufficient
credit quality. This can produce misdirected incentives and entice fiscal policy to rely on
the central bank's financial stability policy assistance as well as to refrain from taking the
necessary precautions itself by adjusting fiscal policy tools (moral hazard)21.
3.3. Economic Effects for Financial Institutions
As a general rule, final deposition through the purchase and transfer of financial
instabilities can benefit all financial entities while final deposition through accepting
destabilising finances as collateral benefits only credit institutions acting as
counterparties of the central bank. Particular importance for financial stability is ascribed
to certain financial entities by providing them with the possibility to deposit their
financial instabilities in the central bank's balance sheet. Such particular importance of a
financial entity is also described as “systemic relevance.” The term systemic relevance
can, however, only relate to relevance for the financial system in its current state. No
financial entity can be of absolute or abstract systemic relevance, because the financial
system would continue to exist, even if a financial crisis resulted in the insolvency of all
large financial entities (though in a different state and under different conditions). Where
a financial entity is of systemic relevance, (only) the specific architecture of the financial
system and distribution of economic resources and output are to be protected.
Final deposition does not prevent a financial crisis which might arise intentionally as a
consequence of the legislator's or the central bank's (financial stability) policy strategy or
in the event that the central bank misjudges the importance of a factor destabilising the
financial system. Where the central bank resolves to maintain financial stability by
depositing risks at any cost there should, however, be hardly any risk of insolvency for a
financial entity categorised as being of systemic relevance because the central bank can

intervene with final deposition measures to stabilise such entity and the financial system
until shortly before the financial system ceases to function, i.e. a financial crisis occurs.
The assumption of risk by the central bank distorts competition between financial entities
of systemic relevance and other private economic actors which may be justified from a
financial stability policy point of view. Such distortion of competition can, in particular,
result in improved credit ratings and lower refinancing costs for systemically relevant
financial institutions. In addition, financial entities categorised as being of systemic
relevance might be enticed to accept higher risks and to frustrate incentives to take
protective measures of their own accord (moral hazard)22.
Financial institutions which, in fact, cannot become insolvent for financial stability policy
reasons differ materially from the other private actors within the financial industry. Banks
without insolvency risks will become mere money or credit managers and as such cannot,
due to a lack of entrepreneurial risks, justify profitable interest components. Losses
entailing the risk of insolvency will be transferred in full to the central bank's balance
sheet as final depository. The central bank's balance sheet, being part of public finances,
would thus be liable for privately generated losses. Banks of systemic relevance would
have the power to decide on and be responsible for material risks of loss of a state,
bestowing a sovereign-like quality on them which cannot be legitimised for private
economic actors in a democracy.
3.4. Economic Effects for Other Financial Market Actors
Final deposition of financially destabilising losses will also affect all other economic
actors. The increased money supply resulting from final deposition measures particularly
affects the rate of inflation, i.e. losses might, above all, have macro-economic effects and
affect the internal price level or trigger changes to the currency’s external value23.
Depending on their scope and duration, final deposition instruments might affect the
inflation rate negatively, so that the permanent use of such instrument appears
inadvisable. Financial stability policy must assess, on a case-by-case basis, if inflation
should be given preference over the dissolution of (possibly only short-term) financial
instabilities (i.e. if price stability should be given up for financial stability). This
assessment must take into consideration that it is neither possible to clearly quantify
price developments in advance nor to make clear statements as to the quality which are
constant over time. After all, inflation has monetary as well as non-monetary causes
which may have overlapping and parallel effects24.
In a final deposition-scenario, financial instabilities are replaced by central bank money
(Quantitative Easing). Hence, unless the central bank initiates additional monetary policy
neutralisation measures, final deposition instruments generally increase money supply.

Max Danzmann
Quantity theory, therefore, generally assumes that final deposition is accompanied by
inflationary risks. While neutralisation measures are, insofar possible as the central bank,
due to its basically indefinite ability to absorb losses, is not required to apply a profit
maximisation strategy, such neutralisation could be impaired by destabilising effects
should the central bank, within a short period of time, withdraw large amounts of money
from sources other than those where the money was injected in order to deposit losses.
On the other hand, financial instabilities often result in restricted bank lending and,
consequently, book-money creation, which may thwart the inflationary effects of the
central bank's monetary expansion. Financial instabilities can also be accompanied by
recessionary economic developments (not least due restricted lending) and deflationary
effects which may neutralise the monetary effects of the increase in central bank money
supply25. While empirical research suggests a long-term positive correlation between an
increasing money supply and a rise in inflation26, nobody has until today been able to
deliver a sufficient inflation theory explaining the current inflation trends27.
Rising prices caused by final deposition instruments would have large social policy
consequences. A general increase in prices primarily affects people with little savings or
poor people, because they spend a bigger share of their income for consumer goods and
can barely cover themselves against price rises by demanding higher nominal interest
rates for their small savings28. At the same time, (wealthy) holders of assets, whose
market value increased, benefit from higher asset prices. The effects of inflation are
comparable to a tax on savings affecting small savers in particular29. These primarily
invest in savings deposits because other types of investments involve a more sophisticated
asset management and, therefore, higher costs. Higher inflation reduces incentives to
invest money, possibly prejudicing the propensity to save, because an environment of low
real interest rates does not entice savers to abstain from consumption30. On another note,
sustained financial stability risks should also prevent private economic actors from
building financial reserves.
Be it as it may, the final deposition of losses will result in the reallocation of economic
resources since shareholders and creditors, which would be affected by insolvency, are
not obliged to write-off their assets (which are supported with public funds). From a
financial stability policy perspective, final deposition instruments preserve a macro-
economic state of distribution, which would not be possible in a financial crisis.
Neutralising the expansion of money supply can also entail a macro-economic shift of
burdens, if it brings about a change of monetary allocation of capital – which will happen
if money is withdrawn from another source within the monetary system than where it was
injected.

An additional disadvantage of final deposition is that financial stability policy effects are
remedial rather than preventive. The cause of financial instabilities, such as the drifting
apart of real economy and the financial sector31, is not mitigated by this financial stability
policy instrument. Rather, a further decoupling of real economy from the financial sphere
should be expected from misdirected incentives and a rising monetary basis. Moreover,
final disposition could also give rise to new financial instabilities. Inflationary tendencies
curbed by final deposition instruments reduce real interest rates, forcing capital investors
to accept higher risks if they want to constantly meet their return expectations. In the end,
investors will either accept lower yields or – particularly when they have high
(contractually agreed) return targets (such as life insurers) – invest in higher-risk assets
which could, in abstract terms, entail additional financial stability hazards32.
4. FINANCIAL STABILITY POLICY WITH FINAL DEPOSITORY
Final deposition tools play a vital role for financial stability policy. They must primarily be
characterised as financial stability policy measures, even if they also affect monetary and
fiscal policy areas. Not least due to their substantial importance for financial stability
policy and the shift in competencies they require a legal framework set by the legislator.
4.1. Allocation of Final Deposition Tools to Financial Stability Policy
Final deposition of financially destabilising losses affects the interests of several political
areas: monetary policy, fiscal policy and financial stability policy in particular. Each and
every use of final deposition instruments has a financial stability policy dimension.
Taking assets from financial companies and/or relaxing eligibility requirements serves to
save credit institutions from insolvency and to maintain the functioning of the financial
system. At the same time, because monetary and fiscal instabilities also qualify as
financial instabilities, the dissolution of monetary and fiscal instabilities by way of final
deposition also has a financial stability policy character.
Final deposition tools are often claimed to be monetary policy measures – in particular by
central banks. One argument for assigning final deposition instruments to monetary
policy is that they are in the hands of the central bank as the major monetary policy
player. Moreover, the central bank is also responsible for the purchase of debt and equity
instruments as one of the central bank's central tools to manage money supply and the
collateralisation of monetary policy refinancing loans protects the central bank against
losses arising upon insolvency of a counterparty.
To the extent that final deposition tools reduce or eliminate the central bank's profits,
which are to be transferred to the state, they can also have fiscal policy consequences. It is

