SovMoney_-_Final_Deposition_ECB_Balance_Sheet

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Final Deposition of Losses through the
European Central Bank's Balance Sheet
Max Danzmann
Abstract
The ECB’s 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 ECB’s
balance sheet to permanently deposit financial market participants' losses which would
otherwise jeopardise financial stability. 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 ECB's independence and the instable financial condition of
the European Monetary Union, these consequences raise questions as to the member
states' sovereignty.

Final Deposition of Losses through the European Central Bank’s Balance Sheet
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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 a 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 a 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 a central bank is basically unlimited due to the
inherent instability in the financial system. 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. The (dis-)solution of financial instabilities – 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 (which concept is to
be described by the following). If a final deposition concept is not only applied to physical
substances, as in environmental policy, but also to social phenomena, it is also
(semantically) possible to finally deposit losses caused by certain financial 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, a central bank ascribes a
financially destabilising effect to specific financial assets and extracts them from the
financial system by transferal to it. By neutralising financial losses through final
deposition in the central bank's balance sheet, financial 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 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 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 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.

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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 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, if any). Unlike the assets, the losses themselves cannot,
however, be dissolved or extinguished (except through currency changeover) as the
consequences of losses cannot be neutralised within the central bank's balance sheet with
future effect since a central bank's balance sheet is a cumulative reflection or summary of
all monetary actions of a central bank in the past. Inevitably, the economic consequences
of money issuances and quantitative easing 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
by money and thereby support financial stability in general1. In doing so, a 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. A central bank then acts as a public
winding-up agency, commonly known as a 'Bad Bank'2.
2. FINAL DEPOSITION TOOLS
All tools for final deposition have in common that a 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 a central bank has the ability to absorb losses indefinitely and can indefinitely create
central bank money. When taking losses into the final depository, a 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
Among a variety of tools for final deposition of financial instabilities in the central bank's
balance sheet, the assumption of destabilising finances by a central bank is the most
direct tool. Losses subject to final deposition are caused by loss-incurring assets. Such
assets include obligations and ownership rights (assets), such as, but are not limited to,

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loans, securities (including (government) bonds and loan securitisations), derivative
instruments, currencies and insurance policies. The assets are purchased by a 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 a 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.
Such financial stability policy operations do not necessarily entail central bank losses if
the assets purchased do fully perform or if the purchased ownership rights do not decline
in value as anticipated. If, however, losses are incurred, 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 maturity3.
2.2. Eligibility of Inferior Assets for Monetary Policy Refinancing
Financial stability risks – i.e. destabilising risks of loss – can also be transferred to a
central bank by collateralisation under monetary policy refinancing operations. In its
monetary policy refinancing operations, a central bank generally protects itself against
the insolvency of its debtors by taking collateral and setting eligibility criteria for loan
collateral4. To avoid central bank losses, strict criteria are applied by a central bank to the
eligibility of assets providing protection upon insolvency of the borrowing bank5.
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 a
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, a central bank will
not record a loss in its balance sheet before the loans, for which insufficient collateral was
provided, go into default6.
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

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consequently the liquidity of credit institutions – will deteriorate as a consequence of
financial instability7. A 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, a central bank escalates its own
risks of loss upon insolvency of its counterparties because collateral provided does not
provide sufficient cover for the claims outstanding8. 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.
3. FINANCIAL STABILITY POLICY WITH FINAL DEPOSITORY
Final deposition tools 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. However, it is necessary to weigh the
consequences of final deposition instruments against their financial stability policy
benefits in each individual case. This 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.
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 over-indebtedness. By
purchasing financially destabilising assets, a central bank can, in the amount of the
purchase price, contribute to avoiding the financial entity's losses, which are the cause of
the over-indebtedness. 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 a central bank with an inexhaustible stabilisation resource.
Thereby, 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

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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 banks as the major monetary policy
players. Moreover, a central bank is also responsible for the purchase of debt and equity
instruments as one of the central bank's main tools to manage money supply and the
collateralisation of monetary policy refinancing loans protects a 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
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 a 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 a 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. 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

