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Why central banks can’t go bust

Central banks are not like trading companies. They can literally print or create money for their own use. So long as that power remains with them, they cannot go bust.

| 7 min read

Central banks do not have to follow normal company rules over solvency. Although they can’t go bust, they can, of course, print to excess so they devalue the money they are creating. That may become unsustainable. Their host government – and the people they serve – may intervene if all they do is create an ever-faster inflation. Most central banks proceed by creating or allowing moderate inflation most of the time. The typical target of 2% inflation a year, which roughly halves the value of money every 36 years.

Central banks sometimes take on foreign currency assets and liabilities. Dealing with debts in foreign currencies places more restraint on them, as they can lose a lot of money if their own currency devalues. They could struggle to buy enough foreign currency to meet their obligations in extreme cases. Central banks with large foreign exchange exposures are more vulnerable to market pressures.

Bond buying has resulted in losses

The topic of central banks’ own finances is now current because a number of formerly well financed central banks in advanced countries are sitting on large losses on bonds that they bought at very high prices. They created money to buy expensive bonds as part of their money policies to get through the financial crash of 2008-9 and then the Covid-19 lockdowns. If those paper losses materialise as actual losses, some central banks will have liabilities in excess of their assets.

They are losing money by holding the bonds where they pay more out on their deposits than they receive in income on the bonds, as well as losing on the capital value on disposal of the bonds. Their share capital and reserves could go negative. There is an active debate about whether this matters and what should be done about it. The Reserve Bank of Australia has already reported negative equity.

Some say a central bank that loses all its reserves and wipes out its starting capital should be recapitalised by the state that backs it and often owns it. Some say there is no need to do this. They say the central bank simply identifies a deferred profit item on its balance sheet to match the reported losses and waits for better times when it can generate profit to turn the balance sheet positive again.

There is an important difference in the results of these two divergent approaches. If the central bank needs to be recapitalised by the state making cash payments, then that is a charge on taxpayers or requires more state borrowing to finance it. If the central bank just leaves it on its balance sheet the state is spared the need to raise more money.

Other central banks think if their balance sheets go negative, they may need to recapitalise.

The Federal Reserve (Fed) is busy taking lots of losses on bonds, selling $95bn a month of Treasuries and mortgage-backed securities. It is also paying more out in interest on commercial bank reserve deposits than it is getting in interest on the bonds it owns. The Fed takes the view that it is not a profit-making, private-sector company. Its losses are the result of monetary policy choices. It will therefore create an asset to match its losses as they occur and place it on the balance sheet if need arises. The Treasury has not promised to pump in new capital.

Other central banks think if their balance sheets go negative, they may need to recapitalise. In the cases of central banks that are part of the Euro system, the European Central Bank will look to the individual member states central banks to seek top up capital from their member state government should need arise. Bond buying was a Euro policy, but each member state national central bank was given the task of buying the government bonds issued by its own government. The German central bank, for example, owns the German bunds the Euroscheme bought, and will be responsible for recapitalising or accounting for the many of the losses on them as they occur.

In the case of banks such as Canada and Australia it is simpler, as each bank bought its own country’s bonds and looks to the same government to make good losses if need arises. They have both decided to end dividends from the central bank but to live with a negative balance sheet when losses exceed reserves.

The New Zealand central bank is now receiving payments from the state against its losses on bonds. The Bank of England has a guarantee from its government and receives full reimbursement from the Treasury for losses. All countries have been receiving a share of the profits from their central banks when they were making money on buying and holding bonds, and all accept that they will not be receiving dividends from loss making central banks. There are arguments over whether and to what extent states should reimburse for losses.

Fiscal challenges for central government

It is a shock to national governments to see that they can no longer enjoy a stream of profits from central banks making big gains on buying and holding their government’s bonds. It is an even bigger shock if they conclude they need to pay for some, or all, the losses to ensure sufficient capital in their central banks. Where states are recapitalising, the costs of the central bank policy compete with public services for the tax revenue, or lead to additional state borrowing. Most countries seem to be avoiding sending cash to loss-making central banks, so they are avoiding the need for tax rises or spending cuts.

Monetary and fiscal policy turn out to be intimately connected and need high levels of agreement between a central bank and its sponsor government. Markets are accepting that central banks have lost a lot of money and live with the idea that a loss-making central bank can just report the losses without demanding new capital. This eases the fiscal position compared to the state subsidising the bank.

The Fed has said that it is considering cutting back on its large bond sales, with an emphasis on reducing its sales of longer dated Treasury bonds where the losses at current market prices are high. They propose this for general policy purposes but reducing the actual losses taken may also be in their minds. This would be a welcome modest easing of monetary policy.

The European Central Bank is not selling bonds into the market and has cut the amount of interest it pays the commercial banks on reserves to reduce the losses it would otherwise be making.

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Why central banks can’t go bust

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