Central banks, especially in Europe, face an uncomfortable and potentially self-reinforcing accumulation of challenges over capital, profitability and credibility that could badly erode their independence and performance. Klaas Knot, De Nederlandsche Bank president and a pivotal figure on the 26-member European Central Bank council, has underlined the seriousness of the problems by publicly warning that central banks should ‘critically assess their capital levels’.
Central bank losses in northern Europe have been recognised since 2022 as adding to monetary policy-making complexity. They are likely to rise well above previously calculated levels – and persist for longer – if interest rates stay high in coming years.
A working paper by the International Monetary Fund in July 2023 stated that Eurosystem losses through large-scale quantitative easing purchases of government bonds were ‘temporary and recoupable’.
However, the forecasts in the IMF paper underestimate the true size of the current problem. The calculations did not foresee the further rise in ECB interest rates since summer 2023 and their persistence at high levels despite the fall in inflation.
A new version of the IMF paper, containing a recalculation of the euro area loss-making position, would intensify the debate on central bank capital. Although the IMF is looking at euro area central bank capital as part of its general work on central bank independence, there are no plans for an update of the July 2023 study.
Knot lifts veil over risk management
At a workshop on central bank capital organised by the Dutch central bank in Amsterdam, Knot lifted a veil over little-examined aspects of central banks’ risk management practices. In the nearly two decades since the 2007-08 financial crisis, central banks have greatly expanded their activities, including, in Europe, by taking responsibility for supervising large banks.
Above all, through the longer-term effects of QE introduced to counter the 2007-08 upsets and later the 2020 Covid-19 outbreak, central bank activities have become ever more risky. This has led to large accounting losses, reflecting sharp increases in interest rates since 2022 to combat inflation. Central banks have been faced with a large mismatch between their low (and sometimes negative) interest income on holdings of government debt, and their much higher payouts on sizeably expanded bank liabilities, with the Eurosystem deposit rate set at 4% since September 2023.
In the euro area, the losses have been concentrated on the northern national central banks. Their QE purchases have been concentrated on the relatively low-yielding bonds of their own generally more creditworthy governments. The skewed nature of north-south losses has been a result of a 2014-15 Eurosystem compromise allowing large-scale QE to start. This stated that NCBs would bear responsibility for the profits and losses on most securities purchased, rather than sharing them with other Eurosystem members.
The subsequent unforeseen outcome – sizeable losses on non-risk-shared northern portfolios – has led to discreet satisfaction at some southern euro area central banks which have been protected from large losses by higher returns on their own governments’ debt. The NCBs are the ECB’s shareholders. So the heterogeneity of their capital, accounting and operational arrangements, allied to the differences that have opened up in their individual financial positions, are a structural impediment to the overall smooth running of the Eurosystem.
Review of interest rate risk
Knot has been a member of the ECB audit committee since the beginning of 2022. During this time the committee has significantly tightened its review of the interest rate risk taken by the Eurosystem as a result of greatly increased QE.
In his Amsterdam speech, Knot said that, before across-the-board QE started in 2015, risk managers at De Nederlandsche Bank had reviewed possible negative effects on the balance sheet. They considered ‘extreme but plausible interest rate scenarios’ – but these did not include the pandemic or Russian invasion of Ukraine. The actual outcome – ‘a sudden and massive spike in inflation leading to an increase in policy rates [and] the current huge losses’ – was, Knot said, ‘the worst-case scenario’.
Knot dropped some hints about the ‘structural portfolio’ of securities the Eurosystem will build up in future years as part of its new operational framework. ‘It is crucial for the Eurosystem to consider its capital position in relation to these structural operations,’ Knot said.
The euro area balance sheet is likely to be significantly higher than in the years before 2007-08, due in part to commercial banks’ need to hold higher reserves at central banks.
Partly reflecting losses at northern euro area central banks, opinion is building that future bond-buying to replenish the euro area balance sheet should be ‘risk-shared’. However, because of the legal and political complexity of the issue, as well as the likelihood that necessary top-up purchases will not start until around 2028, the governing council has not started deliberations on the issue.
Central banks’ views about losses and occasional negative equity have fluctuated over time. When the capital position is under strain, central banks tend to play down the possibility of serious problems. Central banks, in contrast to commercial banks, do not have to value their assets and liabilities at market prices and – since they print money – cannot go bankrupt. However, in view of generally increased politicisation of central banking in recent years, as well as higher losses, there is now realisation that central banking accounting has strong political dimensions.
At the DNB seminar, there was criticism of the central banking practice of incorporating ‘deferred assets’ into balance sheet calculations, on the basis that current losses will be recouped as interest rates fall. This calculation could go badly awry if inflation stays high in coming years. Speakers urged an all-round assessment of the effects of QE, taking into account positive as well as negative effects on the economy and the broader public sector balance sheet.
Transparency on central bank capital and risks
Knot made a strong plea for transparency on central bank capital and risks. He said the ECB should be ‘more cautious’ about QE in the future. But if it were needed again, central banks ‘should clearly communicate the benefits of QE for price stability, for liquidity in the financial system and for the economic welfare of society – and they should also proactively communicate about the impact these purchases might have on their balance sheets.’
Knot did not dwell on an important corollary of the debate about QE. If, rather than staying high, inflation descends to overly depressed levels in coming years, and interest rates have to be cut again to zero or even negative levels, it will be highly difficult to restart QE in the same way as in 2015, because of worries about repeated loss-making.
Another key issue in interactions with government finance was widely debated at the DNB conference. It is generally accepted that governments need to protect central banks from the impact of losses, by absorbing them either at the time they occur, or over a period of time. This can take place through curtailed dividend payments, transfers to the central bank from central government or, in extreme cases, recapitalisation (which can take place, for example, by the government transferring a bond from its books to central bank ownership)
The stronger the fiscal position of the central government, the better will be the capital position and general security of the central bank. However, too close an interaction with the government over shoring up the capital position – for example, through complicated intra-public sector asset swap arrangements – could itself generate doubts over the independence of the central bank.
Furthermore, government efforts to help central banks can end up impairing the fiscal position of the state itself. So, if this cycle continued, it could turn negative, with ill-effects for all concerned. The emergence of large losses at leading euro area central banks has arguably shown the steadfastness of central bank independence. Central bankers have resisted the idea of lowering interest rates to counter worsening profitability. However, past sturdiness does not guarantee that such behaviour will continue, especially as central banks change leadership in coming years.
In his assessment of the future, Knot – who steps down from De Nederlandsche Bank and the ECB council in summer 2025 after two seven-year terms – said central banks should be ‘forward-looking’ and build up capital accordingly. ‘More risk means more capital’. He made clear successors will face difficulties. ‘Central banks are not expected to return to their lean balance sheets of the pre-QE era any time soon – which means that they will face heightened financial risks for quite some time to come.’
David Marsh is Chairman of OMFIF.