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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. Prevalence
of the financial stability policy character is also indicated if a financial stability policy
measure is directed towards a situation representing monetary, fiscal and financial
instabilities at the same time.
4. 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.
4.1. Inherent Financial Instability of the European Monetary Union
Whereas empirical economic research has shown that a convergence of real economies in
a monetary union – an optimum currency area9 – is the prerequisite for a financially
stable single currency10, the economies of the member states within the EMU are not only
different in their size, but also in their basic structure. The EMU as a monetary
association of independent states has a financially instable constitution, because,
although the differences between the participating economies require effective
instruments, the European Central Bank (ECB) must not engage in final deposition –
which is the most effective financial stability policy tool of a central bank.
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 needs. The ECB cannot adequately respond to unsynchronised
economies and asymmetrical shocks11. 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 development12. Likewise, deflation in
southern European countries does not only pose a risk as reasoned by the ECB, but it is
necessary in a currency union which has no devaluation means to re-establish competitive
prices in these economies.
However, because final deposition instruments are classified as financial stability policy
instruments and no independent financial stability policy mandate has been conferred to

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the Eurosystem by the member states13, 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, discrete
and comprehensive 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 states14.
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 EMU for economies with weak competitive positions and an
overvalued currency. After all, in accordance with the assistance prohibition of
Article 125(1) of the TFEU, the member states cannot, de lege lata, be made liable for
commitments of other member states.
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 de lege lata 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 represented15.
4.2. Final Deposition Tools in the European Monetary Union
Disregarding legal determinants of competencies within the EMU, final deposition
instruments could factually also be used by the Eurosystem for financial stabilisation
purposes.
4.2.1. 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

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financial markets and the assumption of most assets (with the exception of non-
marketable securities) by stipulating that the Eurosystem 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 transactions16. In
accordance with the principle of decentralisation17, purchases of financially destabilising
assets are generally not made centrally by the ECB, but rather decentrally by national
central banks18. 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
itself19. 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 price20. 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 asset21. If held to maturity, the purchased assets are recorded at cost and not
at market value22. Furthermore, provisions are set aside for imminent losses23.
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 ECB24.
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 ECB25. Such holding is not governed by general
ownership interests but by the Statute 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

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the property of a state. 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 sheet26.
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 ECB27. 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.
However, 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 ECB still reports losses, the ECB must revert
to its reserves28. Where the amounts are not sufficient to cover losses, the ECB must
record a loss carry-forward in its annual financial statements until the losses are offset by
future profits29. Such losses may weigh heavily on the ECB's net equity position, which
may fall below the share capital or even turn negative. Nevertheless, as a general rule,
neither a loss carry-forward nor a negative equity position will have further consequences
on the ECB's ability to act. The ECB is a public-law entity and as such cannot become
subject to insolvency proceedings, i.e. insolvent30. Pursuant to Article 1 of the Immunities
Protocol31 in connection with Article 6 of the Headquarter Agreement32, the ECB's assets
are exempted from any attachment or other freeze, except with the prior authorisation of
the ECJ, which may only be granted if such measure would not affect the functionality of
the ESCB, e.g. the promotion of the smooth operation of payment systems33.
Furthermore, the ECB 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 often subject to different interpretations and approaches.
Its monopoly to create (central bank) money enables a central bank to fulfil any and all
payment obligations (unless such obligation is denominated in a foreign currency what
could lead to a default34). Technically speaking, a central bank does not need any equity
capital at all. Today, its equity capital has an ideational 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 central bank creditors are protected by the central bank’s
commitment to achieve the target of monetary stability35.

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To effectively implement monetary policy, a central bank depends on its credibility. This
credibility could be impaired if private economic actors expect a central bank to pursue a
profit maximisation strategy. In view of the principle of the central bank's financial
independence, many economists think 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 tasks36.
Parliament might then have to approve and provide sufficient fiscal funds in the budget37.
Disregarding credibility issues, an obligation of the sovereign to make additional capital
contributions is at least not required for the functioning of a central bank38. However, if a
central bank remains actually indifferent towards its loss carry-forwards and negative
equity capital positions, it may still be fully able to focus its policy on non-profit-related
monetary policy targets, regardless of any losses39. It seems therefore possible that private
economic actors’ expectations of a central bank profit maximisation-strategy, i.e.
inflation, disappear over time if the relevant central bank actually, despite final deposition
of losses, neither pursues a profit maximization-strategy nor a monetary expansion
strategy. Consequently, if a central bank has, at an earlier stage, pursued final deposition
programmes without subsequent strategies for profit maximisation and undertaken a
neutralisation of the money supply injected into the market by final deposition, it might
eventually not lose so much credibility that this jeopardises its ability to act. Provided that
credibility is preserved, a 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 century40.
4.2.2. 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 Documentation41 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 prerogative pursuant to Article
14(4) ESCB Statute.
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 rule42.
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-value43. By

