Are central banks about to take losses—even go insolvent? That question, or forms of it, appear to be popping up with increased frequency lately, paired with varying degrees of alarm. Some coverage focuses on unrealized losses in the Fed and other central banks’ bond portfolios tied to rising interest rates, as if this has implications for capital as it would for a commercial bank. Others dwell on negative net interest income, warning central banks’ operating in the red stores up trouble. We think all of the chatter misses some key points about how central banks function. Namely, it is impossible for central banks to go bankrupt, and their purported losses are not a financial crisis in the making, in our view.
Yes, it is true that the Fed, Bank of England (BoE), European Central Bank (ECB), Bank of Japan (BoJ) and others own a lot of bonds. And yes, it is true that bond prices are down this year, as they move inversely with interest rates. Hence, the market value of some of these central banks’ holdings is likely well below the purchase price. The Swiss National Bank (SNB) and others who own stocks as well as bonds are also sitting on declines, with the SNB’s year-to-date paper losses topping 20% of Swiss GDP.[i] Other researchers estimate the Fed has racked up about $1 trillion of unrealized declines this year.[ii] That is a lot of red ink for entities that supposedly underpin the financial system.
Yet it is also mostly imaginary red ink. Central banks aren’t like commercial banks. They don’t have regulatory capital requirements. They may report their assets at fair value, but they aren’t actually subject to mark-to-market accounting rules. They would take a loss if they were to sell assets for less than they paid for them, but only the BoE is presently selling bonds—and its holdings are in an account indemnified against losses by His Majesty’s Treasury. The Fed, meanwhile, is passively letting maturing securities roll off its balance sheet—no sales, no realized losses, except to the extent it may have bought bonds at a premium to par value years ago.
Then too, a central bank isn’t a company. It can’t declare bankruptcy, it isn’t subject to bank runs, and it doesn’t have to worry about making creditors and investors whole. Private entities do not have claims on it. Therefore there is no functional need to be solvent or liquid, whatever that would even mean for a public institution whose purpose is to serve monetary policy objectives and which cannot legally earn a profit. The Fed’s equity capital doesn’t represent controlling ownership, but rather it is a required contribution from banks that are members of the Federal Reserve System. That contribution is a percentage of member-banks’ capital, so the Fed’s capital rises as banks get bigger.[iii]
While paper losses are imaginary, the prospect of central banks paying more in interest than they receive is real. The Fed has been in this predicament since September, and its weekly operating loss hit a record -$7.2 billion in the week ending November 2.[iv] This is largely because its rate hikes have raised the interest rate on reserve balances to 3.9%, so payments have swelled even as the amount of reserves on deposit at the Fed has fallen by over -$1 trillion this year—and those payments have leapt ahead of the interest the Fed receives on its bond portfolio.[v] This all sounds bad, but it is a mere accounting entry—all it means is the Fed isn’t currently sending its net income back to the Treasury, which it is legally required to do. Instead, it places an item on its balance sheet called a “deferred asset,” which shows up as a negative liability. In practical terms, this means that once the Fed earns positive net income again, it won’t send remittances to the Treasury until it has earned enough income to cover the prior loss. This effectively sterilizes money the Fed might create to pay interest on excess reserves—because the Fed has to cover present losses with future income, it isn’t simply ballooning the money supply to satisfy its liabilities.
We guess there could come a point where the Fed’s losses grossly exceed its capital, but we are still skeptical that this would present grave problems. The SNB has had a negative equity position on several occasions in recent years, and the Czech National Bank has been in the red for 20 years now.[vi] Yet both have been able to implement monetary policy just fine, and neither has gone hat in hand to its Treasury for a recapitalization. The scenario may be new for the Fed, but it isn’t clear to us that there is a tipping point that would require Treasury backing above and beyond the deferral of remittances, which aren’t a government funding source but rather a partial return of interest paid by the Treasury.
Overall, we see the present concerns as a prime example of the morphing fears that typically accompany later-stage bear markets. The Fed has been a focal point during this bear market, with fears morphing from rate hikes to the reduction of its balance sheet and now its solvency. To us, that is a sign of how far sentiment has deteriorated, building a big wall of worry for the next bull market to climb whenever it begins.
[i] “The West’s Beancounters Are Guilty of a Great White Lie,” Ambrose Evans-Pritchard, The Telegraph, 11/7/2022.
[iii] “The Federal Reserve’s Balance Sheet and Earnings: A Primer and Projections,” Seth Carpenter, Jane Ihrig, Elizabeth Klee, Daniel Quinn and Alexander Boote, International Journal of Central Banking, March 2015.
[iv] Source: St. Louis Federal Reserve, as of 11/7/2022. Federal Reserve Liabilities: Earnings Remittances Due to the US Treasury: Wednesday level, 11/2/2022.
[v] Ibid. Reserves of Depository Institutions, Total, December 2021 – September 2022.
[vi] “Are Central Banks Going Bankrupt?” Robin Wigglesworth, Financial Times, 10/10/2022.
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