Max Danzmann
moreover conceivable that the state's funding conditions in the capital markets are
affected if government bonds are subject of final deposition tools. Sovereign debt could,
for example, be purchased in the primary market to directly fund monetary state finances
and deposit the resulting losses.
Since the central bank can only claim comprehensive competence for monetary policy,
final deposition measures must be allocated to one of the affected policy fields in order to
determine that the central bank has decision-making competence for final deposition
tools. Such allocation is based on the meaning of the measure for overall financial
stability. Where final deposition of financially destabilising losses is of fundamental
significance for financial instability as a whole, it should be deemed primarily a financial
stability policy measure. Basically, the meaning of final deposition for financial stability is
determined by the level of the threat to financial stability which emanates from the
relevant condition against which the final deposition measure is directed. Therefore, final
deposition is primarily a financial stability policy measure if the situation, which is to be
remedied, is characterised by a high level of risk for financial stability.
As a general rule, final deposition tools should be characterised as financial stability
instruments because they are only applied in a financial stability policy emergency due to
price stability risks caused by the final deposition tools and since preventive financial
stability policy instruments should have priority over the application of final deposition
tools. As an additional argument, final deposition instruments support solvency of the
beneficiary financial economy actors. Another indicator for the financial stability policy
nature of such a measure is the acceptance of low-quality collateral from many recipients
which serves to strengthen financial stability of the banking sector as a whole. The same
applies where measures are taken over a long period of time. Linking financial aids to
fiscal policy or financial stability policy conditions or requirements is also indicative of a
financial stability policy character of a measure. Additionally, large volumes of losses
which are the subject of final deposition also form an indicator of such a financial stability
policy character.
If a financial stability policy measure is directed towards a situation representing
monetary, fiscal and financial instabilities at the same time, prevalence of the financial
stability policy character is also indicated. While, for instance, the purchase of sovereign
debt from financial enterprises by the central bank – as a consequence of financial
difficulties of sovereigns with the objective to finally deposit the losses – has a fiscal policy
dimension (due to sovereign liquidity difficulties) and a monetary dimension (due to
downward pressures on the domestic currency). It primarily constitutes a financial
stability policy measure since it relieves the financial enterprise of its financially
destabilising assets.

Although the central bank's activities serve to maintain the functioning of the monetary
policy transmission mechanism, they are primarily of a financial stability policy nature
because, overall, the functioning of the transmission mechanism (which is the reason why
the measure was taken) is of minor importance compared with the maintenance of the
financial system as a whole33. This is because the functioning of the central bank's
transmission mechanism in the event of financial instabilities – which generally also
(negatively) affect banks due to their central position in the financial system – also
depends on financial instabilities which are (in the beginning) unrelated to the monetary
system. Otherwise, the central bank as central monetary policy actor would, for example,
be made responsible for funding or not-funding a state, only because fiscal instabilities
can also affect banks and, eventually, the transmission mechanism.
4.2. Most Effective Tool of Financial Stability Policy
Final deposition of financially destabilising losses is the most effective responsive
instrument of financial stability policy. The first category of final deposition instruments
is particularly suited to remedy the weakness of the 'lender of last resort' concept, which
can only resolve a credit institution's inability to pay, but not its overindebtedness. By
purchasing financially destabilising assets, the central bank can, in the amount of the
purchase price, contribute to avoiding the financial entity's losses, which are the cause of
the overindebtedness. It thus provides solvency assistance. In contrast to emergency
liquidity, the purchase price is paid not as loan since it is paid without a repayment claim.
If financial stability policy resolves to stabilise the financial system at any cost, it will be
bound to use the central bank's balance sheet to deposit losses. In the modern monetary
and financial system, the central bank's final deposition ability is at the centre of the
financial stability policy. With its unfailing loss absorption capabilities, the final
deposition ability provides the central bank with an inexhaustible stabilisation resource.
4.3. Priority of Preventive Financial Stability Policy Tools
The prevention of financial instabilities generally takes priority over the mere reaction to
financial instabilities. Despite their huge stabilising potential, the risks associated with
final deposition instruments suggest that this responsive financial stability policy
instrument should only be used as a last resort. Final deposition of destabilising assets
has detrimental consequences which can permanently damage the central bank's
credibility and the whole (domestic) monetary system. By final deposition, losses caused
by the assets are borne, through risks of inflation and lost profits of the central bank, by
the private financial sector as a whole together with the sovereign, although such losses
were caused by individual economic actors who – with the exception of the sovereign –
would have been insolvent without such financial stability policy assistance. By

Max Danzmann
transferring losses, the aggregate resources of an economy are reallocated in a socio-
politically important manner, thereby causing disincentives, because losses (as negative
external effects) are not borne by those who have caused them (moral hazard). It is
possible in such constellations, that private economic actors take risks at levels which are
of relevance from a financial stability policy point of view precisely because they want to
benefit from financial stability policy assistance (free-rider phenomenon). This leads to
competitive advantages for those economic actors, who are, from a financial stability
point of view, deemed of relevance to financial stability.
These hazards require a cautious use of final deposition instruments in accordance with
the principle of prudence. Such restrictive use must be made mandatory in order to
prevent financial stability policy from seeking simple short-term solutions through final
disposition instruments, despite their possible long-term negative effects. On the other
hand, the requirements for using such instruments must not be so restrictive that they
cannot be used for financial stabilisation in a timely manner. However, financial
instabilities could cause, for example in certain instances, a financial crisis before final
deposition instruments could be applied. It will often be impossible to uncover financial
instabilities in a timely manner.
4.4. Disincentives Caused by Final Deposition Tools
Disincentives diminish pressure on financial institutions to adjust to new circumstances
and to take own precautions in terms of financial stability policy34. Final deposition
instruments may even accelerate isolation of the financial economy from the real
economy35 and have long-term destabilising effects. While they stabilise the current
monetary and financial stability policy in the short run, they do not necessarily liberate
the financial system from its inherent instability, so that crucial adjustments are
effectively stalled by the use of final deposition instruments.
The capitalist (financial) economic system is characterised by financial primacy in that
(economic) decisions are primarily determined by financial issues. Financial damage (at
least short-term damage) triggered by a financial crises, and the resulting adjustments to
the economic system, seem to be too severe as to base political action on other
propositions. There are no economic policy concepts which make changes appear
attractive, if they involve financial damage and adjustments – especially since economies
compete against each other and financial damages and adjustments jeopardise the
relevant competitive positions.

