European monetary policy is becoming increasingly complicated by the thorny issue of losses accumulated by the European Central Bank and national central banks as a result of eight years of quantitative easing.
Amid signs of economic slowdown or even recession, debate about these losses is coming to a head at a time when the ECB is considering ending its series of rapid interest rate rises since July 2022. The source of the losses – interest rate mismatches on the Eurosystem balance sheet – reflect similar reasons to those elsewhere, above all at the Federal Reserve and Bank of England, which have also acquired massive quantities of government bonds under QE.
From a purely economic point of view, central banks can withstand losses without serious difficulties. They cannot technically become bankrupt, and they can resort to many different devices to plug gaps in their balance sheets. However, the problems faced by the euro area could become troublesome because of the heterogeneous nature of Europe’s economic and monetary union. All this could have a serious effect on the ECB’s credibility in its main policy goal: maintaining price stability.
Governments relied on central banks to enact important emergency action to counter the effects of the 2007-08 financial crisis, the 2010-15 euro area upsets and the Covid-19 pandemic that started in March 2020. The convoluted questions facing the euro area show that governments cannot sidestep responsibilities for action taken by central banks which – though operationally independent – are ultimately held responsible by governments and taxpayers.
Imbalances in receipts and outgoings stem from two sets of policies
Euro area central bank losses are caused by imbalances in receipts and outgoings. They stem from two sets of policies. First, under heavy and possibly excessive QE over the past 10-15 years (accelerated since the Covid-19 pandemic), the Eurosystem has significantly increased its holdings of expensive, low- (in some cases negative-) yielding government bonds.
Second, the belated but (once it started) accelerated rise in interest rates in the past 14 months has greatly increased the cost of central banks’ liabilities, while reducing the value of their assets. After a year of rapidly raising interest rates, the ECB and its shareholder central banks are paying significantly greater sums in interest on deposits from commercial banks than they are receiving on their large portfolios of mainly domestic government bonds.
The overall Eurosystem balance sheet roughly doubled during the pandemic – from €4.7tn at end-2019 to €8.6tn at end-2021 (Figure 1). But it fell to €8tn at end-2022 and has since declined further to €7.2tn in mid-August. This reflects the slowdown of QE and planned repayment by banks of loans extended under the ECB’s targeted longer-term financing operations.
Figure 1. Eurosystem balance sheet doubled during the pandemic
Balance sheet by component, 2018-22, €bn
Source: Eurosystem
As Ashok Bhatia, one of the co-authors of a ground-breaking July 2023 International Monetary Fund paper on euro area central bank balance sheets put it, ‘The ECB 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.’
The IMF paper termed the euro area losses ‘temporary and recoupable’, saying there would be no need for state intervention (including recapitalisation) to strengthen central banks’ capital base. There are some question marks – both economic and legal – over the IMF paper’s arguments and assumptions. The losses could be larger, as shown by the authors’ alternative scenarios, and their distribution among the Eurosystem members could be more problematic.
The net weakening of balance sheets is significantly greater than anything modelled by the ECB when it started large-scale QE in 2015 and higher than expected until recently. Admittedly, the estimates of the losses are surrounded by many uncertainties. Cumulative losses could also be lower, depending on factors such as interest rate paths, reinvestments and reserve requirements.
In contrast to some other central banks such as the Swiss National Bank, with its especially large share of foreign assets, including equities, the Eurosystem does not value its full balance sheet to market prices. As the IMF paper points out, ‘amortised cost accounting at the Eurosystem dictates that valuation effects on the QE book are realised only if securities are sold outright.’ The IMF calculates that, assuming the QE book remains static in its size and composition as of end-2021, valuation losses would be €758bn at end-2022, equivalent to 5.7% of euro area gross domestic product, exceeding the sum of general provisions, capital and reserves and revaluation accounts as of end-2021.
Bundesbank expected to register losses until 2026
Different Eurosystem central banks face different scales of losses and are accounting for them in disparate ways. The central banks of the northern countries in the euro area, with the highest credit ratings, are suffering the largest nominal losses because their bonds offer the lowest yields.
Germany, the biggest economy in EMU, the largest creditor and the country where the entry of the euro in 1998 was most sensitive, is in an exposed position. The Bundesbank faces larger and more persistent losses than at other euro area central banks. According to the IMF paper, the Bundesbank is expected to register losses until 2026. Under certain conditions, this sequence of losses could extend further.
The dilemmas are likely to come to public attention in the run-up to the next German general election in autumn 2025. The far-right anti-euro Alternative for Germany party (AfD), currently performing well in opinion polls, is front-runner in three important East German state elections next year. These will be seen as a bellwether for the nationwide 2025 poll.
Critics of the Bundesbank point out that it should have accepted in 2014-15 to buy lower-rated government debt (such as Italian bonds) as well as German bonds during fundamental discussions on starting QE. Furthermore, the Bundesbank could have decided under pandemic emergency purchase programme procedures not to buy its full allotment of German government securities in 2020-22 – which would have both narrowed euro area spreads and curtailed its own eventual losses.
Debate about the losses will be exacerbated by analysis from many different sources across Europe. Many commentators – including several who are supportive of the ECB’s overall policies – point out the strategic miscalculations of  the past few years. A paper from Daniel Gros and Farzaneh Shamsfakhr of the Brussels-based Centre for European Policy Studies states, ‘The large bond holdings accumulated by the Eurosystem over the last eight years have represented a massive fiscal bet that interest rates would stay low forever. This bet has now gone spectacularly wrong. Euro area taxpayers are likely to lose around €700bn over the coming decade.’ (Figure 2)
Figure 2. Bundesbank faces larger losses than other euro area central banks
Expected cumulative losses on PEPP and PSPP holdings, €bn
Source: Centre for European Policy Studies
In addition to the purely economic debate, the Bundesbank is affected by a nexus of lawsuits, past and present, at the German constitutional court in Karlsruhe, which could constrain its monetary policy action, with potentially serious repercussions for the rest of the Eurosystem.
