Macro

FED, BoE, ECB: How strong are central banks to not fail?Oct 11, 2022

Central banks FED, BoE, ECB may not fail because they know when losses matter and when they don’t.

Quantitative Easing (QE) changed central bank balance sheets forever. In August 2007, the Fed’s balance sheet was about $900 billion, and this year peaked at $9 trillion. Within 15 years its balance sheet was raised 10 times more. However, the answer is that central banks are not going to fail, because it is worth thinking about when losses matter and when they don’t.

FED, BoE, ECB: How strong are central banks to not fail? FED's Balance Sheet Monthly Chart
FED’s Balance Sheet Monthly Chart

All FED’s revenues generated by the Open Market Account System portfolio, less interest expense, realized losses, and operating expenses, are remitted to the US Treasury. Before the Global Financial Crisis, these remittances averaged $20-25 billion a year swelling to more than $100 billion as the balance sheet grew. These remittances though reduce the deficit and borrowing needs. Net income depends on the (mostly fixed) average coupon on assets, the share of interest-free liabilities (physical paper), and the level of reserves and reverse-repurchase balances, the cost of which fluctuates with the policy rate.

FED, BoE, ECB: How strong are central banks to not fail? FED's earnings remittances
FED’s Earnings Remittances

From virtually zero in 2007, interest-bearing liabilities have soared to nearly two-thirds of the balance sheet. As the chart shows, the Fed’s net income has turned negative, and losses will deepen as the policy rate rises.
Because the Fed—like most central banks—does not mark its assets to market. Portfolio losses are unrealized and do not pass through the income statement. So, what do losses mean? Is capital affected? First, remittances to the government end and the government issues more debt, according to Morgan Stanley. The Fed then piles on its losses and, instead of reducing its capital, creates a “deferred asset”. When profits turn positive again, remittances remain at zero until losses are made. Profitability will eventually return because the currency will continue to appreciate, reducing interest expenses, and QT will shrink interest-bearing liabilities.

BoE has an express indemnification agreement with the UK Treasury for losses from QE. The result is essentially the same as the Fed, but the political economy is different. Where the Treasury and the BoE share responsibility, the Fed stands alone. Passive clearing for the BoE is difficult given the uneven duration structure of gold holdings, while the Fed has up to $95 billion a month being passively cleared. For the BoE, a one percentage point rise in Bank Rate cuts remittances by around £10bn a year, a significant amount for a country facing fiscal problems. The proposal to reduce costs by prohibiting the payment of interest on reserves deserves careful consideration. Otherwise, the BoE will have to sell assets to regain monetary control, incurring losses.

ECB’s balance sheet is structured quite differently, but the logic is similar. The deposit rate will settle at 2.5% by next March regarding the forecasts, implying losses for the ECB of around 40 billion euros next year. Bank deposits get the depo rate, which will be much higher than the portfolio yield.
In conclusion, Central bank losses matter, but only when they matter. They affect fiscal outcomes and may have political ramifications, but banks’ ability to conduct policy- like the definition of ‘’political economy’’ in the early 1900s – is not affected.

by Stavros Chanidis

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