Central bank losses
Dr.. Muhannad Taleb Al-Hamdi is Professor of Economics at Kansas State University
Muhannad Talib Al-Hamdi *
If commercial banks facing losses are a source of concern, then the losses of central banks, which are bank banks, are of particular concern.
The low value of assets held by the Bank of Japan and the Swiss National Bank appears to be a sure sign that central banks have acted recklessly and put their countries' economies at risk.
The concern about bond purchases in Germany, where the Constitutional Court indicated on May 5 that it might prevent the Bundesbank (German Central Bank) from participating in the asset purchase programs offered by the European Central Bank, partly reflects these concerns.
But central banks are not the same as commercial banks.
Central bank losses do not show financial weakness, but rather a reminder of their strange institutional location.
How does the central bank incur losses?
Like private banks, central banks have budgets.
These budgets contain assets: such as government bonds and liabilities: which include savings balances belonging to private financial institutions on which the central bank pays interest, which are identical to the current accounts in banks in public markets.
The central bank incurs a loss if the income it earns from its assets falls below the interest it pays on its financial obligations.
Devaluation of assets can also create a gap in the central bank’s budget, and the central bank will need funds to fix its balance sheet.
Central bank profits generally tend to go to the government; In 2019, for example, the US $55 billion net income of the Federal Reserve flowed into the nation's central treasury.
The range of central bank losses has grown significantly in the recent period.
With the global financial crisis continuing in 2007, many central banks have cut key interest rates to zero in order to revitalize collapsed economies.
In order to pump more stimulus funds, most central banks have switched to a quantitative easing policy: using recently created funds to purchase more risky assets such as long-term government bonds, mortgage-backed securities, and in some cases, stocks.
Asset purchases in central banks' response to the spread of the Corona epidemic mean that central bank budgets have been amplified.
Since late February, for example, US Federal Reserve assets have ballooned nearly 60%.
Central bank measures and the broader appetite for owning relatively secure assets has inflated government bond prices across the rich world.
If government bond prices fall as economies recover, for example, central banks may incur a loss when they decide to scale back their budgets by selling bonds.
New forms of emergency lending increase direct credit risks to which central banks are exposed.
The European Central Bank deals in large amounts of public and private sector bonds.
The US Federal Reserve buys corporate bonds and securities issued by municipalities, and bank loans provided by banks to companies of all sizes.
A recent economic rescue bill in the United States protects the Fed in the event of losses amounting to $454 billion.
It is well known that the losses have already occurred elsewhere.
The Bank of Japan's financial portfolio was hit hardly by nearly 30 trillion yen (about $270 billion) of equity funds when stock values fell earlier in the year.
Likewise, the value of large holdings of foreign currencies and shares that have accumulated with the Swiss National Bank, as part of its efforts to curb the appreciation of the Swiss franc.
However, the losses in central banks are quite different from the losses that commercial banks face.
The commercial bank may lose its balance if it becomes negative (or the so-called red zone) the confidence of its creditors, including the depositors, which could put it at risk of bankruptcy.
Conversely, depositors of the central bank have no other place to deposit their money: they have no choice but to keep their reserves with the central bank.
Likewise, it is not possible, in most cases, to implement cash liquidity at the central banks in order to pay what they owe, because they are able to create new money according to what they deem appropriate.
(Of course there are some exceptions: In Lebanon, large foreign currency liabilities have accumulated on the Bank of Lebanon that cannot be fulfilled by issuing more local currency).
In general, central banks cannot collapse, and economists largely agree that the negative net worth of the central bank’s budget is not an impediment to monetary policy development.
However, in practice, the budget position of the central bank with negative capital will cause much scrutiny.
The central bank is ultimately part of the state’s institutions, and in some respects its financial obligations are similar to public debt.
Paying debts by issuing money does not give the central bank a good position, especially since newly created reserves require interest payments on them.
It may be necessary to have a positive central bank in order for the monetary and financial system to be credible.
If so, taxpayers (or governments in rentier countries) must ultimately cover the central bank’s losses, by actually allowing it to use some government reserves, thereby nullifying some of the expansionary impact of the monetary easing policy on the money supply.
The UK Treasury has already promised to compensate the Bank of England for any losses caused by bond purchases in this period.
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Thus, central bank losses reveal the fragility of its independence from the government.
After years of inflation in the 1970s and 1980s, economists began to view the independence of central banks from the influence of political influence as crucial: this allowed them to prove their credibility with the public and thus achieve their policy goals.
But monetary policies pay for financial policies when the benefits of government bonds are determined by the amount of bond purchase.
If recapitalization is seen as necessary, the central bank will be at the mercy of the politicians.
Central bankers seem to take this political risk very seriously.
Research by Professor Igor Goncharov and Professor Vasu Ioannido from Lancaster University and Professor Martin Norths from Oxford University indicate that central banks are more likely to report small profits than they do face small losses.
This trend is steadily increasing when central bankers are more able to control publicly reported reports of bank entry, and when they face greater political scrutiny (for example, when they face the issue of reappointment to office).
Central banks face a dilemma: setting monetary policy independently which motivates the government to try to intervene, or preempt political intervention by reducing losses.
The solution may be to recognize that central banks are now working closely with governments.
Years of financial turmoil and low interest rates have forced central banks to do more and cooperate with financial authorities.
Rather than worrying that losses could erode their independence and enable reckless financial policy by the government, it may be time to recognize that governments also have a role to play in stabilizing the economy, and demanding that they do so properly.
* Professor of Economics at Kansas State University, USA
Number of views 223 Date added 06/06/2020