4.5. Parliamentary Control over the Central Bank’s Financial Stability Policy
Mandate
Despite its significant long-term risks, final deposition of financially destabilising assets
plays a central role in financial stability policy. The possibilities to stabilise the financial
system by final deposition instruments cannot be ignored by financial stability policy
actors. The actual control of central bank over final deposition instruments – through its
power of control over the creation of money and its own balance sheet – has taken
domestic competencies away from the legislator and assigned them to executive
authorities. More precisely, the central bank as monetary authority can thereby
significantly undercut parliamentary authority. Without a legal framework for final
deposition instruments, the central bank in fact has the sole power over granting and
shaping financial stability policy aids36. The central bank thus takes decisions about
distribution-relevant questions without sufficient democratic legitimisation, thereby
determining the basics of the (financial) economic system without legislative guidelines
and without coverage under its monetary policy mandate, although the democratic
allocation of powers does not vest the discretion to decide on the permanent use of public
funds in the central bank37.
In addition, final deposition instruments and the reliance by the central bank on its
independence can, in fact, seal off the central bank's power from supervision by other
authorities. Generally. its independence protects the central bank from the influence of
other governmental authorities and guarantees a monetary policy which is guided by the
objective of price stability, independent of other political interests. The central bank's
independence impedes the principle of democracy and can only be justified to the extent
that it is limited to monetary policy38. Financial stability policy has, however, never been
vested in the independent central bank and will, for democracy reasons, never be vested
in it because it is of fundamental importance for the distribution of economic resources
and economic output39. Where the central bank claims independence in relation to the
final deposition of financially destabilising assets, it not only goes beyond its mandate but
also disputes the parliament's competence to regulate these affairs.
The central bank's decisions relating to final deposition measures must be subjected to
parliamentary control, due to the lack of democratic legitimacy. However, the central
bank should not be fully excluded from decisions relating to its balance sheet, if its
organisational autonomy and monetary policy independence is to be preserved. Statutory
final deposition procedures could make parliamentary approval obligatory. For instance,
when the assets to be deposited exceed a certain threshold and, where danger is
imminent, parliamentary committees could be equipped with decision-making authority.
The parliamentary bodies could hold confidential consultations and make confidential
decisions, in order to avoid disturbance of the financial market actors and speculation –

Max Danzmann
at least prior to the decision. Since the parliament's financial stability policy expertise will
most probably not match the professional competence of the central bank, the approval
requirement would force the central bank to communicate its insights and assessments of
financial stability policy procedures with greater transparency. This in turn would
reconnect the central bank's financial stability policy measures with the parliament's
democratic legitimising powers, while at the same time supporting parliamentary
discourse.
5. FINAL DEPOSITION IN THE EUROPEAN MONETARY UNION
Final deposition tools cause specific issues in the European Monetary Union (EMU).
While the EMU with its financially instable condition in particular requires effective final
deposition tools, it is also true that the disincentives and redistribution effects between
economies, which accompany final deposition instruments in a monetary union, are
contrary to economic principles and the provisions of European law. This dilemma shall
be exemplified by the Euro bail-out policy.
5.1. Inherent Financial Instability of the European Monetary Union
The EMU as a monetary association of independent states has a financially instable
constitution, because, although the heterogeneity of the participating economies requires
effective instruments, the ECB must not engage in final deposition – which is a central
bank’s most effective financial stability policy tool.
Empirical economic research has shown that a convergence of real economies in a
monetary union – an optimum currency area40 – is the prerequisite for a financially
stable single currency41. In contrast, the economies of the member states within the
European Monetary Union are not only different in their size, but also in their basic
structure.
The economies' heterogeneous structure engenders diverse needs, which cannot be
individually satisfied by the ECB's uniform monetary policy and its instruments. The
paramount importance of monetary policy requires that each economy has a monetary
policy tailored to its needs42. The ECB cannot adequately respond to unsynchronised
economies and asymmetrical shocks43. Since the ECB's monetary policy mandate is
restricted to the price stability target, the ECB is not authorized to address the socio-
political differences resulting from divergent economic developments (thereby fighting
economic instabilities such as high unemployment or external trade imbalances)44. Its key
interest rate policy is geared towards an average rate for the complete monetary area so

that in fact no economy has the key interest rates, which best serves its economic
development45.
Macro-economic fundamentals have also not converged after the introduction of the
common currency, but have rather moved further apart from each other, aggravating
heterogeneity instead of reducing it46. The European Monetary Union has seen
substantially different inflation rates since the introduction of the Euro. Inflation rates in
Greece, for example, were two times higher than in Germany in the past decade47. Unit
labour costs have similarly drifted apart because output figures and labour costs have
developed differently. While Finland and Germany, for example, were able to reduce unit
labour costs, Italy recorded an increase of 40 %48. As a result, current account balances
and, by now, also refinancing costs of economic actors in the individual economies have
developed differently49.
In the European Monetary Union, differences in economic performance cannot be offset
by actual or administrative revaluations or devaluations50. Normally, exchange rates
function as an outlet for inhomogeneous structures and financial policies because
fluctuating capital flows generally cause changes in the supply of and demand for
currencies. Capital inflows result in demand for a currency and increase the exchange rate
(being the price of a currency), whereas capital outflows increase the supply of a currency,
thereby reducing the exchange rate51. Where economic actors cannot keep pace with the
prices in international competition, a devaluation of the currency ensures that their price
offers, relatively speaking, are increasingly favourable and that the relative price of
domestic assets will decline, thereby providing incentives for foreign investment52.
Devaluations have the additional advantage that imports become more expensive,
prompting domestic economic actors to shift to domestic products, without affecting
obligations or ownership rights within an economy. While devaluation will result in rising
external debt compared to domestic assets, an internal, real devaluation or an open
devaluation by a change of the currency will have the same outcome53.
Open devaluations trigger an adjustment mechanism for capital outflows which, if
abolished between individual economies by fixing constant exchange rates or even
introducing a common currency (as in the European Monetary Union), requires that
capital flows offset each other54. In a monetary union, the capital flows required to pay
imports will, in the beginning, be funded by capital inflows from loans in the opposite
direction55. For less productive economies, low interest rates in the financial markets are
a substantial incentive to take on excessive debt, even though their economies were not
able to achieve a competitive position in global markets precisely because of the single
monetary policy56. Once the indebtedness of some economies had become excessive and
destabilising for the currency area as a whole, capital outflows from heavily indebted