In judgements on outright monetary transactions in 2016, and on the public sector purchase programme in 2020, Karlsruhe set down a requirement for the Bundestag to give prior approval for any purchase programmes that could lead to ‘incalculable liabilities affecting the German budget’. And it obliged the government to recapitalise the Bundesbank with ‘an adequate amount’ in the event that financial losses affect its functioning.
Central banks could draw on other sources of equity on their balance sheets to help cover losses
Central banks could draw on other sources of equity on their balance sheets to help cover losses. One possible buffer alluded to in the IMF paper would be the ‘valuation reserves’ many European central banks have built up over the years, mainly stemming from the sharp increase in the price of gold in their reserves.
However, many central banks would rather not draw attention to such additional capital backing for fear that governments might wish to draw upon such funding sources to plug their own budgetary gaps. Highlighting the ‘valuation reserves’ – as both the IMF and the Bundesbank has done in its 2022 financial statement – may raise more attention on the role of gold in the financial system. This could increase the attractiveness of gold to many central banks and governments around the world which see gold as a source of stability in a world affected by overarching geopolitical risks.
All these issues will be on the mind of Christian Lindner, German finance minister, as his ministry draws up a legal response to a challenge during the summer from the German court of public auditors. The court claimed that the ministry did not independently check risks on the Bundesbank’s balance sheet when it signed off the central bank’s 2022 accounts. The court of auditors’ report, dated March 2023, came to light in July. It has been sent to the constitutional court as part of a legal complaint lodged in March 2021 against PEPP.
Central bank policy dilemmas
According to central banks’ long-established doctrine, monetary policy always takes priority over balance sheet issues. However, the Bundesbank case shows the difficulty of resolving conflicts between these two sets of considerations. The actions that the Bundesbank might favour for monetary policy purposes – raising the ECB deposit rate further and accelerating the phase-out of securities purchases by ending PEPP reinvestment earlier than planned, or even starting outright sales – would exacerbate losses.
Net purchases of bonds under PEPP were stopped in March 2022. But the Eurosystem is continuing to operate PEPP because maturing bonds are being reinvested, under a process which the ECB at present says it intends to continue at least until end-2024.
It is legitimate to question why PEPP reinvestment is continuing when the pandemic is over. A tacit reason could be that, under the flexible PEPP reinvestment policy, the Eurosystem can intervene discreetly to prevent spreads from widening between German and Italian government bonds. Moreover, as of a certain point during the monetary tightening process, reinvestments become profitable, reducing previous losses.
Pressure for recapitalisation in Germany may grow, both because of publicity for the losses and also on account of the legal action at the German constitutional court. Recapitalisation can be carried out relatively simply. A government transfers bonds to its central bank and takes equity into consideration. Yet such action would carry a stigma that, in a febrile pre-election period, Chancellor Olaf Scholz, from the Social Democratic Party, and Lindner, Free Democratic Party leader and his successor as finance minister, would rather avoid.
This is a much more severe situation than that faced by the Bundesbank in the 1970s, when it ran losses as a result of falls in the value of the dollar against the D-mark, which affected its sizeable foreign exchange reserves.
Questions raised by IMF paper
The IMF paper throws up many questions. Many might ask why the IMF – and not the ECB itself – has mounted the first serious inquiry into the euro area balance sheet. The paper highlights differences in accounting procedures and methodology as well as policies on profit distribution and provisioning among euro area central banks. In the interest of public transparency, these central banks should be trying to harmonise their approaches. This is also important in the light of efforts to align European accounting rules to help pave the way for capital markets union in Europe, which is vitally necessary to secure the European Union’s macroeconomic and climate mitigation goals.
The issues raised in the IMF paper are likely to influence a wider debate about the volume and composition of high bank reserves in the euro area, now around €3.5tn. The ECB and its shareholder national central banks have decided in recent weeks some relatively minor loss-mitigation steps on remuneration of reserves deposited by commercial banks and government entities. In a step which took some by surprise, the Bundesbank decided on 4 August to reduce to zero, effective 1 October, the interest rate on German government and public agency deposits. In a more general action, the ECB council decided on 27 July to reduce to zero, effective 20 September, the interest rate on minimum reserves, which apply to a relatively low 1% of deposits. With the goal of draining excess liquidity, maintaining relatively tight monetary policy and improving the profit position, some governing council members favour sharply increasing non-interest bearing minimum reserves in coming months.
A proposed Italian bank tax led to sharp falls of Italian bank share prices in August and to a partial retraction by the government – even though Giorgia Meloni, the prime minister, says she is standing by the idea. This is a sign of tensions over the profits generated by commercial banks across Europe as a result of the liquidity created by the Eurosystem’s QE.
The ECB will however be very cautious about the possible impact, both on financial markets and on bank lending behaviour, of over-hasty shifts in reserves requirements and remuneration and on the interlinked issues of QE reinvestment policies. Much more debate can be expected before the ECB takes necessary decisions.
Nout Wellink was President of De Nederlandsche Bank (1997-2011) and a member of the ECB Governing Council (1998-2011). David Marsh is Chairman of OMFIF.
German and Dutch translations of this article were also published in Handelsblatt and Het Financieele Dagblat.