Abstract:
– Today more than ever, central banks are exposed to significant risks of loss. This article examines the « safety buffers » that central banks use to protect themselves against such losses, and more specifically how these buffers are generally determined in the central banking world.
– The first observation is that the level of capital held by central banks is generally determined by the organic law governing their statutes and therefore remains unchanged.
– The second observation is that other safety buffers exist (revaluation reserves, provisions) and that central banks generally have more discretion in setting their levels.
– The third observation is that the recapitalization of central banks is not always provided for in the organic law: this is the case for 45% of the 82 central banks analyzed in Pinter (2017), for example.
Central banks, like companies, have « capital. » Most of the time, this capital is held by the government [1]. Through the interest generated by the assets purchased with this initial capital, a central bank’s capital provides it with a basic income sufficient to cover its operating expenses (employees, operating costs, etc.) without resorting to money creation. It also allows it to absorb losses in the event of a crisis. But how is this level of capital determined? Why do some central banks have a very high level of capital in proportion to their assets, while others have a very low amount?
« Capital » in the strict sense: a rigid upward account
In most cases, the amount of « capital » in the strict sense is determined by the law governing the central bank’s statutes. For example, the 2005 law on the status of the Central Bank of Morocco states that the central bank’s capital « is set at 500 million dirhams. » The 2003 National Bank Act, which establishes the statutes of the Swiss Central Bank , states that the capital of the Swiss Central Bank must be set at « 25 million Swiss francs. » Since 1984, when the Act was passed, the capital of the central bank has remained at this level, as can also be seen in Figure 1.
Graph 1: Liabilities of the Swiss central bank, « capital » level (in the strict sense) always constant
Capital in the strict sense is therefore very often inert, set by a very old law. To cover potential losses, central banks therefore generally have other tools at their disposal.
Reserves, revaluation accounts, provisions: other accounts that are often flexible upwards for a central bank
The first is a simple « reserves » account, also used to absorb potential losses, the level of which is often set with a certain degree of autonomy. This reserves account is generally built up from the profits made by central banks each year. In concrete terms, instead of redistributing profits to the state, the central bank keeps them for itself in its « Reserves » account. For most central banks, the law clearly states the mechanism to be followed: in general, central banks must allocate a certain proportion of profits to the « Reserves » account until it reaches a certain level. The level may be the same as that of capital, for example, or it may depend on the amount of assets held by the central bank (a rarer case). For example, the Bundesbank must first set aside 20% of its profits in its « Statutory Reserves » account until this account reaches the level of capital. Once this level is reached, either the profits continue to be retained by the bank but in a smaller proportion, or they are redistributed in full to the Treasury (as in the case of the Bundesbank).
A second tool, separate from the « Reserves » account for some central banks (included in it for others), is the « revaluation account. » This captures unrealized profits, for example those arising from movements in gold prices or foreign exchange reserves. These profits are in most cases not distributed to the Treasury and therefore remain in « reserve » in this account.
Another line of defense that most central banks have is an « ad hoc » provision account. These provisions are generally based on risks assessed by the central bank itself. For example, the Bundesbank increased its provisions to exceptional levels after the ECB introduced the SMP in 2011 (purchases of Greek, Spanish, Portuguese, Italian, and Irish debt), bringing them to nearly €15 billion. These are profits that are not redistributed to the Treasury (Bundesbank, 2015), and the central bank must therefore strongly justify their relevance.
And if a loss occurs, should the Treasury recapitalize the central bank?
The recapitalization of a central bank, should it suffer losses, is often not automatic. For example, if the ECB were to suffer a significant loss, there is no legal obligation for Member States to recapitalize it, which has given rise to much debate in the past (Belke, 2010). The same applies to the Swiss National Bank: its private shareholders and the cantons have no obligation to recapitalize it in the event of a significant loss.
For some central banks, the situation is different. For some, such as the Central Bank of Peru, the law stipulates that recapitalization must take place within 30 days of the loss (Pinter, 2017). In other cases, the monetary institution even has the right to directly withdraw the amount corresponding to the loss from the public treasury account. An analysis by Pinter (2017) of the laws of 82 central banks shows that in 45% of cases, no automatic recapitalization is provided for by law. It is often in countries where central bank losses have been problematic in the past that this recapitalization obligation is found [2].
Conclusion
Capital, reserves, ad hoc provisions: central banks therefore often have various accounts to absorb future losses. It is all of these accounts that must be considered as the institution’s « capital » from a symbolic point of view. While central banks can adjust some of these accounts upwards most of the time, their room for maneuver in doing so remains limited. Some have experienced significant losses exceeding the level of these protective buffers (see Pinter (2017) for references on this subject). Recapitalization by the Treasury is not always automatically guaranteed, which in some cases can pose certain problems (see Pinter (2017) or BIS (2013) for discussions on this point).
For further reading:
Bank of International Settlements, 2013: “Central bank finances.” BIS Working Paper.
Angel Belke, 2010: “How much fiscal backing must the ECB have?”. International Economics.
Bundesbank, 2015: « Bundesbank posts €3.2 billion profit in 2015«
Peter Stella, 2002: “Do central banks need capital?”. IMF Working Paper.
Peter Stella, 2008: « Central Bank Financial Strength, Policy Constraints and Inflation. » IMF Working Paper.
https://snbchf.com/2016/12/snb-provisions-currency-reserves/
Notes:
[1] If held in the form of shares by individuals or banks, as may be the case in Switzerland, Turkey, or the United States, for example, these shares confer very little power over the central bank and generally have only symbolic status.
[2] For some central banks, insufficient capital can prevent them from generating enough profits to cover their costs, so they resort to money creation. In some countries, such as Costa Rica, Jamaica, and Hungary, economists have argued that the low level of capital of these central banks has led them to excessive money creation, preventing them from controlling inflation at appropriate levels (see Stella (2002), Stella (2008), and Pinter (2017) for more information and references on this subject)..
