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Central bank capital adequacy; the simple analytics and complex politics
CEPR
2024.05.13
Central banks in many advanced economies have since 2022 incurred huge operating losses and unprecedented balance sheet losses, mostly not (yet) realized mark-to-market losses. A key driver of this financial shock was the massive expansion of central bank balance sheets following the Great Financial Crisis of 2007-09 and again following the start of the Covid pandemic in 2020. Large quantities of long-duration, fixed rate debt instruments were purchased in these Quantitative Easing and market marker of last resort operations at very high prices, reflecting the unprecedently low policy rates of interest and longer-duration interest rates. Operating loss es were driven mostly by the higher interest rates central banks had to pay on commercial bank reserves. Many central banks, including the Fed and the ECB have avoided reporting negative equity by valuing most of their assets at historic cost rather than at fair value.
In addition, both the Fed and the ECB add reported losses that would take their equity below some threshold level as positive assets (or, in the case if the Fed, negative liabilities) on their balance sheet. This extraordinary accounting gimmick (called a deferred asset by the Fed) can be viewed as a selective and misleading attempt to add a subset of the implicit assets and liabilities found in the comprehensive balance sheet (or intertemporal budget constraint) of the central bank to the conventional balance sheet containing only contractual and legally enforceable assets and liabilities. The conventional balance sheet of the central bank is a poor guide to equitable insolvency risk of the central bank even if the deferred asset fudge is corrected and even if all assets are priced at fair value.