TARGET2 Imbalances as a Settlement Substitute: Interbank Market Fragmentation and Financial Stress in the Euro Area

This paper examines TARGET2 imbalances in relation to the slowdown of the euro area overnight interbank market and the transformation of the Eurosystem’s operational framework after the global financial crisis and the European sovereign debt crisis. It argues that TARGET2 imbalances are not merely technical by-products of Eurosystem balance-sheet expansion, but balance-sheet traces of a structural reorganization of liquidity circulation inside the euro area. The paper develops and tests a substitution hypothesis: when private cross-border redistribution of central-bank liquidity through the overnight interbank market weakens, public settlement through TARGET2 increasingly records liquidity flows no longer intermediated through private money markets. Using a vector autoregressive framework for the euro area, the analysis links TARGET2 dynamics to overnight interbank market activity, the overnight money-market rate, and the Composite Indicator of Systemic Stress. The results show that positive shocks to TARGET2 imbalances generate a significant and persistent contraction in overnight interbank transaction volume, while financial-stress shocks generate an immediate and durable increase in TARGET2 imbalances. A complementary transmission analysis further shows that TARGET2 is the most persistent balance-sheet response to excess-liquidity shocks among the variables considered, exhibiting a larger and more durable response than sovereign bond yields, equity prices, or bank lending. Finally, regime-threshold results suggest that the center–periphery confidence gap becomes statistically relevant for TARGET2 accumulation only in the abundant-reserves regime, linking settlement dynamics to safe-asset scarcity and incomplete financial integration. The findings imply that TARGET2 should be interpreted not only as an accounting counterpart of central-bank operations, but also as a signal of impaired private liquidity circulation, financial fragmentation, and the evolving operational architecture of the Eurosystem.