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This new series of OMFIF Insights explores the relationships between the monetary and fiscal policy of the world’s major central banks, such as interest on reserves and the central bank’s balance sheet. For more data and analysis on this topic, please visit Monitoring of OMFIF central bank policies.
The tension between the independence of the central bank, profit accounting and the structure of the Eurosystem was highlighted. This is due to the rising balance sheet of the European Central Bank and its growing exposure to sovereign bonds with often negative yields. In addition, there is the introduction of loss-making monetary policy instruments such as longer-term targeted refinancing operations.
In testimony before the European Parliament in November 2020, ECB President Christine Lagarde said that “ by definition, [the Eurosystem] will not go bankrupt or run out of money… and on top of that, any financial loss, if it does occur, will not affect our ability to seek and maintain price stability ”.
In practice, the conditions for this to happen are unlikely to materialize. Even if they do, there are several options to deal with them. However, Lagarde’s statement was perhaps overconfident. The possibility of a capital loss must be considered in relation to the structure of the Eurosystem and the way in which the risks are distributed between it. More importantly, the European treaties make it clear that the profit policy of central banks must not infringe on the mandate of the Eurosystem.
From a risk-sharing perspective, the public sector debt holdings of the national central bank and the ECB are treated differently. While the ECB’s assets are all risk-shared – in other words, the risks of default on sovereign debt are shared between the ECB and the NCBs – only the supranational debt holdings of the NCBs are held on a risk sharing basis. The public debt holdings of the NCBs are not shared (Chart 1).
This created a potential sovereign-BCN link. The riskier the assets held on the ECB’s balance sheet, the greater the danger. And the longer the quantitative easing persists, the more likely the ECB is to add riskier assets to its balance sheet. During the various asset purchase programs of the ECB, the NCBs have accumulated large portfolios of public debt issued by their own sovereign. They now hold around 92% of the public sector debt purchased by the Eurosystem (including 12 percentage points of supranational debt), the remaining 8% being held by the ECB. All private sector debt purchased under these programs is also held by the ECB.
But there is another dimension to this problem which concerns the flows between the different institutions of the Eurosystem, rather than the NCB outstanding amounts of government bonds (Chart 2). NCBs (and the ECB to a lesser extent) receive interest payments from governments on their sovereign assets. In the case of negative bond rates, the payment will go the other way. At the same time, both the ECB and the NCBs pay (or currently receive) interest payments on deposits held by governments and eligible banks. In addition, NCBs earn income through their monetary operations.
In the past, the net result of these flows has generally generated a profit for the NCBs. For example, under normal circumstances, central banks can earn seigniorage by issuing money at very low cost, which is then invested in a portfolio of profit-generating assets. The total profit of the NCBs is then shared among all the NCBs according to their respective subscriptions in the capital key, as indicated in Protocol 4 of the Treaty on the Functioning of the European Union. The same goes for the profits of the ECB, which are shared between the NCBs “after an appropriate transfer to the general reserve fund”.
The ECB generally accepts the benefits of properly capitalized central banks and notes the risks of central banks losing financial independence. However, he clarified that the objective of price stability takes precedence over such concerns, noting that “the treaty mandates the Eurosystem to implement monetary policy measures to ensure price stability, even if this entails losses for the Eurosystem or individual NCBs ”. Making a loss is therefore a possibility. Several central banks – including those of Switzerland, Sweden, Chile and Slovakia – have operated with negative capital in the recent past.
In the context of policy normalization, this would happen when the deposit facility rate and other policy rates start to rise. The gap would widen between the higher cost of funds on liabilities (with reduced interest income from the deposit facility) and the low or negative return on assets (with lost interest on bonds purchased at fixed negative rates).
Unlike commercial banks, central banks cannot take compensatory financial measures to hedge or prevent such losses. Instead, they must make provisions for risks. The ECB which suffers a loss can be compensated in the first place by the general reserve fund. In the most recent annual accounts, this fund was equal in size to the ECB’s capital buffers. Otherwise, the loss can be compensated “by the monetary income of the financial year concerned” according to the capital key. Should this prove to be insufficient, the ECB notes that losses can be “ recorded on the ECB’s balance sheet, to be offset by any net income received in the future ”, in the same way that the Federal Reserve has accounted for “ deferred losses ” on its QE Portfolios.
What happens in the event of losses in NCBs is much less clear but requires urgent resolution. The Statute of the ESCB does not impose automatic loss sharing by the Eurosystem NCBs on a permanent basis, leaving in theory the NCBs to bear the brunt of their losses. However, legal gymnastics and practical examples suggest that there are ways around this vulnerability. On the one hand, the ECB “may decide that national central banks will be compensated for costs incurred in connection with the issuance of banknotes or, in exceptional circumstances, for specific losses resulting from monetary policy operations undertaken for the ESCB ”. Unfortunately, it is very vague.
A 2009 decision of the ECB on the losses suffered by the Bundesbank, De Nederlandsche Bank and the central bank of Luxembourg is instructive. These central banks recovered collateral from defaulting counterparties in 2008 (including Lehman Brothers Bankhaus AG), mainly in the form of asset-backed securities. This guarantee was likely to generate a loss given its “limited liquidity under current exceptional market conditions”.
In response, the ECB said that “any deficit, if it were to materialize, should eventually be fully shared by the Eurosystem NCBs… in proportion to the key ECB capital shares in force”. It is not clear whether the losses on these guarantees actually materialized.
While much remains uncertain, it appears that the losses are ultimately shared by the NCBs. This uncertainty will only add to the tension between central banks and loss accounting currently in the spotlight.
Danae Kyriakopoulou is chief economist and director of research, Pierre Ortlieb is economist at OMFIF.
OMFIF will publish a series of articles on central bank accounting, capital policy and their relationship to monetary policy strategy during 2021.
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