Are central banks going bankrupt?

Are central banks going bankrupt?

The bond market had a bad year. And no one owns more bonds than central banks, which have amassed a portfolio of fixed-income securities worth well over $30 billion over the past decade. But do their mounting losses really matter?

Yes and no. Central banks are obviously quite unique institutions. For one thing, they have a balance sheet and a P&L like anyone else, and right now they’re not looking great.

Toby Nangle estimates the Bank of England losses alone are currently around £200bn, and the Federal Reserve says it recorded nearly $720bn in unrealized losses at the end of the second quarter. (updated with more recent data).

On the other hand, central banks are constructs of sovereign states and can literally create money out of thin air, which makes the whole issue of bankruptcy take on a different dimension.

Morgan Stanley chief economist Seth Carpenter wrote one of the definitive pieces on the subject while at the Fed a decade ago, and revisited the topic over the weekend. Given current events, we thought we would share and paraphrase generously.

Central bank profits and losses matter. . . but only when they count. Prior to the 1900s, the subject of economics was called “political economy.” Central bank losses that affect fiscal outcomes may have political ramifications, but banks’ ability to conduct policy is not compromised. . .

. . . Beginning with the Fed, all revenue generated on the System Open Market Account wallet, less interest expense, realized losses, and operating costs, is remitted to the US Treasury. Before the global financial crisis, these remittances averaged $20-25 billion a year; they soared to over $100 billion as the balance sheet grew. These rebates reduce the deficit and borrowing requirements. Net income depends on the average (mostly fixed) coupon of assets, the share of interest-free liabilities (physical paper money), and the level of reserves and reverse repo balances, the costs of which fluctuate with the policy rate. From virtually zero in 2007, interest-bearing liabilities have multiplied to nearly two-thirds of the balance sheet.

As shown in the chart below, the US central bank’s net income (which was returned to the US Treasury) has turned negative, and Morgan Stanley expects losses to increase as interest rates rise.

Carpenter points out that most central banks, including the Fed, do not mark-to-market, so any losses are not realized and reflected in the central bank’s income statement until ‘she did not sell the asset. But that obviously raises a lot of interesting questions.

So what do losses mean? Is there a blow to capital? Bankruptcy? An inability to conduct monetary policy? No. First, remittances to the Treasury end and the Treasury issues more debt. The Fed then accumulates its losses and, rather than reducing its capital, creates a “deferred asset”.1 When profits turn positive again, remittances remain at zero until the losses are recouped; imagine the Fed facing a 100% tax rate and offsetting current losses with future revenue. Profitability will eventually return as the currency will continue to grow, reducing interest expense, and QT will reduce interest-bearing liabilities.

Things are similar elsewhere, but with local twists, like the Czech central bank’s long-running negative equity, or the fact that the Bank of England got explicit compensation from the UK government to recover any losses when she started passing on her QE profits.

The effect is essentially the same as with the Fed, but the political economy differs. Where HMT and the BoE share responsibility, the Fed is alone. Passive unwinding for the BoE is difficult, given the lumpy maturity structure of gilt holdings, while the Fed has up to $95 billion a month in passive unwinding. For the BoE, a one percentage point increase in the bank rate reduces remittances by about £10 billion a year, a significant sum for a country struggling with fiscal problems. The proposal to reduce spending by prohibiting interest payments on reserves deserves careful consideration. If no authority remains, the BoE would have to sell assets to regain monetary control, realizing losses. Losses exist; it is the moment that is in question.

The ECB’s balance sheet is structured quite differently, but the logic is similar. Our European team forecasts a deposit rate of 2.5% by next March, implying ECB losses of around 40 billion euros next year. Bank deposits receive the deposit rate, which will be much higher than the return on the portfolio. The BoJ’s balance sheet also swelled, but in March (latest data available), the BoJ was in an unrealized gain position. We believe yield curve control (YCC) will be maintained until the end of Governor Kuroda’s term, but when it ends, if the JGB curve sells sharply, losses could be significant, although not carried out.

The most interesting variant is the Czech National Bank. CNB has had a negative equity position for most of the past 20 years. Running a small open economy means focusing on the exchange rate, and most assets are denominated in foreign currencies. If the central bank is credible and the Czech koruna goes up, the value of its assets goes down. The same goes for the Swiss National Bank, whose profits and losses have soared by several billions in a few years, without losing control of its policy.

Negative central bank equity; soon in a Fed, BoE or ECB near you?

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