What to watch in 2023: Central banks in the red

The era of ultralow and negative interest rates has been over since last year. This sea change means not just higher yields for investors, but also imposes massive losses on central banks. Although central banks can’t “go bankrupt” and are able to operate even with negative equity, the red ink on their balance sheets nonetheless has consequences. A long string of losses could endanger central banks’ independence.

A sea change for commercial banks and central banks

Banking stocks have ranked among the relative winners on the equity market in recent weeks and months. After a multiyear-long dry spell, net interest margin prospects for commercial banks have brightened considerably, and investors are finally seeing light at the end of the tunnel again, particularly for financial institutions in Europe that had long been plagued by ultralow interest rates. But the increase in policy interest rates and bond yields also has consequences for central banks – consequences that are neither trivial nor entirely unproblematic. Central banks, in fact, are piling up losses. The Reserve Bank of Australia (RBA) recorded a 2022 book loss of 37 billion Australian dollars, which more than wiped out the central bank’s equity. The Swiss National Bank (SNB) in early January reported a record preliminary loss of 132 billion francs for 2022. Last September, the central bank of the Netherlands notified the country’s government in a letter that it projects net interest losses amounting to a potential EUR 9 billion for the years 2023 through 2026. Even the US Federal Reserve has no longer been able to remit weekly billion-dollar transfers to the US Treasury since autumn 2022. Instead, a debt obligation to the US Treasury (a liability that the Fed recognizes as a deferred asset) has been growing on the Fed’s balance sheet since then. The Fed eventually will have to pay this liability sometime in the future (when it resumes generating profits).

The mechanics of the losses

The causes of the transformation from profit-generating machines to loss-making sinkholes sometimes differ in the details from one central bank to another. By and large, though, the primary cause lies in the massive expansion of central-banks’ balance sheets over the last decade, which is now becoming a problem. For instance, central banks by now have had to resume paying interest on the commercial bank deposits on the liabilities side of their balance sheets. Those deposits likewise have massively accumulated in recent years. This interest expense in the meantime now substantially exceeds the interest income that central banks book on the assets side of their balance sheets through their bond holdings because those bonds were purchased in the past mostly at considerably lower or sometimes even negative yield levels. Since the interest expenses will increase further in the months ahead as policy rates climb higher while interest income only looks set to rise comparatively slowly, net interest losses for now will continue to mount for quite some time yet. The mechanics of the losses in the example of the Bank of England (BoE) feature an additional driver of losses. In contrast to the Fed (and soon also the ECB), the BoE in its quantitative tightening operations is not only running off securities holdings without replacing them, but is also selling bonds that it had previously purchased at much higher prices and thus is actively incurring realized losses. The situation facing the SNB and the RBA looks a bit different. They rank among the few central banks that use the mark-to-market method of valuing their securities holdings. This explains their enormous book losses caused by last year’s poor equity- and bond-market performances.

From continuous surpluses… | …to a growing liability

US Federal Reserve transfers to the US Treasury and Fed liabilities as of September 2022 (in USD billion)

Sources: Bloomberg, Kaiser Partner Privatbank

Does it matter?

Are losses by central banks really a problem, or are they a non-event? The fact is that central banks remain completely capable of conducting monetary policy even if losses entirely wipe out their equity or turn it negative. Theoretically, a central bank can print as much money as it wants to at any time. It cannot become insolvent or go bankrupt. So, in theory, there is nothing that forces a central bank to repair an overleveraged balance sheet. One not-so-distant example of an overleveraged central bank is the Czech National Bank, which reported negative equity from 2002 through 2013 due to valuation writedowns on its sizable foreign currency reserves. Even the German Bundesbank, which was famously lauded by many for its commitment to a policy of stability, was technically overleveraged in the early 1970s because its losses exceeded its equity.

A feeble central bank, however, is not entirely without repercussions. Although it is not necessary to recapitalize overleveraged central banks, taxpayers are affected indirectly if central-bank losses lead to a reduction in or a cessation of profit distributions. This is exactly what has happened in the current example involving the Swiss National Bank. The gigantic losses at the SNB mean that Switzerland’s federal and cantonal governments have to completely forgo up to six billion francs this year. An extended string of losses would arguably present an even bigger problem. If the general public perceives a chronically overleveraged central bank as posing a devaluation risk to the national currency, this could jeopardize the central bank’s reputation. If policymakers then feel compelled to recapitalize the central bank to curb the reputation damage, this not only could endanger the central bank’s independence, but would also hurt its credibility as a guardian of the stability of the value of money.

Conclusion: Losses at central banks will continue to mount in the months ahead, but this does not necessarily constrain their ability to operate. However, the prospect of massive losses could prompt the Fed and the ECB, for example, to shrink the amount of assets on their balance sheets faster than originally planned (which would have the effect of further tightening monetary policy). In a scenario of a long string of losses, recapitalizations could cause central banks to lose credibility and autonomy. This issue is unlikely to quickly vanish from the agenda.