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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 institution44.
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 rates45. 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 deposition46.
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 most of the economic risks of inferior assets in the first place and who act as final
depository for losses upon insolvency of a borrower47. 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 Governing Council of the ECB48.
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 state49. 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.
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
transactions50.
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 created51. 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

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accordance with the key for subscribing the ECB's capital)52. 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 relaxation53.
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 volumes54. 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 banks55.
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
TARGET256. 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 actually not as
claims either).
Moreover, the ECB and eventually the other national central banks are affected by such
losses when a member state with 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 losses57.

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4.3. 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 rates58, 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 alone59.
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)60. 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 creation61. 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 bank62. By such debtor-creditor-relations – with the ECB as intermediary –
substantial default risks are redistributed among the economies.

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15
Fiscal consequences of final deposition tools are another source of redistribution effects
between economies. 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 usually 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. 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.
Moreover, a central bank can support fiscal policy through final deposition instruments
by purchasing, or accepting as collateral for refinancing, sovereign debt of insufficient
credit quality. Thereby, a government's financing conditions are – at least partially –
detached from financial markets prices because they are predetermined by the
Eurosystem's intervention63. 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)64.
4.4. Externalities and the Polluter Pays-Principle
In a final deposition-scenario, financial instabilities are replaced by central bank money
(Quantitative Easing). Hence, unless the ECB initiates additional monetary policy
neutralisation measures, final deposition instruments generally increase money supply.
Quantity theory, therefore, generally assumes that final deposition is accompanied by
inflationary risks. 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
value65. 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).
Currently, the ECB justifies its unconventional measures to increase central bank money
supply as support of lending activity in order to stimulate macro-economic investments.
While bank balance sheet risks could be transferred to the ECB by final deposition
instruments, investments are, as a general rule (with the exception of construction-
related investments), not interest rate sensitive. Therefore, the increased money supply is

16
currently not to be expected to result in higher investment activity. Even though 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, and 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 supply66, empirical
research suggests a long-term positive correlation between an increasing money supply
and a rise in inflation67.
Through risks of inflation and lost profits of the ESCB, losses caused by financially
destabilising assets are borne 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 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.
The assumption of risk by the ESCB distorts competition between financial entities of
systemic relevance and other private economic actors. 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 accord68. 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 ESCB's balance sheets as final depository.
Consequently, 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.
Furthermore, 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

Max Danzmann
17
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. 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.
Therefore, 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 deposition69. Such economies might even be
tempted to exploit the benefits of this negative (not fully internalised) externality70.
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.
Moreover, 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 costs71. The "polluter pays-principle" is one of the main
principles of environmental policy, where it is also applied to the final deposition of
waste. From an EMU perspective and under the "polluter pays-principle", those member
states' 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 deposition as creditors or owners72.
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, i.e. where the assets causing the deposition are
located. The individual 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.
4.5. Parliamentary Control over the Eurosystem's Final Deposition
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

18
system by final deposition instruments cannot be ignored by financial stability policy
actors. The actual control of a 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, a central bank as monetary authority can thereby significantly
undercut parliamentary authority. Without a legal framework for final deposition
instruments (e.g. stipulating competencies and procedure), a central bank has in fact the
sole power over granting and shaping financial stability policy aids73. A 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 a central bank74.
In addition, final deposition instruments and the reliance by a central bank on its
independence can, in fact, seal off the central bank's power from supervision by other
authorities. Generally, its independence protects a 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 policy75. 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 output76. Where a 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.
Especially, 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.
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) exist77.
4.6. 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)78, the emergency credits under the ELA-

