This series of OMFIF Insights explores the impact of monetary-fiscal policy coordination on central banks and their balance sheets. For more data and analysis, see OMFIF Central Bank Policy Tracker. The first part of this article appeared on 27 January.
Central banks looking to manage balance sheet risks have five means to control possible threats to their financial and political standing. First, they must distinguish between unrealised and material losses. Losses on the stock of government bonds would materialise only in the case of a sovereign default, or, more plausibly, if the Eurosystem were to sell these bonds in the market, for example, under balance sheet unwinding as monetary policy normalises. This is because national central bank asset purchases are held at amortised cost, rather than marked-to-market. Unless sold, all losses would remain unrealised.
Second, from a flow perspective, the loss-making transfers to commercial banks – in other words, higher interest rates – would be likely to materialise only in in an environment in which inflation and returns on investment assets were higher as well. As such, these flows would be partially offset by greater seigniorage revenue. Any losses incurred through interest rate mismatches would also be partially offset, alleviating the burden on the Eurosystem.
Third, NCBs have significantly enhanced their loss provisions in recent years to pre-empt potential losses on unconventional monetary policy. In its 2019 annual report, the Bundesbank noted that it had increased its provisions for financial risk for the third consecutive year. It added an additional €1.5bn to its reserves, bringing them to €17.9bn (Figure 1).
As Bundesbank president Jens Weidmann noted in a press conference, ‘general risk provisions are traditionally used to hedge against exchange rate risk, but, due to the non-standard monetary policy measures, also against default and interest rate risk.’ The Banque de France added €192m over the same period, a smaller figure than the Bundesbank, underlining the lack of a fully harmonised approach.
Fourth, the practical examples from the past show the European Central Bank stepping in to pre-empt even potential losses on monetary policy implementation. Presumably, it would do so in the case of serious capital losses which threaten the insolvency of the NCB. This de facto loss-sharing across the Eurosystem means that an individual NCB can become insolvent only if the Eurosystem chooses to let it. This is an unlikely scenario.
If negative equity capital were to materialise, NCBs have ways to restore their financial position. Foremost, they can seek recapitalisation from their national treasury. This may result in political tension, both between the NCB and treasury as well as among other Eurosystem NCBs, if there is inconsistency in how it is applied. This political risk is real, highlighting how policy choices ultimately determine the debate over central bank capital.
Alternatively, visiting professor at Columbia University Willem Buiter has suggested that NCBs facing serious capital losses should be allowed to borrow against a share of future seigniorage revenue equivalent to an individual NCB’s capital key share. In other words, the Eurosystem would provide financing where markets fail to do so.
Risks to the financial health of NCBs in the Eurosystem exist and are intensifying as a result of continued unconventional policies. There are a range of technical solutions to preclude potential dangers. But should these risks materialise the problem would ultimately be a political one with potential repercussions for central bank independence. As noted by the ECB in 2010, ‘if the financial health of a central bank deteriorates, it might seek recapitalisation from the government, which then might try to influence the central bank’s decisions in return for committing public money.’
Following a decade of QE and renewed enthusiasm for fiscal-monetary co-operation, this ‘influence’ might not seem as pernicious anymore. QE is an operation that seeks to reduce government borrowing costs as one of its key channels. As the Riksbank’s deputy governor Martin Floden noted in a 2016 speech, QE ‘reduce[s] the nominal cost of the government’s new borrowing, while inflation reduces the real cost of… outstanding debt and new borrowing when the policy rate is restricted by its effective lower bound.’
As such, it’s not unreasonable for the central bank to expect eventual recapitalisation from its fiscal authority in the interest of good economic policy, once the economy recovers and its QE portfolio is unwound. Framing the politics of central bank profits in this positive light might produce more fruitful fiscal-monetary collaboration.
In any case, this debate should not distract from the clear message of the Treaty on the Functioning of the European Union, which prioritises the objective of price stability. The ECB warns that to prevent this risk materialising, ‘the central bank might try to avoid situations where recapitalisation is required, for fear of government intervention or political pressure. Therefore, the central bank might find itself in a situation where monetary policy objectives are not the only goal pursued and, as a result, a sub-optimal monetary policy might be implemented.’
This leads to a somewhat paradoxical conclusion. The real risk to central bank independence results from central banks over-reacting to fears that it might be taken away. ´This can lead to ineffective and sub-optimal monetary policy which ultimately meets political resistance – and the eventual loss of the independence that the central bank has done so much to uphold.
Danae Kyriakopoulou is Chief Economist and Director of Research, Pierre Ortlieb is Economist at OMFIF.