Central banks’ capital adequacy
In this policy brief Wessels and Broeders argue that central banks, in addition to the calculable financial risks from current exposures, face “latent risks,” namely financial risks from future exposures, that they might have to accept under their mandate. Examples are risks from contingent policy measures such as quantitative easing and lending of last resort. The size of these latent risks is proportional to, for instance, GDP or the size of the banking sector. Capital, which consists of statutory capital plus retained earnings and other provisions or reserves with unlimited loss-absorbing capacity, provides a central bank with risk absorbing capacity and therefore plays a key role in central bank risk management. Abrupt changes in risk exposures raise the question of how much capital is considered adequate, but since there is no consensus within the central bank community on a target level of capital versus the level of financial risks, Wessels and Broeders suggest seven guidelines which could serve as a basis to a central bank’s capital policy:
- “A central bank’s capital policy has a target capital level that may correspond to a lower confidence level than the Basel capital requirements for commercial banks.”
- “A central bank’s capital policy is based on an assessment of financial risks, covering both calculable financial risks and latent risks.”
- “A central bank’s capital policy has a target capital level that is stable relative to the key macroeconomic variables and sustainable for a long term.”
- “A central bank’s capital policy focusses on buffers that are directly and unconditionally available to absorb losses.”
- “A central bank’s capital policy relies on the central bank’s own profitability for capital growth.”
- “A central bank’s capital policy is robust and objective.”
- “A central bank’s capital policy is simple and transparent.”
Central bank capital
By: Paul Wessels, Dirk Broeders – De Nederlandsche Bank, Maastricht University
Central banks are incurring losses
Patrick Honohan in this commentary points out that the Swiss National Bank in 2022 lost the equivalent of $143 billion, a sum which is almost 18 percent of Swiss GDP and may be the largest one-year loss ever recorded by a central bank. These losses are due to the huge foreign reserves (over $1 trillion, with more than half in bonds and almost a quarter in equities) accumulated as the Swiss National Bank tried to prevent the Swiss franc from appreciating. Other big central banks are in a similar situation: a) the Fed does not mark its bond portfolio to market, but the interest rate jump means that its baseline expectation is to make net losses for several years; b) the Deutsche Bundesbank and the Nederlandsche Bank were among the first of the euro area central banks to forecast sizable annual losses; c) the Bank of England is projected to have losses related to QE of a total £230 billion for the next decade.
Practitioners tend to worry more than academics about the impact of balance sheet weakness. This concern may reflect reluctance to be in the position of a mendicant rather than a benefactor in dealings with government officials. Not every central bank can rely on a budgetary subvention from the government when it incurs losses. If it has to rely on creating the money to cover its operating expenses for a prolonged period, inflation may follow. Or budgetary help may come only at the cost of conditions that weaken the central bank’s independence.
There is some cross-country econometric evidence that central banks with weak balance sheets tend to operate with less effective policies: they tend to have higher inflation rates or to have recourse to quasi-taxes like unremunerated reserve requirements.
Central banks are incurring losses, but critics’ concerns are overblown
By: Patrick Honohan – Peterson Institute for International Economics
