If you ask monetary economists whether we should care if a central bank’s capital level falls below zero (even for an extended period of time), most will say no. Pose the same question to central bank governors, and the answer in nearly every case will be yes.
What accounts for this stark difference? How can something that seems not to matter in theory be so important in practice?
The economists correctly argue that central banks are fundamentally different from commercial banks, so they can go about their business even if they have negative net worth. However, central bankers know instinctively that the effectiveness of policy depends critically on their credibility. They worry that a shortfall of capital would threaten their independence, which is the foundation of that credibility.
The recent experience of the Swiss National Bank (SNB) can help us to explain what we mean. On January 15 of this year, when the SNB abandoned its three-year effort to cap the currency and let the franc soar, everyone knew the central bank faced a massive foreign exchange loss. The first-quarter impact is now documented. According to the SNB, its foreign exchange investments lost CHF41 billion, or about 6½% of Swiss GDP, in that three-month period.
As a result of the loss, the SNB’s end-March level of capital and provisions slipped below 10% of assets (having temporarily set a new low of 6.2% in January). At the same time, its foreign exchange risk remains enormous: a further decline in the value of foreign currency instruments of 11% would wipe out the SNB’s capital.
What role did the SNB’s portfolio losses and potential losses play in its policy shift? Did the retreat from its exchange rate commitment partly reflect political concerns about the impact of even larger future portfolio losses had the commitment been maintained? We think so (see our earlier post).
It is important to realize that the SNB is not alone in taking risk, so they may be just the first in a wave of central banks that face a capital shortage. Indeed, the portfolio exposures of several major central banks have surged since they expanded their balance sheets massively. This makes it important to understand the implications of the health of central bank balance sheets.
Let’s start with the economists’ perspective: there are several reasons to believe that central banks should have no difficulty operating with negative capital. First, a central bank can issue liabilities regardless of its net worth. It can never be illiquid. Second, because it is really part of the government, it is reasonable to consolidate the central bank’s balance sheet with the government’s broader balance sheet. From this standpoint, it is of little import whether a single part of the larger balance sheet exhibits positive or negative net worth. Instead, when thinking about the government as a whole, we ask whether it has access to sufficient revenue to meet its obligations, both debt repayment and otherwise.
Third, and most important, in a world of stable prices, under almost any reasonable set of assumptions, the central bank’s future profits will be more than sufficient to offset a moderate capital shortfall in a reasonable time frame. Why? Central banks earn seignorage – the real value of the goods and services that they can command through the creation of central bank money (currency and reserves). That is a big reason temporary episodes of negative cash flow do not pose a policy challenge. [Keep in mind that central banks do not operate for profit, but rather to secure a public purpose (such as economic stabilization), and that (with only a few exceptions like the SNB) they do not issue stock that trades in financial markets or can be used as collateral.]
While seignorage is finite, it is very large even in low-inflation countries. Consider a simple thought experiment for the United States. As of end-April, there was $1.36 trillion of U.S. currency in circulation. This amounts to 7.7% of (nominal) GDP. If we assume that currency grows at the rate of nominal GDP, and the Fed earns 2% on its assets – the recent weighted average on outstanding Treasury bills, notes and bonds – its annual income would be 0.02*7.7 = 0.154% of GDP per year. To get the present value of this, we divide by the difference between the long-run real interest rate and the long-run real growth rate of the economy. Based on the past 40 years, that’s a number like one-half of one percent, so the present value of Federal Reserve seignorage from issuing currency alone is on the order of 30% of GDP, or nearly $5½ trillion. (For a detailed discussion of this calculation, see here.)
That’s a profitable business! To put it into perspective, the present value of the Fed’s future profits from currency alone is larger than its current $4½ trillion balance sheet, which is thought to be enormous. The point is that the Fed can easily make up even very large capital losses from the routine earnings it should expect under a regime of price stability. Private banks cannot be so confident.
Not to belabor the point, but quite a few central banks, including those of Chile, the Czech Republic, Israel, and Mexico, have operated effectively in the past – maintaining their anti-inflation credibility – despite episodes of capital shortfall. However, in our knowledge, no leading central bank has faced this challenge, or even a significant prospect of it, until relatively recently.
So, why worry? Well, as any central bank governor will tell you, the real threat arising from episodes in which there are significant losses is political, not economic. For example, will anxiety and impatience cause the central bank to operate with less independence – and with less credibility – say, in order to obtain (or to avoid the need for) recapitalization from the relevant fiscal authorities? Alternatively, during an episode of negative cash flow, will a temporary halt in the remittances of central bank profits to the fiscal authority prompt a legislative threat to its independence? (For a general discussion of these issues, see here).