Max Danzmann
economies were primarily funded by overdraft facilities under TARGET2 and a reduction
of imports altogether57.
As a matter of fact, interest rate differences are a market automatism and support a
financially more stable allocation of capital58. Therefore, where member states report
heterogeneous macro-economic fundamental data, this should lead to diverging credit
ratings and market interest rates. In a single monetary area, however, interest rates
converge – with little consideration (if any at all) of the relevant debtor's creditworthiness
– because different interest rates cause capital to flow from low interest rate regions into
high interest regions (interest rate arbitrage)59.
The single monetary policy, however, also promised financial stability of investments in
former high-interest countries to many investors and thereby provided these economies
and states with higher creditworthiness. This resulted in a temporary convergence of
interest rates because the former high-inflation countries were no longer associated with
a higher risk of devaluation than the other participants of the European Monetary Union
and supporting measures were anticipated, should financial instabilities arise. The
(anticipated) funding guarantee provided by the ECB to such member states has
contributed to upward adjustment and equalization of the credit ratings to those of low-
inflation countries, resulting in an unjustified interest-rate advantage from a macro-
economic point of view.
While nominal interest rates converged, real interest rates drifted apart because the
differences in inflation rates remained significant, albeit on a narrower scale. The decline
of real interest rates was primarily restricted to the former high-inflation economies
which triggered incentives in such economies to reduce savings efforts and rather expand
their debt.
Therefore, the European Monetary Union should only have been implemented after a
comprehensive political integration of the member states. This would have enabled
members to successfully coordinate monetary policy, fiscal policy, financial stability
policy and social policy in order to do justice to the interdependencies in these areas of
policy (Coronation Theory). Attempts were made to reduce the heterogeneity of
economies by the convergence criteria of the Maastricht Treaty: debt ceilings for
governments and, prior to admission to the European Monetary Union, price stability
targets, interest rate convergence targets and exchange rate targets60. It was, however, not
possible to make the adherence to these criteria sufficiently binding and enforceable,
because the addressees maintained fiscal and social policy sovereignty61. In many states, it
was not possible to support price stability, the monetary policy's primary target, by
democratically enforcing a restrictive fiscal policy since the latter was also not in line with
the financial incentives on which the expectation of interest rate convergence were based.

While primacy of price stability is a great advantage, it also comes along with the
disadvantage that anti-cyclical fiscal policy measures may not be applied as stability
policy tools62. Return-driven financial markets cannot be expected to provide financial
aids for structural investments whose profitability is in most cases limited to macro-
economic returns63. Rather, investments which promise the highest returns are even
more in demand as a consequence of the integration of financial markets through
monetary unification. As a consequence, exaggerated destabilising price developments
will be even greater because capital will be available to affect demand throughout the
European Monetary Union64. In addition, member states have replaced sovereign debt
denominated in their own currencies with foreign currency debt, thereby accepting
external interest rate particulars65.
However, because final deposition instruments are classified as financial stability policy
instruments and no independent financial stability policy mandate has been conferred to
the Eurosystem by the member states66, the Eurosystem is not permitted to use final
deposition instruments despite the heterogeneity of the participating economies. In line
with the principle of limited conferral of competences, responsibility for material aspects
of financial stability policy rests with the member states. Article 127(5) of the Treaty on
the Functioning of the European Union (TFEU) does not confer an independent financial
stability policy mandate upon the European System of Central Banks (ESCB). It is only
obliged to "contribute to the conduct of policies pursued by the competent authorities
relating to ... the stability of the financial system". Such contribution can under no
circumstances be deemed to be the conferral of the competence to finally deposit
financially destabilising assets as this important and most effective financial stability
instrument would bestow comprehensive competence and not only facilitate the
contribution to a financial stabilisation of member states67.
In addition, the use of final deposition instruments for fiscal stabilisation is excluded
under the prohibition of monetary state financing, as per Article 123(1) of the TFEU,
although, by conferring monetary sovereignty to the Eurosystem, the member states'
governments are forced into taking on debt in a foreign currency. If the composition of
the single currency area is to be upheld, monetary state financing through final deposition
instruments may become inevitable, in particular against the backdrop of the borrowing
incentives provided by the European Monetary Union for economies with weak
competitive positions and an overvalued currency. After all, in accordance with the
assistance prohibition of Art 125(1) of the TFEU, the member states cannot, de lege lata,
be made liable for commitments of other member states.
From a macro-economic point of view, the European Central Bank's willingness to take
unconventional measures, such as the financial deposition of losses, cannot be justified as
supporting lending activity in order to stimulate macro-economic investments. Neither

Max Danzmann
can it be defended as being a measure against deflationary risks in financially instable
economies. Until it is possible for banks to resolve their (serious) balance sheet risks, i.e.
non-performing loans, it cannot be expected that banks will raise lending volumes only
because the European Central Bank supplies large volumes of money. While bank balance
sheet risks could be transferred to the European Central Bank by final deposition
instruments, investments are, as a general rule (with the exception of construction-
related investments), not interest rate sensitive. Therefore, the higher credit supply is
currently not to be expected to result in higher investment activity. Also, deflation in
southern European countries does not pose a risk, but it is necessary in a currency union
which has no devaluation means to re-establish competitive prices in these economies.
Without final deposition instruments, the member states' debt markets – not least
because of the bank-government nexus – will fall to a financial stability level which was
last seen at the time of the gold standard. Without final deposition instruments, the
financial industry lacks the Eurosystem's financial stability assistance of financial capital
injections in financially instable times, which have occurred with increasing frequency
since the elimination of the substantive link to the monetary system, which the gold
standard represented68.
5.2. Final Deposition Tools in the European Monetary Union
In the absence of legal provisions, final deposition instruments could also be used by the
Eurosystem for financial stabilisation purposes.
5.2.1. Assumption of Financially Destabilising Losses by the Eurosystem
The Eurosystem can in fact assume various obligations and ownership rights for final
deposition. Even the statute of the ESCB allows for open market operations in the
financial markets and the assumption of most assets (with the exception of non-
marketable securities) by stipulating that the central banks may operate in the financial
markets by buying outright (spot and forward) or under repurchase agreements, and
thereby assuming, claims and marketable instruments, whether in Euro or other
currencies, as well as precious metals.
In the Eurosystem, both, the ECB (centrally) and the national central banks (decentrally)
may engage in open market transactions to purchase financially destabilising assets in
order to deposit losses in their balance sheets. The Governing Council of the ECB may
decide upon the use, the timing and the conditions of open market transactions69. In
accordance with the principle of decentralisation70, purchases of financially destabilising
assets are generally not made centrally by the ECB, but rather decentrally by national
central banks71. In response to the fiscal instabilities of the past years, the Eurosystem has
been building up securities portfolios, for which the Governing Council of the ECB has