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19
programme and the expanded asset-purchase programme (EAPP). The OMT and the ELA
(currently) relate to government bonds79, but can also be applied on a broader scale and
scope, such as the EAPP, which relates to various asset classes besides government bonds,
has a trillion Euro amount and is meanwhile applied indefinitely. While the OMT had not
been implemented, the OMT programme has been suspended as a consequence of the
EAPP. However, the OMT are still of importance since the German Federal Constitutional
Court (GFCC) and the European Court of Justice (ECJ)80 have rendered judgements on
OMT with diverging conclusions in substance. Initially, the GFCC had signaled that it
might consider OMT as ultra vires due to the reasons pointed out below subject to
material limitations to be imposed by the ECJ. Contrarily, the ECJ ruled that the OMT are
in line with European laws to the extent that these are required to preserve price stability
but without any material threshold limitations, whereas a final decision of the GFCC is
expected for 2016.
4.6.1. Outright Monetary Transactions
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 case. With the OMT (similar to EAPP), final deposition
measures can be used by the Eurosystem to assume financially destabilising losses. The
goal is for the ESCB 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 policy81.
When assigning the OMT to one of the policy areas, the GFCC 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

20
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 measures82.
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 EMU 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"83 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”84.
Another indicator for exceeding monetary policy is that under OMT, unlike EAPP,
selected 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, nature85.
In addition and different to EAPP, 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 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
ECJ86). 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
arrangements87.
From a legal point of view, OMT (and EAPP) can likewise not be justified on the grounds
that they are necessary to ensure the composition of the Euro Zone. The composition of a

Max Danzmann
21
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 union88. Hence, 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
Zone89.
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)90.
The secondary market government bond purchases envisaged by OMT (and EAPP) 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. 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,

22
which directly contribute to state financing with their assistance loans, also indicate the
state financing effects of OMT91.
The state financing effect of OMT (and EAPP) 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 government92 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. In the event of a haircut, such
risks of loss would materialise and trigger loss write-offs by the ESCB93.
The very announcement of OMT (and EAPP) 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 rates94. Moreover, OMT provide
the Eurosystem with the possibility to purchase government bonds from financial entities
shortly after the latter have subscribed for the bonds since the ECJ has not imposed a
minimum holding period95. 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 (and EAPP) 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 ECB96. 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
levels97. 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.
4.6.2. 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

Max Danzmann
23
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 requires (realisable) collateral for its credit operations under Article
18(1) of the Statute of the ESCB98. Nonetheless, it will be difficult 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 Statute of the ESCB. In addition, 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 Statute 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 liquidity99.
ELA as per Article 14(4) of the Statute of the ESCB, which is sometimes provided without
any collateral at all, has the primary objective to prevent beneficiary credit institutions
from becoming insolvent100. It is therefore to be categorised as mainly being a national
financial stability policy measure and not monetary policy measure. Supporting illiquid
credit institutions as lender of last resort with ELA is a national task of the national
central banks. While national central banks act on their own responsibility in this regard,
they still are part of the Eurosystem and, as such, must (not least due to the risks of loss in
the event of their exit) adhere to the basic principles of the EMU, such as the prohibition
of monetary state financing101.
In exercising its national tasks within the meaning of Article 14(4) of the Statues of the
ESCB, a national central bank may at most provide short-term liquidity assistance,
whereas solvency assistance is prohibited102. In the end, the provision of solvency
assistance can only be avoided by adequate collateralisation of its lending activities. Every
loan granted by the ECB or a national central bank to an insolvent credit institution, i.e.
when (alleged103) liquidity assistance turns into solvency assistance, is to be seen as
financing governmental tasks and therefore constitutes a violation of Article 123(1) of the
TFEU. After all, financial stability policy support of credit institutions remains a task
incumbent upon, and to be financed by, the member states104.
Accepting inferior government bonds as collateral can easily be qualified as prohibited
monetary state financing since the government bonds' loan-to-value clearly exceeds their
market values. The possibilities to facilitate state financing by favourably assessing the
loan-to-value of government bonds105 become particularly obvious in the context of the