Moreover, times have changed. Large portfolios of bonds and private-sector assets naturally expose central banks to bigger losses and to episodes without profits to remit to their fiscal authorities. Because it was the first central bank to undertake quantitative easing – already in the late 1990s – the Bank of Japan (BoJ) was the first major central bank to perceive a significant risk to its capital; its worries about the potential need for recapitalization may have made it less forceful than economic fundamentals warranted. Not anymore. Today, the BoJ is in the midst of what is arguably the most aggressive monetary expansion of any major central bank, making it vulnerable to a range of portfolio risks: in addition to its massive holdings of government bonds, the BoJ’s assets include corporate equities and real estate investment trusts. In the case of the SNB, the portfolio risk is mostly from exchange rate fluctuations. In the case of the ECB, credit exposure plays an important role – for example, imagine that another sovereign or a large group of banks were to default
The Fed primarily faces interest rate risk – on both sides of its balance sheet. On the asset side, rising bond yields would lower the value of its long-term securities, which consist of Treasuries and federally-backed mortgage securities. With an average bond duration of just under 7 years (see here), a one-percentage-point rise in market yield lowers the value of its portfolio by roughly 7%. Given that the bond portfolio is currently worth $4.2 trillion, this implies a loss of nearly $300 billion per percentage point of upward shift in the yield curve. This hypothetical loss exceeds the sum of capital ($58 billion) plus unrealized capital gains ($183 billion) currently on the balance sheet (see here).
On the liability side, the Fed plans to tighten monetary policy by raising the interest rate that it pays on excess reserves and on reverse repo agreements. In theory, the rising cost of carry of its large portfolio could eliminate the Fed’s profits and its ability to pay remittances to the Treasury. Since 2010, these remittances averaged a whopping $84 billion each year, and reached a record $99 billion in 2014. (Prior to the financial crisis, remittances were less than $30 billion annually.) In the absence of these transfers, the U.S. Treasury would have been forced to issue an additional $420 billion in debt to the public – an increase of three percentage points in the amount outstanding.
Reflecting the importance of the Fed’s dilemma, several recent studies (see here, here, and here) have addressed whether policy tightening in coming years is likely to compel the U.S. central bank to halt remittances. The most recent and methodologically sophisticated analysis (by Christensen et al) is relatively optimistic – putting the likelihood of a remittance halt in the years through 2020 at about 5%, albeit with a wide range of uncertainty (see chart below). Should the Fed halt remittances, it would do so to build up its own capital (temporarily reporting a “deferred asset” on its balance sheet that would be worked down as profits accrue). Again, Christensen et al. put the probability at less than 5% that the peak deferred asset would surpass $10 billion in the period to 2020.
Projected Fed Remittances to Treasury, 2014-2020
Source: Reproduced from slides presented at NYU Stern Volatility Institute 2015 Annual Conference, April 21, 2015; updates based on Jens Christensen, Jose A. Lopez and Glenn Rudebusch, “A Probability-Based Stress Test of Federal Reserve Assets and Income,” forthcoming, Journal of Monetary Economics.
Yet, as we have said, the risk associated with central bank portfolio losses is primarily political, not economic. In the United States, diminishing returns from the Fed’s portfolio could become a problem even if they fall short of halting remittances. Indeed, as the Fed raises interest rates in coming years, remittances almost certainly will decline (see chart above) while the rising payments on reserves likely will go mostly to large U.S. banks and to foreign banks (see next chart). This mix could easily fuel a populist assault on Fed independence in Congress (see our earlier post).
Total Reserve Balances at the Federal Reserve and Cash Assets of Domestic and Foreign Banks (U.S. dollars in billions), 2008-April 2015
Sources: Federal Reserve H.3 and H.8; FRED.
So, while we may be trained economists and like to think that way, the instincts of central bankers are noteworthy and compelling. The theory isn’t wrong: central bank net worth shouldn’t matter because the present value of future revenue should be sufficient to fill even a very large capital hole. And, besides, unlike a commercial bank, turning a profit isn’t part of their job. But occasionally politics trumps economics. And this may be one of those times. It may be too late for the Federal Reserve and other major central banks to avoid temporary episodes of a capital shortfall. If that happens, be prepared for a renewed, more powerful attack on central bank independence.