assigned purchase quotas to the national central banks in accordance with their capital
share in the ECB. In each case, 8 % of the purchase volume was realised by the ECB
itself72. The executing central bank ensures technical settlement of the relevant operations
and, in an open market purchase, becomes the owner of the asset and the debtor for the
purchase price73. The purchasing central bank must thus record the asset in its balance
sheet and bear the losses itself, thereby serving as final depository for the financially
destabilising asset74. If held to maturity, the purchased assets are recorded at cost and not
at market value75. Furthermore, provisions are set aside for imminent losses76.
Where losses are recorded directly by the ECB, they are offset against the general reserve
fund of the ECB and its provisions. Where these prove to be insufficient, the Governing
Council of the ECB may opt for monetary income to not be distributed to the national
central banks, but to be used to compensate losses instead. Whereas this will reduce the
national central banks' income, the national central banks are not under any further
obligation to assume the ECB’s losses. Where such losses can still not be fully
compensated, the ECB must record a loss-carryforward in its annual financial statements.
Since, apart from the general reserve fund, loss compensation is restricted to monetary
profits reported in a given financial year, any loss carry-forwards are not automatically
fully offset by subsequent profits since this would require a resolution of the Governing
Council of the ECB77.
Any further automatic participation in losses through a capital contribution obligation
imposed upon national central banks does not follow from ownership interests either,
because the national central banks are not the owners, but merely the sole subscribers
and holders of the capital of the ECB. Such holding is not governed by general ownership
interests but by the statutes of the ESCB. The national central banks are part of the group
of central banks comprising the ESCB and a group of public-law entities is not the
property of a state. Through its central bank, the state acts as a public-law sovereign and
not as private company, even though it takes recourse to banking procedures in order to
facilitate interventions in the money market with as little harm as possible. Should the
ESCB decide to increase the ECB's equity capital, any amounts paid for the increase by
the national central banks cannot be used to compensate losses directly but only
indirectly through recognition of additional provisions in the ECB’s balance sheet78.
If losses are incurred by national central banks though, the national central banks shall
bear such losses from write-downs of financially destabilising securities themselves, even
though they were forced to purchase such securities by a decision of the Governing
Council of the ECB79. The Governing Council of the ECB may, however, decide that
national central banks shall be indemnified for their transactions. Any other losses must
be compensated by revenues and provisions or, if necessary, carried forward. In any

Max Danzmann
event, as already set out, the member states are not obliged to make additional capital
contributions80.
5.2.2. Eligibility of Inferior Assets for Monetary Policy Refinancing
The Eurosystem has recently made substantial use of the final deposition instrument of
relaxing the requirements for eligible assets for monetary policy refinancing operations.
This final deposition instrument is used in the Eurosystem either centrally through
definition of the ECB's requirements in the General Documentation81 or through
emergency liquidity assistance (ELA) of a national central bank as lender of last resort, at
its own expense and in the exercise of its own discretion or prerogative82.
Against the backdrop of past years' financial instabilities, the Eurosystem has reduced the
eligibility criteria for eligible assets. The most significant measure is deemed to be the
lowering of minimum creditworthiness thresholds, which has been compensated for only
partly by the valuation haircut of 5 % and which has by now become a permanent rule83.
The Eurosystem has, for example, abolished the minimum creditworthiness requirements
for debt instruments of some member states and enabled banks to post as collateral
securitised loans of inferior quality, even with discounts of their loan-to-value84. By
accepting inferior assets, the Eurosystem has provided liquidity for financially instable
credit institutions and, at the same time, assumed these credit institutions' risks of loss
which would materialise in the case of the insolvency of a credit institution85.
Simultaneously, the expansion of the money supply in the Eurosystem and the ensuing
possibility to refinance high-yield government bonds at very low interest rates with the
ECB has enabled credit institutions to enter into profitable government bond
transactions, while providing them with incentives for ever increasing lending on the back
of low refinancing rates86. The prohibition of monetary state financing, however, means
that the ECB itself is prohibited from purchasing government bonds in the primary
market and forces the ECB to involve credit institutions in final deposition87.
The lowering of collateralisation criteria is particularly obvious in the context of ELA,
where the collateralisation requirement can be entirely eliminated. ELA enables national
central banks to flexibly grant refinancing credits and thereby act as lender of last resort
since the Eurosystem's general requirements for eligible securities do not apply to such
transactions88.
The modification, within the scope of ELA, of eligibility requirements for refinancing
credits, which were granted by individual national central banks, facilitates not only
liquidity assistance (as a financial stability policy measure), but also control over the
location (i.e. the national central bank) where money is created89. Due to the principle of
an open market and free domestic competition, the legal framework does not provide for
a quota for the creation of money supply by individual economies (for example in

accordance with the key for subscribing the ECB's capital)90. Applying the same
requirements for collateralisation, does, in fact, result in individual economies indirectly
having different shares in the macro-economic creation of money supply because the
volume of eligible securities depends on the economic size of the individual economies. By
individually relaxing the requirements, individual national central banks can increase
their relative potential to create money supply, insofar as they have more eligible
securities available on the basis of such relaxation91.
Central bank money, which was created through the provision of ELA, has been
transferred to other economies in amounts which have enabled banks in the recipient
state to substantially reduce their national central bank's refinancing volumes92. The
additional liquidity created by those national central banks which have granted
emergency loans has been neutralised by the other national central banks in that the
latter have reduced their own monetary policy refinancing loans so that the overall
refinancing volume determined by the Governing Council of the ECB has been met. This
development has temporarily led to an almost complete shift of money creation and a
concentration of money creation by individual national central banks93. The shift in
money creation and the following implementation of free movement of capital by
transferral of the created central bank money into other economies of the monetary area
was only possible under the financial stability policy support provided by TARGET294.
TARGET2-balances have been used as an indicator for financial stability policy support,
with a positive (negative) balance meaning that central bank money inflows recorded by
credit institutions of a member state have exceeded (have fallen short of) their central
bank money outflows. Positive (negative) balances represent claims against (obligations
towards) the ECB which can, however, never become due by giving notice or being
accelerated and can therefore not be qualified as loans (and really not as claims also). As
TARGET2 itself does not provide liquidity, the balances rather reflect the decentralised
implementation of monetary policy decisions taken by the Governing Council of the ECB
on the one hand and external imbalances (resulting from current and capital
transactions) which have been balanced by comparably cost-efficient central bank
financing, on the other95.
The relevant national central banks (which granted the refinancing loan) will be the
secured party in all collateralisation transactions related to monetary policy refinancing.
In line with the decentralisation principle, it is therefore the national central banks who
bear the economic risks of inferior assets in the first place and who act as final depository
for losses upon insolvency of a borrower96. Nonetheless, losses caused by refinancing
transactions will be split between the member states' central banks in accordance with
their capital share in the ECB, because individual national central banks generally do not
have control over the eligibility of certain securities – which is determined by the