24
ECB's Euro rescue policy, whereby credit institutions receive large amounts of liquidity
which can (should) be invested in government bonds in primary and secondary markets.
By providing such purchased government bonds as collateral, banks will receive
additional liquidity from the Eurosystem which can then be used to purchase even more
government bonds, thereby triggering a positive chain reaction.
In accordance with the second half sentence of sentence 1 of Article 14(4) of the Statute of
the ESCB, the Governing Council of the ECB should also establish that ELA is
incompatible with the ESCB's tasks and objectives106. However, such a finding can in
practice not be expected since the central banks providing ELA together hold a blocking
minority of more than one third of the votes.
4.7. Eurosystem without "Bad Bank"-Function
The Eurosystem, already de lege lata, (largely) cannot make use of the discussed final
deposition instruments. The same applies with respect to economic incentives. Final
deposition can only be permitted to a limited extent, if at all, which will (presumably) not
suffice to provide fiscal or financial stabilisation. Where unlimited use of the central
banks' balance sheets as a final depository is not possible, the Eurosystem's final
deposition instruments are likely to lack their financially stabilising effects107. The OMT or
the EAPP will then, due to their (restricting) limitations, have little economic effect. It is
doubtful whether limited programs can provide financial market actors with the same
level of comfort as the original pronouncements of the OMT and the EAPP should
financial instability deteriorate once more.
The Eurosystem is largely unconnected to financial stability policy because it is prohibited
from supporting financial stability policy by assuming losses from financially destabilising
assets for the benefit of financial market actors. Therefore, the Eurosystem may not
function as a “bad bank”108. The absence of this function further deteriorates the
condition of the EMU, which is already unstable because it cannot fend off the
consequences of the heterogeneity of its economies by currency devaluation.
5. SOVEREIGNTY AND THE FINANCIAL STABILITY UNION
The ECB has assumed material financial stability policy competencies with a view to
safeguarding financial stability. The ECB cannot be mandated such fundamental
sovereign competencies, even if amendments are made to primary legislation of the
European Union, as long as the member states want to preserve their sovereignty.
State sovereignty requires certain material elements which, if lost, lead to a loss of
sovereignty as a whole. Sovereignty requires substantial reservations when sovereign

Max Danzmann
25
rights are transferred to international parties. If a state abandons regulatory authority –
i.e. sovereignty – over certain policies which are characteristic of sovereignty, such
abandonment will result in the loss of its sovereignty and, therefore, (existential)
statehood. Such authorities include constitutional sovereignty as well as the essential
legislative, executive and judicative powers such as fiscal policy and social policy109.
Consequently, overall responsibility for fiscal policy must rest with the member states'
parliaments because decisions relating to fiscal policy instruments are a fundamental part
of the ability of a constitutional state to democratically define and govern itself. Automatic
financial compensation between member states – a transfer union – would hence
constitute a violation of the member states' sovereignty. Furthermore, the state's
authority over social policy also plays a major role in state sovereignty, because the
distribution of economic performance and wealth within an economy is a crucial task of a
(social) state110.
Next to fiscal and social sovereignty, the state's authority over financial stability policy is
another integral part of state sovereignty. Financial stability is of such importance for the
macro-economic development and general welfare of a state that a government cannot
relinquish its state authority over the (stabilising) order of the financial system or
material financial stability policy instruments – in particular through final deposition
instruments – without losing a material component of sovereignty. While only a state
which is in fact a sovereign state can guarantee financial stability, only a state which is by
law a sovereign state may take responsibility for financial stability.
The tremendous importance which financial stability authority has for a state's
sovereignty can be explained by the close interaction between monetary policy, fiscal
policy and financial stability policy as well as by the redistributing effects, and therefore
social policy dimension, of financial stability policy. The influence of financial stability
policy on other policies is so large that fiscal and social sovereignty could not be an
integral part of a state's sovereignty if financial stability authority would not also be part
of it.
Moreover, final deposition tools in the EMU illustrate not only redistributive effects but
also the importance of monetary sovereignty for financial stability sovereignty. Without
monetary sovereignty, a state has no access to the central bank's balance sheet – which is
needed to make use of the most effective financial stability policy instrument. By contrast,
a central bank cannot, without financial stability authority of the legal entity it belongs to,
be equipped with a financial stability mandate to enable it to make use of final deposition
instruments. Since monetary sovereignty and financial stability sovereignty lie in different
hands, the financial system cannot be stabilised through final deposition instruments and
is therefore instable. Hence, a financially stable EMU also requires a "European Financial

