Central bank profits under pressure

Profits aren’t the main objectives of a central bank, but a dependence on government to recapitalise the bank can pose a risk to a central bank’s independence. In turn, central bank independence exists in part to prevent reckless government financing.

It is true that central banks can operate with negative equity: Israel, the Czech Republic and Chile are examples. Indeed, European Central Bank president Christine Lagarde has said the ECB, as the sole issuer of euro-denominated central bank money, can “neither go bankrupt nor run out of money”.

However, some banks are facing political pressure to share their profits – and non-compliance can have consequences.

The Bank of Mexico (Banxico) governor would not be having his mandate renewed, said president Andrés Manuel López Obrador on May 21. López Obrador linked his decision to the central bank’s refusal to share its operational profit. Banxico did not produce enough profit to fund a dividend, Central Banking reported in April. Profits to the federal government are only transferred by law if the transfer “does not imply a reduction of reserves from asset revaluation”, says Article 55 of the Bank of Mexico law.

The Central Banking Corporate Services Benchmarks 2021 report found that rules for distributing profit vary considerably between central banks. In that survey of nine central banks, percentages of profits transferred to shareholders in recent years ranged between 50% and 95%. Many excluded unrealised gains and losses from distributed profits, and two-thirds of central banks surveyed had an agreement with the government that the bank would be recapitalised if needed.

Government deficits have grown, but the extraordinary circumstances of the past year mean the risks on central bank balance sheets have grown, too, putting pressure on central bank profits to perform multiple roles. The structure of the banks’ portfolios, as well as the relationships with shareholders – usually the government – factors into central banks’ decisions on how capital is used to absorb shocks and the amount of distributed profit.

Increased risk provisioning

The Deutsche Bundesbank this year announced it would not be distributing profits for the first time in over 40 years. It normally transfers 20% of the profit, after €250 million ($305 million) has been transferred to the statutory reserves to top these up to a minimum €2.5 billion.

“Default risk is an important element for risk provisioning,” Susanne Kreutzer from the communications team at the Bundesbank, tells Central Banking. In 2020, holdings under the corporate-sector purchase programme increased by €15.85 billion. In addition, new purchases of corporate-sector securities under the pandemic emergency purchase programme amounted to just under €7 billion at the end of 2020. Kreutzer notes that corporate bonds come with higher credit risks than sovereign debt.

Provisions for general risks amounted to €18.82 billion as of December 31, 2020. “A further increase in risk provisions is expected to be reported in the annual accounts for 2021,” she says.

Negative equity

For the Czech National Bank, tensions between the governor and the prime minister played out publicly in 2021. Governor Jiří Rusnok faced a public request from prime minister Andrej Babiš on March 22 for the central bank to share its profits. The next day, Rusnok denied the request, saying the 2020 profits would be used entirely to cover losses from previous years.

“The Czech National Bank, the bank board or any member of the bank board may not, by law, accept or demand instructions from the president, the government, the parliament, administrative authorities or any other entity,” wrote the governor in a response posted on the CNB’s website.

Tomáš Holub, a board member of the CNB, says the bank is currently implementing a strategy to deal with the sudden loss of Kč243 billion ($11.7 billion) in 2017, triggered by the removal of a foreign exchange floor. But negative equity, he argues, does not compromise the central bank.

“The Czech National Bank used to have negative equity,” Holub tells Central Banking. “It lasted for around 16 years from around the start of the millennium, roughly till 2014.”

A key reason was the appreciation of the koruna. The asset side of the balance sheet of the CNB has traditionally been dominated by FX reserves, and the portfolio is mark-to-market.

Since then, the CNB has been working to rebuild its buffers. “We were following a strategy of rebuilding our equity out of future earnings, and this strategy actually worked,” the board member adds.

The introduction of the FX floor in November 2014 helped the CNB rebuild its buffers.

“When we depreciated the currency by around 5%, of course, there were some accounting profits associated with it,” says Holub. “And that brought our equity back to a positive range for several years.”

But the positive equity situation stopped abruptly once the CNB discontinued the FX floor in early 2017, and the central bank began operating with negative equity once more.

We do not see negative equity as any kind of immediate threat to the central bank’s functioning or independence. We were able to fulfil all our legal duties, even in a negative-equity situation

Tomáš Holub, Czech National Bank

“We do not see negative equity as any kind of immediate threat to the central bank’s functioning or independence,” says Holub. “We were able to fulfil all our legal duties, even in a negative-equity situation.”

Once more, the CNB finds itself rebuilding equity out of future profits. Indeed, the board had already decided to retain last year’s profit when Prime Minister Babiš made his request.

Although the government is entitled to its share of the CNB’s profits, the law is written in such a way that, “essentially, the government is the last in the queue”, says Holub: “So, first we need to cover the past losses and our operating expenses. Then, if some money remains, we should decide how much of the profit we should allocate to the reserve fund to cover future losses, and only afterwards, the residue goes to the government.”