Max Danzmann
Governing Council of the ECB97. By contrast, losses from loans granted under ELA will
primarily be borne by those national central banks who grant the loans, because such
loans do not constitute monetary policy refinancing transactions of the Eurosystem but
rather qualify as financial stability policy aid provided by a member state98. However, the
negative macro-economic effects of final deposition, such as risks of inflation, are by no
means restricted to the economy creating money but, due to the common currency, rather
spread over the whole monetary union.
Moreover, the ECB and eventually the other national central banks are affected by such
losses when a national central bank with a negative TARGET2-balance leaves the EMU
without being able to meet its euro-denominated liabilities towards the ECB. Since
collateral for refinancing loans underlying the TARGET2-balance will have been granted
in favour of the leaving national central bank and the exit from the monetary union will
not cause an enforcement event under the refinancing documentation (i.e. the inability of
the credit institution as collateral provider to repay the refinancing loan), the ECB as
creditor will not be able to realise such assets. In any event, the value of collateral granted
– in particular under ELA – will most probably not suffice to cover losses. Should claims
against the leaving national central bank prove to be uncollectable, the ECB would have to
write off such claims. The same liability principles will apply as for open market
transactions. By contrast, positive TARGET2-balances will only be recorded as claims
against the ECB in the balance sheets of other national central banks upon their exit from
the monetary union, provided that the ECB as debtor of the claims defaults on the
repayment of such claims despite its ability to create the required central bank money
itself (even if in violation of the principle of decentralising money creation)99.
5.2.3. ECB vehicle assumes final deposition function
The EMU could also adopt the third final deposition method. Although, in accordance
with Article 14(4) of the statutes of the ESCB, national central banks can provide a vehicle
with central bank money independently from each other and at their own risk and
expense if such vehicle is protected by law from insolvency, it is nevertheless more likely
that the ECB would centrally provide central bank money to a special purpose vehicle
(which is protected from insolvency by law) by monetary policy refinancing activities.
This special purpose vehicle shall then purchase and receive the financially destabilising
assets. Such assets may be used as collateral in future refinancing activities with the ECB,
if the ECB lowers its requirements accordingly. By purchasing financially destabilising
assets, this vehicle creates central bank money. Therefore, if an overall expansion of
money supply is to be avoided, the ECB will have to neutralise the money supply created
by the vehicle by reducing the volume of the other refinancing loans100.

This concept is discussed under the heading “banking licence for the European Stability
Mechanism” in the monetary union which facilitates the implementation of financial
stability policy programmes on the basis of central bank funding101. It is, however,
problematic that such vehicle is not authorised to create money because without fiscal
support by the member states it will not be able to repay refinancing loans.
5.3. Redistribution and Fiscal Equalisation Effects between Member States
In addition to redistribution effects between economic actors within an economy, final
deposition of financially destabilising assets will also result in redistribution effects
between the economies in the EMU. The inflationary trends resulting from the expansion
of the money supply are not limited to the economy causing the deposited loss. While
(distinct) differences persist in Euro Area inflation rates102, the inflationary impact for the
economy causing the relevant final deposition should, due to large monetary capital flows
between the economies in the monetary union, be smaller than if it did not participate in
a currency union. Free movement of capital and the common currency enable the
economy responsible for final deposition to distribute (or have distributed) the money
created by final deposition in the overall monetary union, without bearing the
consequences of monetary expansion alone103.
The assumption of financially destabilising assets by the Eurosystem results in a
reallocation of losses in the Eurosystem's balance sheets. National central banks are
obliged, pursuant to a decision of the Governing Council of the ECB, to purchase assets
pro rata to their share in the capital of the ECB and to bear the losses resulting from
write-downs themselves (whereas the ECB only purchases 8 % of such assets directly at
its own expense)104. Redistribution effects between economies materialise when an
economy's need for final deposition, from a central bank's perspective, is disproportionate
to its share in the capital of the ECB. In fact, economies in which the financial sector
contributes strongly to the gross national product benefit particularly from financial
stabilisation by the Eurosystem because their need for final deposition is not likely to be
proportionate to their capital share.
Another way of redistributing risks of loss is the acceptance of inferior assets for the
collateralisation of monetary policy refinancing operations because this results in a shift
of money creation105. By shifting the location of money creation, some national central
banks have incurred high TARGET2 claims against the ECB, while other national central
banks have incurred high TARGET2 liabilities to the ECB, which, in each case, represent
the majority of the foreign assets or foreign debt, respectively, of the relevant national
central bank106. By such debtor-creditor-relations – with the ECB as intermediary –
substantial default risks are redistributed among the economies.

Max Danzmann
Fiscal consequences of final deposition tools are another source of redistribution effects
between economies. Final deposition of financially destabilising losses by the Eurosystem
leads to a shift of budgetary cost, which is comparable to the effects of fiscal transfers
between member states. The government107, which otherwise would have had to provide
financial stability policy assistance at its own cost, for instance, will not have to bear these
fiscal consequences. Therefore, fiscal policy in economies, with a sophisticated financial
sector, will particularly benefit from the final deposition instruments – not in the least
due to the fact that they would have lost substantial tax revenue had the now stabilised
financial companies been declared insolvent.
Moreover, final deposition instruments can be used for monetary state financing, if the
ECB purchases government bonds from individual member states in the primary or
secondary market in order to write them off and deposit the losses in its balance sheet
(e.g. as under the ECB’s expanded asset-purchase programme dated 22 January 2015
(EAPP)). By way of government bonds purchases in the primary market, the beneficiary
governments are provided with independence from the financial market, whereas
purchases in the secondary market reduce the beneficiary governments' interest burden
under market based financing insofar as financial market actors are enticed to purchase
government bonds by providing them with the ability to sell them to the ECB. A
government's financing conditions are thus – at least partially – detached from financial
markets prices because they are predetermined by the Eurosystem's intervention108. In
addition, lower distributions of ECB profits – resulting from the write-down of assets
subject to final deposition – have different nominal effects on the individual
governments, because they depend on the governments' relevant capital shares and are
not allocated pro rata to their causal contribution to final deposition.
5.4. Externalities and the Polluter Pays-Principle
If an economy decides to provide financial stability policy assistance by way of final
deposition, it must (be able to) take the responsibility for the economic consequences and
disincentives. Final deposition tools elicit additional economic consequences and
disincentives in the EMU, in that every economy within the monetary union can subject
its losses to final disposition in the Eurosystem's central banks' balance sheets, without
any maximum deposition quota.
In a monetary union of several economies, disincentives arise from the fact that
economies with few financially destabilising assets have to participate on a pro rata basis
in the costs of final deposition caused by economies with many such assets while, by
contrast, an economy with many destabilising assets incurs lower costs for joint final
deposition.

