Central bank solvency II: How do central banks go bust?

"We think in generalities, but we live in detail." Alfred North Whitehead

In my last post, ‘Can central banks go bust?’, I looked at the important topic of central bank solvency. I discussed the meaning of central bank solvency from a theoretical point of view and tried to dispute the common claim that solvency is irrelevant for a central bank as it can ‘print’ itself out of trouble. The common misunderstanding stems from either not knowing what ‘printing’ actually means, or from misunderstanding the role the central bank plays in money creation and inflation.  

So we now know that central banks CAN become insolvent. But HOW do they become insolvent? Traditionally, central banks has two primary functions. First, it prints actual currency (i.e. notes) if and when the economy needs it. Second, it exchanges safe, short-term government bonds for central bank reserves from designated banks in order to change short term interest rates as part of monetary policy, otherwise known as Open Market Operations (OMOs). 

Inevitably, central banks made profits from the printing of cash. The cost of printing is essentially zero, but since cash has a unique property as a medium of exchange, people are willing to give resources (which have real value) in exchange for it. This profit, known as seigniorage, has been the defining characteristic of central banks for centuries. Some estimates for seigniorage in the US range from 5% to 12% of GDP. In addition to seignorage, as they essentially converted one safe asset for another as part of OMOs, their capital position remained fairly constant. All-in-all, under old style central banking, large developed-market central banks such as the Fed, BoE and the ECB never made a loss on an annual basis, with most of the profits coming from seigniorage. 

Then came the 2008 recession, and with it a whole new style of central banking. This wave of modern central banking saw the Fed and other central banks across the world issue billions of dollars’ worth of additional reserves, meanwhile buying long-term government bonds of different risk categories, corporate bonds and, in some cases, foreign bonds. All of these carried with them their own risk: long-term government bonds carried interest-rate risk - the prices of these bonds are inherently more sensitive to changes in interest rates than short-term bonds; corporate bonds and government bonds of lower credit ratings (such as Greek bonds in the Euro area) carried increased credit default risk; and holdings of foreign bonds carried both exchange rate risk as well as credit default risk of the issuing government.

Given the complications that these unconventional monetary policies brought to central bank finances, it is clear that central bank solvency can no longer be taken for granted, and understanding it is now more important than ever before. 

Yet another question remains: why is the central bank different from any other arm of the government? Indeed, why should the solvency of the central bank be called into question when other departments’ solvency, such as the US Department of Transport or the UK Metropolitan Police Department, are not? The issue here concerns central bank independence. As has been argued for decades in academia and is now more or less regarded as fact, monetary policy is more effective under central bank independence (see my previous post on the BoE independence for a fuller review). Operationally, this can only be the case if the government has as little control of central bank finances as possible. The result, intuitively, is that the public can subsequently trust the central bank to do what is best for the economy without being shackled by government requirements and orders.

Remember though, that the government still owns its central bank. Consequently, most central bank charters outline agreements declaring how the central bank should treat profits. Typically, it entails some version of profits being remitted back to the Treasury, but how much and when are both idiosyncratic features of the central bank in question. Importantly, it also describes what happens in the event of the central bank making a loss. It is these provisions that ultimately render central bank solvency moot or not. It should, therefore be clear that the importance of central bank solvency can only be determined on a case-by-case basis by examining these charters.

The bottom line

Central bank solvency is real and an important issue. Indeed central banks do not have the Godly powers to run deficits without repercussions as some economists seem to think. Moreover, the financial crisis and the ballooning of central bank balance sheets has made this issue increasingly pertinent - in some instances, these financial barriers might even influence monetary policy decisions in smaller, less financially stable central banks. Ultimately, central bank solvency must be studied individually - a good example of thinking in generalities, but living in the detail.