Bigger buffers

David Kjellberg is an adviser in the strategy division of the markets department at the Sveriges Riksbank. The Swedish central bank is currently strengthening its risk buffer. Citing low interest rates, the Riksbank in 2019 acknowledged in a paper co-authored by Kjellberg that it may need to find other sources of earning to avoid recapitalisation and remain financially independent.

The Riksbank transfers to the Treasury 80% of the average profit or loss for the past five years, adjusted for revaluation results. Now, the central bank is also adding a Skr5 billion ($605 million) buffer – a decision it took in 2021. In its annual report, the Riksbank deems that “in the longer term, the buffer will have to increase by Skr15–50 billion”. The central bank’s accounts show that it experienced an exchange rate loss of Skr13.34 billion last year. However, this loss was excluded from the calculation of profits, meaning that the adjusted profit is positive.

“Since 1988, the profits to be distributed to the state have been calculated in a specific way, where gold and exchange rate effects are excluded. So there are different result measures,” explains Kjellberg.

In the reported result, realised exchange rate effects are included, and in the result measure for dividends, all exchange rate effects are excluded.

There is a need to build reserves, Kjellberg says: “Given that the expanded balance sheet brings higher risks – mostly interest rate risk, from buying domestic long-maturity bonds funded by increasing reserves remunerated with variable interest rates connected to the monetary policy rate – there is a need to have higher risk buffers to reflect that.”

Political pressure

Swiss National Bank governor Thomas Jordan gave a defiant speech at the end of April, saying SNB distributions are “not a matter of course even when profits are high”.

The central bank, he said, used every means at its disposal to perform its mandate in adverse circumstances. Interventions to hold down the value of the Swiss franc have caused the SNB’s balance sheet to balloon, adding to risks and encouraging it to be conservative with its buffers. But not all members of the cash-strapped government were understanding.

Controversy over profits is steeped in history, the governor continued: “There was already heated debate on this more than 100 years ago, as the rules governing the distribution of profits were one of the most contentious issues in the run-up to the creation of the SNB.”

In a similar way to the US Federal Reserve, the Swiss cantons received shares in the central bank in exchange for giving up their right to print money.

In January, a new agreement was set out for profit distribution among the SNB, the confederation and the cantons. Despite making profits, the bank will cap distribution at Sfr6 billion ($6.7 billion), which would allow reserves to increase. Against the backdrop of very low yields and high upward pressure on the Swiss franc, it could not be taken for granted that the SNB would achieve a profit, Jordan said.

Despite the Swiss controversy, a clear profit-sharing framework can help diffuse tensions. In India, for example, in 2019, a committee led by former governor Bimal Jalan developed a range for the bank’s optimal capital, and stipulated that unrealised gains must not be handed over to the government. Although the framework has alleviated some of the frictions between the Reserve Bank of India and the government, the RBI has still been under pressure to hand over profits at the upper end of the agreed range.

Optimum buffers

Francesco Papadia, former director-general for market operations at the ECB, co-authored the paper Should we care about central bank profits? in 2018. Although central banks can simply “print” more money, he says, “I don’t agree that the central bank does not need buffers, because it has this ability to pay in something that it produces”.

It is good that central banks have buffers, so “that they have capital to absorb possible losses,” says Papadia. However, he states that it’s not true that a bigger buffer is always better: “There is an optimum level of buffers. It is not a precise empirical measure, but ideally you would think a bit like a commercial institution.”

Like commercial institutions, one should consider the types of shocks that a central bank is likely to experience. Papadia says central banks should “want to be able to absorb 99% of shocks”, but central banks must invest in very liquid and safe assets, which normally have low returns. Overinvesting into these types of assets could forfeit more remunerative investment opportunities.

In each case, “it depends on the risk to which the central bank is exposed”, he says: “For instance, a central bank that does a lot of foreign exchange intervention probably needs bigger buffers than a central bank that doesn’t do so many interventions.”

We use risk scenarios, simulations from a macrofinancial model and a value-at-risk approach to get some different estimates of how big the losses for the Riksbank could be in the coming years, and to what extent the capital will be below a desired minimum level

David Kjellberg, Sveriges Riksbank

Kjellberg explains that during the Riksbank’s calculations, the Swedish central bank models how capital buffers are likely to evolve: “We use risk scenarios, simulations from a macrofinancial model and a value-at-risk approach to get some different estimates of how big the losses for the Riksbank could be in the coming years, and to what extent the capital will be below a desired minimum level.”

For the Riksbank, corporate bonds are less of a concern, he says: “Our general risk assessment does not point to any specific part of our holdings. However, the corporate bond holdings are investment grade and a small part of our total holdings – approximately 1% of SEK bond holdings, meaning that they are not a large contributor in this risk assessment.”

Kjellberg says central banks must be cautious with their financial position: “A central bank is typically financially robust, as it can create reserves at will, and can withstand large losses well. However, there is a risk that if a central bank faces big losses, it can lose financial strength and become less financially independent. A central bank with insufficient financial strength could jeopardise the general confidence in the central bank’s ability to maintain price stability. Prudent risk management is therefore part of the central bank’s responsibilities.”