Final deposition in the Eurosystem's balance sheets works like an insurance against final
deposition risks for those economies which, due to an instable financial sector, produce
high losses requiring final deposition (moral hazard)109. Such economies might even be
tempted to exploit the benefits of this negative (not fully internalised) externality (free-
rider phenomenon)110. Communitising final deposits in the Eurosystem's balance sheets
undermines incentives to use preventive financial stability instruments or to exclusively
make use of final deposition instruments as last resort.
Final deposition in the community infringes upon the polluter pays-principle. Under the
polluter pays-principle, the party responsible for producing costs by its acts is made
responsible for paying such costs111. The polluter pays-principle is one of the main
principles of environmental policy, where it is also applied to the final deposition of
waste. Under the polluter pays-principle, those economies are made responsible to bear
the possible consequences – such as inflation and lost central bank profits – whose
financial sectors have produced, or last held, the losses subject to final deposition112.
Consequently, the polluter pays-principle requires that the costs for final deposition
should, wherever possible, be borne by that political entity which has the largest influence
on producing final deposition costs. The member states are responsible for the largest
share in such costs because (i) member states are responsible for most of the pre-emptive
financial stability policy tools (such as banking supervision), (ii) fiscal policy is also in the
hands of the member states and (iii) national central banks can grant (theoretically
unlimited) emergency loans to their credit institutions at their own expense. Despite this,
the impact of final disposition – such as expansion of money supply – must be borne by
all members of the community because the monetary area is very inter-linked.
However, due to the liability situation in the Eurosystem, it is not possible in the EMU
that a national central bank, in line with the polluter-pays principle, bears all risks alone.
From the polluter-pays perspective, the joint final deposition should be applied only after
all financial policies have been joined. The defective implementation and/or concomitant
risks are nevertheless – in reversal of the Coronation Theory – now used as an argument
for the necessity of integrating all other financial policies, including financial stability
policy.
5.5. Parliamentary Control over the Eurosystem's Final Deposition
The ECB's independence is very well protected in the EMU by the requirement of an
unanimous vote for change of primary laws. Its financial stability policy activities are, in
fact, sealed off from the influence of other actors, which leads to the question of
parliamentary involvement. Such involvement could be implemented by way of a consent
by sources of legitimacy, i.e. the European Parliament or the member states' parliaments.

Max Danzmann
Democratic legitimisation by the European Parliament would provide the advantage that
only one parliament would be involved in the decision-making process. However, the
European Parliament has no strong legitimisation power because it lacks equality in
representation. A European nation which could be democratically represented by a
parliament does not (as yet) exist113.
5.6. Legal Limits for the Eurosystem's Final Deposition Tools
The legal limits for final deposition instruments can be illustrated by the Eurosystem's
Euro bail-out policy, under which the Governing Council of the ECB takes decisions on
outright monetary transactions (OMT), the emergency credits under the ELA-programme
and the expanded asset-purchase programme (EAPP). The OMT and the ELA (currently)
relate to government bonds, but can also be applied on a broader scale and scope, such as
to the EAPP, which relates to various asset classes besides government bonds.
5.6.1. Outright Monetary Transactions
The decision of the Governing Council of the ECB on the OMT dated 6 September 2012
exceeds the limits of the ECB's monetary policy mandate and violates the prohibition of
monetary state financing stipulated in Article 123 of the TFEU. The ECB acted ultra vires
when it made this decision.
The OMT comprise a programme under which the Eurosystem purchases government
bonds from individual Euro member states in secondary markets, accepting equal
treatment with other creditors while neutralising the ensuing liquidity effects, provided
that the beneficiary states participate in and meet the requirements of the programmes
under the European Financial Stabilisation Facility (EFSF) and the European Stability
Mechanism (ESM) in each case114. While the OMT have not yet been implemented, the
Securities Markets Programme concluded in 2010, under which substantial amounts of
private and government bonds were purchased in volatile secondary markets115, has been
suspended as a consequence of the OMT programme116.
With the OMT, final deposition measures can be used by the Eurosystem to assume
financially destabilising losses. The goal is for the Eurosystem's central banks to purchase
sovereign debt and assume default risks which destabilise the financial system and pose a
threat to the issuer's fiscal refinancing ability.
The limits of the mandate given to the ESCB (and consequently the ECB) in Articles 119,
127(1) and (2) of the TFEU are exceeded by the OMT. The ECB's mandate is limited to
monetary policy under the above provisions whereas the OMT are of a financial stability
policy nature and not of a monetary policy nature. They must therefore be categorised as
“general economic policy”. Where the European Union has not been given explicit

authorisation to the contrary, “general economic policy” is generally the responsibility of
the member states, with the European Union's function being limited to close
coordination in accordance with Article 119(1) of the TFEU. Pursuant to the principle of
conferred powers, the individual member states, but not the European Union, are thus
responsible for financial stability policy117.
When assigning the OMT to one of the policy areas, the German Federal Constitutional
Court focuses on their objectives, instruments and effects as valuation criteria. An indirect
pursuit of a goal (such as fiscal stabilisation) through indirect interdependencies generally
does not suffice for the assignment to a policy area because monetary policy is (at least
indirectly) connected with all other economic policies. Due to several specific factors, the
OMT are to be classified as economic policy measures (more precisely financial stability
policy measures) and not as monetary policy measures118.
In line with the ECB's direct objectives, interest rate components which are considered
unjustified – if not “irrational” – by it, are to be eliminated. This objective can, however,
not be a monetary policy objective, because it does not correspond to the basic structure
of the EMU. The European Monetary Union was based on the assumption of fiscal
autonomy. Financial market participants do not extend loans to governments which are
subject to financial instabilities (or at least only against higher interest payments).
Therefore, interest components are far from unjustified but rather embedded in the
EMU's nature. In addition, "one cannot ... divide interest rate spreads into a rational and
an irrational part" because every human behaviour is always shaped by rational and
irrational factors and financial market actors are by all means free to act irrationally, as
long as they do not violate the law. Where it is not possible to clearly quantify, allocate
and interpret individual risk elements and interest components, “every interpretation and
associated recommendation to act can, in the end, be justified by suitable assumptions”119.
Another indicator that OMT exceed monetary policy is that selected120 government bond
purchases aim to reduce interest rate spreads of individual governments, while the
Eurosystem's monetary policy instruments – key interest rates and minimum reserve
ratios in particular – normally do not distinguish between the individual needs of the
participating economies. Interest rate spreads converge to the disadvantage of those
economies and sovereigns whose fiscal stability and general financial stability has put
them into a better competitive position. Interference with fiscal and macro-economic
competitive positions does, in any event, exceed monetary policy and is of a financial
stability policy, if not general economic policy, nature121.
In addition, conditionality of OTM requires the beneficiary states to respect the
arrangements with the EFSF or the ESM, respectively, and thus ensures a development
which corresponds to these financial stability policy-makers' financial stability policy and

