Are Governments Obliged to Bail Out their Central Banks?
With a worldwide financial crisis in full swing, central banks are being called upon to provide support to an ailing financial sector. In some cases, central bank credit is being provided directly to financial institutions. What are the risks that the central bank itself will not be able to support the financial cost of these operations? Will the government have to step in and bail out its central bank? Is there any chance that the central bank will become bankrupt?
An IMF Working Paper published in February 2008 examines government legal obligations to recapitalize central banks when their balance sheets became seriously impaired. The paper indicates that even in cases where the government is nominally responsible for maintaining the financial strength of the central bank, it may do so only in a cosmetic fashion. In a number of countries, governments have not provided central banks with financial support on a timely basis, leaving them excessively reliant on seignorage to finance their operations and/or forcing them to abandon monetary policy objectives.
In their working paper on issues in central bank finance and independence, authors Peter Stella and Åke Lönnberg first indicate that the central banks of advanced countries rarely make losses. As examples: the U.S. Federal Reserve system has made a profit every year since its first full year of operation in 1915; and the Netherlands’ Central Bank has made a profit every year save one since 1814.
In contrast, in other parts of the world, central bank financial problems have been quite
prominent for decades, due particularly to central banks’ involvement in government quasi-fiscal operations. In a number of cases, the root of long-standing problems has been the provision of credit to ailing banking systems and central banks’ subsequent attempts to issue debt to control immediate macroeconomic consequences. In those situations, central banks have found themselves financially weakened and highly constrained in terms of policy options. However, it is extremely rare for a central bank to be placed into liquidation (although this happened in the Philippines—a new central bank was created in 1993).
Concerns have been raised recently about potential financial difficulties being faced by central banks, because of the impact of the new International Financial Reporting Standards (IFRS). These require foreign exchange revaluation changes to be brought on to the profit- and-loss account. As most central banks have large net exposures to foreign currencies, there is enhanced likelihood of greater volatility in income and balance sheet statements. Central banks that previously might have revalued their assets infrequently or at arbitrary values are increasingly recognizing asset price volatility.
In some countries, volatility has also increased as central banks have accumulated large volumes of foreign exchange reserves. This has been the case particularly in countries experiencing current and capital account surpluses—energy exporters and high real growth exporters in Asia. The accumulation of foreign exchange reserves has exposed central banks both to potential revaluation losses should their currencies appreciate against the major international reserve currencies. With the global rise in international capital flows, central bank balance sheet leverage has also increased. These factors have contributed to a rise in central banks’ balance sheet risks, including the risk that central bank capital may be exhausted.
There are other factors contributing to increased concern for central bank finances, including: (1) a global decline in inflation and consequently declining central bank income from the inflation tax; (2) a reduction in unremunerated reserve requirements; (3) lessened taxation of the financial system; and (4) potentially larger contingent liabilities arising from growth in domestic and international financial markets, coupled with the central bank’s role in providing lender of last resort financing and rising sterilization expenditures.
The risk of central banks making losses, outside countries like the USA, Euro Area countries, the United Kingdom, etc., is not theoretical. The central banks of many countries in South and Central America have made consecutive losses for many years, in some cases averaging 2–3 percent of GDP per annum (data are presented for 15 countries).
Should one worry about such developments? After all, isn’t the central bank backed by the government? The paper discusses the integrated balance sheet approach, including citing Buiter’s view that “the concept of a financially independent central bank is vacuous…. First, the inflation target has to be financeable by the state, that is, the consolidated central bank and government. Second, when monetary policy is institutionally delegated to the central bank, the treasury has to ‘stand behind’ the central bank. ” Losses frequently arise when, in the midst of a banking crisis, the central bank with its “short-term deep pockets” provides risk-laden credit and thereafter hopes to be recapitalized by the government which, in this view, has the capacity to tax with “long-term deep pockets.”
Do legal provisions support this provocative view? Here, the evidence is mixed (an appendix to the working paper surveys over 50 countries’ central bank laws on this issue). On the one hand, some central bank laws support the view that the treasury stands behind the central bank; there are cases of laws that include explicit government guarantee of central bank liabilities. At the other extreme, there are central bank laws that explicitly indicate that the central bank is not responsible for the liabilities of the government, and that the government is not responsible for the liabilities of the central bank, i.e., the two are financially independent.
In a number of central bank laws, the bank’s indirect responsibilities can be inferred from the legal provisions governing how central bank losses or capital insufficiency would be addressed. Some countries’ central bank laws have general clauses, such as “if the general reserve fund, in any year, is insufficient to meet the losses of the central bank, or if it can not be used to meet the losses, the government shall cover the deficit.” When central bank reserves are inadequate, other countries’ central bank laws require legislative approval for recapitalization, for instance through the annual budgetary process. In yet other countries, the recapitalization appears in the law to be “automatic”. Some central bank laws are also relatively specific on how the recapitalization is to occur—by issue of securities or promissory notes, which the law may specify to be negotiable/non-negotiable and/or market-related or not market-related.
Whatever the legal provisions, what happens in practice when there are persistent central bank losses or capital insufficiency? Do treasuries actually stand behind central banks? The answer to the second question is frequently no, at least not on a timely basis. The paper provides evidence and reasons why governments are tardy or ineffective in bailing out central banks. These include: (1) governments simply fail to fulfill their legal obligations; (2) the transfer of resources from the treasury require legislative approval and this takes time; (3) central banks frequently have been “recapitalized” with treasury obligations with virtually no value (and later, recapitalized again with near-worthless instruments); (4) the government provides the central bank with a security, the debt service on which is to be paid out of the central bank’s own retained earnings; and (5) profit transfers to government in years with significant revaluation gains are not balanced by years in which large revaluation losses
Many central bank laws are silent as to how to treat losses, leaving the central bank prone to decapitalization. Moreover, there are no recognized standards for central bank capital, nor is the Basel risk-weighted asset-to-capital ratio applied.
The paper discusses how some central banks can run losses year after year, but continue to show positive capital. These include: (1) most central banks have not fully implemented IFRS, in particular, fair market valuation of assets. Thus, the accounting system may allow the nonrecognition of losses through the use of historical cost of acquisition for valuation; (2) the use of revaluation or adjustment accounts which do not impact on equity.
The paper proposes three possible “stages” or “layers” of central bank financial independence and discusses the problem with implementing these. The main one is that there is no internationally agreed technical trigger indicating central bank capital inadequacy. The authors note that this is impossible, since the real issue is not technical insolvency but policy solvency and its credibility. In conclusion, the appropriate degree of central bank financial strength is both policy-dependent and a political issue.
For the full report, see “Issues in Central Bank Finance and Independence” (IMF WP/08/37) prepared by Peter Stella and Åke Lönnberg of the IMF’s Monetary and Capital Markets Department.