26
Stability Union" as one key characteristic of the "European Federal State" under which
final deposition instruments may be applied. However, the founding of the European
Federal State would at least require a referendum in Germany pursuant to Article 146 of
the German Basic Law.
6. CONCLUSION
No other financial stability policy-maker has more effective tools for financial
stabilisation at its disposal than a central bank, which can use its balance sheet as final
depository for financially destabilising losses. With its tools for final deposition of
financial risks, a central bank has far-reaching control over monetary policy, fiscal policy
and financial stability policy, making it the key actor on the financial policy stage.
Final deposition tools encompass the assumption of financially destabilising losses by
asset purchases and the eligibility of inferior assets for refinancing operations. The basis
for these tools is that a central bank has an indefinite potential to create money and an
ability to indefinitely withstand insolvency, which enable it to act as a "Bad Bank".
In a final deposition-scenario, financial instabilities are replaced by central bank money
(Quantitative Easing). Hence, unless a central bank initiates additional monetary policy
neutralisation measures, final deposition tools generally increase money supply. This is
likely to have macro-economic effects and to affect the internal price level or trigger
changes to the currency’s external value. Additionally, the losses incurred under final
deposition may weigh heavily on the central bank's net equity position, which may even
turn negative. Technically speaking, a central bank does not need any equity capital at all.
However, to effectively implement monetary policy, a central bank depends on its
credibility, which could be impaired if private economic actors expect a central bank to
pursue a profit maximisation strategy.
The final deposition of losses will result in a reallocation of economic resources and
distorts competition between financial institutions of systemic relevance and other
entities since shareholders and creditors, which would be affected by insolvency, are not
obliged to write-down their assets. Moreover, 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. Another moral hazard-scenario would be
triggered if a central bank supports fiscal policy through final deposition tools by
purchasing (or accepting as collateral for refinancing) sovereign debt of insufficient credit
quality.
The differences between the Euro member states' economies lead to an inherent financial
instability of the EMU. Tools for final deposition of losses are used to redress this

Max Danzmann
27
instability. In the EMU, tools for final deposition have material redistribution effects not
only between individual private financial sector players but also between the member
states' economies. If used for fiscal stabilisation they also cause shifts of budgetary cost,
which (might) result in a fiscal transfer system between member states what could result
in another moral hazard-scenario.
Against this background, it must be noted that the ECB has seized the competence to
finally deposit losses and thereby exceeds the limits of its monetary policy mandate,
violating the prohibition to engage in monetary state financing. The ECB's measures
which aim at protecting credit institutions against insolvency and providing governments
with lower interest rates are to be categorised as financial stability policy and not
monetary policy measures, even if they also affect the general price levels. Therefore, the
Eurosystem must (largely) not make use of the discussed final deposition instruments
and may not function as a “bad bank”. The OMT or the EAPP will then, due to their
(restricting) limitations, have little economic effect.
Despite this, the ECB has factually assumed material financial stability policy
competencies even though, as long as the member states want to preserve their
sovereignty, the ECB cannot be mandated with such fundamental sovereign
competencies. The application of the OMT or EAPP might eventually give rise to the
foundation of the European Financial Stability Union.