Max Danzmann
economic policy arrangements. By conditioning government bond purchases upon these
arrangements, the ECB is leaving monetary policy grounds. Neither the EFSF nor the
ESM are engaged in monetary policy (which is also the view of the European Court of
Justice122). Where the arrangements are not honoured, interest rate spreads will widen
further. Therefore, if the ECB wants to guarantee the composition of the Euro Zone, it has
to purchase government bonds, even if a beneficiary state breaches the contractual
arrangements123.
Moreover, OMT could undermine the strict conditionality for operations on the secondary
market in relation to sovereign bonds pursuant to Article 18(1) of the ESM-Treaty. It
seems questionable that the ECB should have the ability to recognise the existence of
“exceptional financial market circumstances and risks to financial stability” within the
meaning of Article 18(2) of the ESM-Treaty, if the ECB itself provides assistance by final
deposition instruments at the same time. Besides, it cannot be assumed that governments
will endeavour to solicit secondary market purchases by the European Stability
Mechanism which are subject to strict conditionality, if they, on the other hand, already
get support from OMT which, as per the EFSF or the ESM, merely require simple
conditionality124.
From a legal point of view, OMT can likewise not be justified on the grounds that they are
necessary to ensure the composition of the Euro Zone. The composition of a monetary
union which does not provide the participating countries with devaluation or monetary
state financing possibilities can, eventually and in fact, only be guaranteed by final
deposition instruments. The only other possibility to prevent a fiscal crisis would be the
exit from the monetary union125. Therefore, the composition of a monetary union is also a
monetary policy question. However, the importance of final deposition tools goes beyond
monetary policy. These instruments must therefore primarily be classified as financial
stability policy tools, for which the ECB has not received a mandate under primary law.
Furthermore, the ECB's mandate has been closely tied to the price stability objective
which – due to the inflationary potential caused by final deposition instruments and the
resulting expansion of the money supply – can only be safeguarded by neutralising
interventions, which in turn may prove detrimental to financial stability. Additionally,
primary law of the European Union explicitly vests the competence to determine the
composition of the Euro Zone to the European Council, the Commission, the European
Parliament and the member states, but not to the ECB. Pursuant to Article 139 and 140(3)
of the TFEU, the ECB only has a right to be heard when a state accedes to the Euro
Zone126.
Monetary financing of individual states not only leads to redistributions between
creditors, debtors, cash holders and the governments due to inflation, but also to
redistributions between their economies because their claims and liabilities (which are

both subject to inflation) are not balanced. The purpose of the prohibition of Article
123(1) of the TFEU is to extensively preclude inflationary risks, which result from
monetary state financing, and the accompanying redistribution effects. Consequently, the
prohibition of monetary state financing does not only apply to direct financing through
primary market government bond purchases but also to any and all acts of circumvention,
due to the requirement of the principle of effectiveness or effet utile (which is often
referred to when enforcing European law)127.
The secondary market government bond purchases envisaged by OMT are designed to
circumvent the prohibition of monetary state financing. To provide the relevant
governments with more favourable funding conditions in the primary markets, the ECB
neutralises interest rate premiums by using central bank money (i.e. monetary means) to
purchase government bonds. Such state financing is particularly effective where
government bonds are held until final maturity by the Eurosystem because the purchase
of government bonds reduces market supply which, in turn, influences market pricing.
Under OMT, the Eurosystem intends to purchase only selected government bonds from
individual fiscally unstable governments. This highlights the fiscal and financial stability
policy elements of such purchases, which would also be material elements of monetary
state financing in the primary market. Common monetary policy must not distinguish
between member states of the common monetary area, if only because of the principles of
non-discrimination, free competition and the open single market. Concurrency of OMT
and the financial stability programmes of the EFSF and the ESM, which directly
contribute to state financing with their assistance loans, also indicate the state financing
effects of OMT128.
The state financing effect of OMT is most likely not limited to providing governments
with access to liquidity. It will also affect the states' debt volumes as soon as the
Eurosystem foregoes its claims represented by government bonds (in whole or in part).
Under the OMT programme, the Eurosystem indeed accepts equal treatment (pari passu)
with the other creditors of the relevant government129 and is automatically affected, if the
majority of creditors accepts a haircut. By targeted purchases of bonds issued by fiscally
instable states and in particular in order to provide relief for bank balance sheets, the
Eurosystem incurs increased (avoidable) risks of loss under the OMT. In the event of a
haircut, such risks of loss would materialise and trigger loss write-offs by the ESCB130.
The very announcement of OMT has already prompted financial market actors to conduct
primary purchases of government bonds despite fiscal instabilities because they hoped
that the on-sale to the Eurosystem (which had in fact been guaranteed in the event of
significant deterioration of fiscal instabilities) would enable them to realise risk-fee
profits at relatively high interest rates. Moreover, OMT provide the Eurosystem with the
possibility to purchase government bonds from financial entities shortly after the latter

Max Danzmann
have subscribed for the bonds131. The use of financial entities as intermediaries would
then only serve to circumvent the prohibition of monetary state financing, while being
expensive and pointless from an economic point of view.
Lastly, OMT can neither be justified by a possible disruption of the monetary policy
transmission mechanism which would otherwise generally justify the exercise of influence
on price levels by the ECB132. Not every contribution to price stability can be deemed a
monetary policy measure merely because price stability constitutes the central monetary
policy objective. Every economic act (at least indirectly) influences price levels133. The
disturbance of the monetary policy transmission mechanism is a common consequence of
fiscal instabilities and, because of the various interactions between fiscal policy and
financial stability policy, fiscal instabilities often result in the financial instability of
private financial sector entities. At the same time, financial instabilities generally also
coincide with disturbances of the transmission mechanism due to the interconnectedness
of monetary policy and financial stability policy. Nevertheless, the resulting effects do not
entitle the ECB to interfere with other policy-makers’ responsibilities.
5.6.2. Eligibility of Inferior Assets for Monetary Policy Refinancing
In the like manner, the ECB exceeds its mandate in accepting inferior assets for monetary
policy refinancing on the basis of the provisions of Chapter 6 of the Guideline of the ECB
of 20 September 2011. Just like OMT, the acceptance of inferior assets constitutes a final
deposition instrument and is primarily a financial stability policy in nature.
The Eurosystem has not been furnished with an assistance tool-set, such as ELA. It
requires (realisable) collateral for its credit operations under Article 18(1) of the Statute of
the ESCB134. Nonetheless, it will hardly be possible to identify an infringement of the
monetary policy mandate by the ECB, because the ECB is left with wide discretion when
determining eligibility and assessing adequacy of collateral, within the meaning of Article
18(1) of the Statutes of the ESCB. In addition, unlike securities purchased under the OMT,
such collateral is neither owned nor held by a central bank (in its balance sheet). The risk
of loss rather only arises if and when the underlying credit institution becomes insolvent.
It can therefore be expected that a breach of its mandate can only be assumed in the event
of a serious divergence between the market value of an underlying asset and its loan-to-
value. Nevertheless, the requirement of “adequate collateral” in Article 18(1) of the
Statutes of the ESCB would have been violated in any event if, as is the case with Greek
government bonds, assets with lowest ratings are accepted. The requirement of "adequate
collateral" must rather be understood as valuable financial assets of investment grade
rating and excellent liquidity135.
ELA as per Article 14(4) of the Statutes of the ESCB, which is sometimes provided without
any collateral at all, has the primary objective to prevent beneficiary credit institutions

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