The euro area’s central banks, having purposefully expanded their balance sheets in recent years, now confront a period of loss-making as rising policy rates lift the remuneration of bank reserves while income from assets rises more slowly.
Quantitative easing – large-scale, across-the-board purchases of government bonds introduced in 2015 – removed duration risk from the private sector’s balance sheet to induce portfolio rebalancing in order to support credit provision to the real economy. On the liability side, it created more than €4tn of bank reserves on which the Eurosystem’s central banks pay interest to bank depositors.
In effect, the European Central Bank at the core of the Eurosystem executed a fixed-for-floating rate swap for public debt. This leaves the ECB and its shareholder national central banks with a large interest rate exposure in the current tightening cycle. This was not an unexpected outcome, but rather a feature of balance sheet policies pursued with a view to raising inflation.
A paper published by the International Monetary Fund on 7 July, of which I am a co-author, presents 10-year projections of the net income of the Eurosystem and its ‘top five’ NCBs: Deutsche Bundesbank, Banque de France, Banca d’Italia, Banco de España and De Nederlandsche Bank. Its principal finding is that the losses, while large, will be temporary and recoupable. Significantly, we see no need for capital support or indemnities from the state.
Our baseline scenario, which uses market interest rate paths and announced policies, indicates two years of loss-making for the Eurosystem as a whole, and a dispersion of results for the top five NCBs. We project five years of loss-making for the Bundesbank while, at the other end of the range, Banca d’Italia is projected to narrowly avoid annual losses.
Given the home bias in NCBs’ bondholdings – itself an outcome of mutually agreed Eurosystem safeguards – and with coupon income from the home sovereign as the key driver of the projected return to profits, NCBs in lower-debt countries with lower funding costs will, barring other factors, tend to see lower net income.
The paper also outlines various different possible outcomes under alternative assumptions. Faster quantitative tightening reduces cumulative net income over the 10-year horizon as savings on the swifter reduction of bank reserves are exceeded by lost interest income from lower reinvestments. Parallel upward shifts in yield curves are profit-enhancing, whereas a scenario that combined higher interest rates in the near term with lower rates further out would be more challenging.
Lower banknote demand, say as a result of advancing digitalisation, predictably reduces seigniorage income. A fourth scenario examines how the Eurosystem NCBs share monetary income.
Our policy conclusions are fourfold. First, the temporary and recoupable nature of the loss-making obviates any need for capital support or indemnities from the state, instead suggesting losses can be offset against future net income in line with the US Federal Reserve’s approach.
Second, even without capital injections, fiscal impacts will be material, at about 0.1% to 0.2% of gross domestic product per year in terms of lost taxes and transfers, interrupted in one case for 11 years (Figure 1).
Third, more conservative profit distribution policies in the future steady state could help mitigate the on-off pattern of dividends.
Finally – and most importantly – the temporary loss-making must not be allowed to influence monetary policy. This is the case at the ECB, where the governing council structure helps ensure that monetary policy decision-making is insulated from NCB-specific considerations.
Figure 1. Selected NCBs: average annual tax payments and transfers to state, 2008-31
(% of GDP unless otherwise indicated)
|Old steady state|
|Replenishment and resumption|
|No. of years without tax or transfer|
|Banque de France||0.17||0.00||0.19||3|
|Banco de España||0.21||0.00||0.26||2|
|De Nederlandsche Bank||0.09||0.00||0.18||4|
Source: Fund staff estimates and projections
*Periods set by P&L profile of Eurosystem as a whole; periods for individual NCBs vary.
Looking back to the years before the current monetary tightening cycle began, the paper shows that pay-out ratios were remarkably stable. In 2008-21, an average of 40% of the pre-provision, pre-tax net income of the top five NCBs flowed to provisions and retained earnings. During the same period, Banque de France paid out 46% of its post-provision net income as corporate tax, on average, and Banca d’Italia 22% (the Bundesbank, Banco de España and De Nederlandsche Bank do not pay taxes). Pay-outs peaked in 2019 before most of the top five NCBs, most notably the Bundesbank and De Nederlandsche Bank, chose to prioritise provisioning.
In the final analysis, the ECB’s credibility rests, and will rest, on its ability to fulfil its primary objective of price stability. As policy-makers discuss interest rates, the pace of QT or other tools to reduce excess liquidity, they should set aside the attendant profit-and-loss effects.
Finally, one overriding point is noteworthy. As regards the fiscal effects of the ECB’s balance sheet policies since the 2007-08 global financial crisis, the budgetary impacts from temporary Eurosystem loss-making are projected to be material in the coming years. But without those policies a weaker macroeconomic environment might well have had a larger negative impact on the public finances.
Ashok Bhatia is Director, IMF Offices in Europe, International Monetary Fund.