28
NOTES
1 T. Mayer, Die Zentralbankgeld-Wirtschaft, p. 239.
2 GFCC, Order of 14 January 2014 - 2 BvR 2728/13
(https://www.bundesverfassungsgericht.de/SharedDocs/Entscheidungen/EN/2014/01/rs2014011
4_2bvr272813en.html), section 89; D. Gros/ T. Mayer, How to deal with sovereign default in
Europe, p. 2.
3 Annex IV (balance sheet item 7.1) of the Guideline ECB/2010/20 dated 11 November 2010.
4 Article 18 (1) of the ESCB Statute and chapter 6 of annex I of the Guideline ECB/2000/7 as
amended by ECB/2011/14 dated 20 September 2011 (General Documentation).
5 G. Rule, Collateral management in central bank policy operations, p. 8.
6 Annex IV (balance sheet item 5.1 and 5.2) of the Guideline ECB/2010/20 dated
11 November 2010, p. 52.
9 R. A. Mundell, A Theory of Optimum Currency Areas, p. 657 ss.
10 K. Ullrich, Unterschiede zwischen Fiskal- und Geldpolitik, p. 12.
11 W. Hankel, Euro, p. 205.
12 J. Starbatty, Euro, p. 82.
13 C. Steven, Kommentar zur EWU, no. 50 of Article 14 of the ESCB Statute.
14 S. Radtke, Liquiditätshilfen im Eurosystem, p. 87.
15 W. Hankel, Die ökonomischen Konsequenzen des Euro, p. 403.
16 Pursuant to chapter 1.3.1 and 4.1, 4.2 of annex I of the General Documentation (as cited above); C.
Keller, in: H. Siekmann, Kommentar zur EWU, no. 123 of Article 18 of the ESCB Statute.
17 Pursuant to sub-paragraph of Article 12 (1) of the ESCB Statute and to chapter 1.3.1, 3.1.2, 3.1.3,
3.1.5 of annex I of the General Documentation (as cited above); C. Keller, Kommentar zur EWU, fn.
104 of Article 18 of the ESCB Statute.
18 H.-W. Sinn, Die Target-Falle, p. 136.
19 Deutsche Bundesbank, Statement vis-a-vis the GFCC dated 21 December 2012
(http://www.handelsblatt.com/downloads/8124832/1/stellungnahme-bundesbank_handelsblatt-
online.pdf), p. 26.
20 C. Keller, Kommentar zur EWU, no. 126 and 128 of Article 18 of the ESCB Statute.
21 C. Keller, Kommentar zur EWU, no. 127 of Article 18 of the ESCB Statute.
22 Annex IV (balance sheet item 7.1) of the Guideline ECB/2010/20 dated 11 November 2010, p. 52;
GFCC, 2 BvR 2728/13 (cf. note 2 above), section 91.
23 J. Langner, Kommentar zur EWU, no. 15 pre Article 28-33 of the ESCB Statute.
24 Deutsche Bundesbank, cf. note 19 above, p. 27; J. Langner, Kommentar zur EWU, no. 8 of Article
33 of the ESCB Statute.

Max Danzmann
29
25 Deutsche Bundesbank, cf. note 19 above, p. 27 s.
26 Deutsche Bundesbank, cf. note 19 above, p. 27.
28 Deutsche Bundesbank, cf. note 19 above, p. 27; cf. Article 33(2) of the ECB Statute.
30 If a central bank is not immune to insolvency, such central bank could be furnished with
insolvency immunity by law.
31 Protocol (7) on the Privileges and Immunities of the European Union dated 26 October 2012.
32 Agreement between the Government of the Federal Republic of Germany and the ECB on the
Headquarters of the ECB dated 18 September 1998.
33 ECJ, C-1/04 (SA Tertir-Terminais de Portugal vs. Commission).
34 W. Buiter, Can Central Banks Go Broke?, p. 10.
35 J. Langner, Kommentar zur EWU, no. 13 ss. of Article 33 of the ESCB Statute.
36 ECB, Convergence Report 2010, p. 23 ss.; ECB, Convergence Report 2012, p. 28 s.; Deutsche
Bundesbank, cf. note 19 above, p. 28; J. Langner, Kommentar zur EWU, no. 9 ss. pre Article 28-33
of the ESCB Statute.
37 M. Del Negro/Christopher Sims, When Does a Central Bank’s Balance Sheet Require Fiscal Support?, p.
44 s.
39 K. A. Schachtschneider, Die Souveränität Deutschlands, p. 305.
40 J. Langner, Kommentar zur EWU, no. 13 ss. pre Article 28-33 of the ESCB Statute.
41 Chapter 6 of Annex I of the Guideline ECB/2011/14 dated 20 September 2011.
43 H.-W. Sinn, Die Target-Falle, p. 151 and 155.
46 W. Buiter/E. Rahbari, The ECB as Lender of Last Resort for Sovereigns in the Euro Area, p. 18.
49 H.-W. Sinn, Die Target-Falle, p. 153; C. Steven, Kommentar zur EWU, no. 50 of Article 14 of the
ESCB Statute.

30
55 H.-W. Sinn, Die Target-Falle, p. 196 and 201.
57 Deutsche Bundesbank, cf. note 19 above, p. 24 s.
58 W. Hankel/A. Hauskrecht/B. Stuart, The Euro-project at risk, p. 5.
59 P. Spahn, Die Euro-Verschuldung der Nationalstaaten als Schwachstelle der EWU, p. 534.
60 Deutsche Bundesbank, cf. note 19 above, p. 16 and 26.
63 Deutsche Bundesbank, cf. note 19 above, p. 10 s. and 16.
66 M. Bargel, Risiken der ultraexpansiven Geldpolitik nehmen zu, p. 99.
67 A. Belke/J. Beckmann, Inflation – Ursachen, Kosten und Nutzen, p. 1378.
69 O. Steiger, Which lender of last resort for the eurosystem?, p. 21.
70 M. Broer/K.-D. Henke/H. Zimmermann, Die europäische Staatsschuldenkrise als neue
Herausforderung für die Europäische Union, p. 420.
71 R. Schmidt/W. Kahl, Umweltrecht, p. 10 ss.
72 A. Belke/G. Schnabl, Europäischer geldpolitischer Exit im Zeichen von QE2 und
Staatsanleihekäufe der EZB, p. 158.
73 S. Oosterloo/J. de Haan, Central banks and financial stability, p. 260 s.
75 GFCC, vol. 89, p. 208; vol. 97, p. 368.
76 C. A. E. Goodhart, The changing role of central banks, p. 151.
77 GFCC, Judgment of 30 June 2009 - 2 BvE 2/08
(https://www.bundesverfassungsgericht.de/SharedDocs/Entscheidungen/EN/2009/06/es200906
30_2bve000208en.html), section 281.
78 ECB, Press release entitled “Technical features of Outright Monetary Transactions“ dated 6
September 2012.
79 W. H. Buiter/E. Rahbari, The ECB as Lender of Last Resort for Sovereigns in the Euro Area, p. 16
ss.
80 ECJ, C-62/14 (Gauweiler et al. vs. ECB).
81 GFCC, 2 BvR 2728/13 (cf. note 2 above), section 39 and 55 s.
82 GFCC, 2 BvR 2728/13 (cf. note 2 above), section 63-69.

Max Danzmann
31
83 GFCC, 2 BvR 2728/13 (cf. note 2 above), section 71.
85 GFCC, 2 BvR 2728/13 , section 73.
86 ECJ, C-370/12 (Pringle vs. Ireland), section 60.
87 GFCC, 2 BvR 2728/13 (cf. note 2 above), section 76 s.
88 Deutsche Bundesbank, cf. note 19 above, p. 9
92 ECB, Press release entitled “Technical features of Outright Monetary Transactions“ dated 6
September 2012.
94 GFCC, 2 BvR 2728/13 (cf. note 2 above), section 92-94.
95 ECJ, C-62/14 (Gauweiler et al. vs. ECB), section 104 ss.
99 C. Keller, Kommentar zur EWU, no. 238, 240 and 257 of Article 18 of the ESCB Statute.
103 H. Remsperger, Zentralbankpolitik, p. 7.
104 S. Radtke, Liquiditätshilfen im Eurosystem, p. 139 and 231.
107 K. A. Schachtschneider, Stellungnahme zum Vorlagebeschluss des BVerfG, p. 4.
108 A. Belke, Driven by the markets. ECB sovereign bond purchases and the Securities Markets
Programme, p. 363; D. Gros/T. Mayer, How to deal with sovereign default in Europe, p. 2.
109 GFCC, 2 BvE 2/08 (cf. note 75 above), section 249 s.; K. A. Schachtschneider, Die Souveränität
Deutschlands, p. 203 s.; U. di Fabio, Die Zukunft einer stabilen Wirtschafts- und Währungsunion,
p. 12.
110 GFCC, 2 BvE 2/08 (cf. note 75 above).

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