Central banks pride themselves on being data-driven and consensus-governed. Surprisingly, policymakers have not much consensus on one fundamental question: how much capital such institutions need to hold, IMF says.
Unlike commercial banks, there are not nationally uniform minimum capital requirements for central banks. Central banks can never go bankrupt as they always have the option of printing their own money to discharge their nominal payment obligations. Still, an inferior capital base can lower institutional credibility and even increase risks to independence. Central banks are thus interested in maintaining sufficient capital buffers. But there is disagreement on how to do it.
This is the reason we recommend including a new approach to stress-testing central banks so that they can enjoy a healthy financial position.
Balance sheet risk did not receive much attention throughout much of central banks' long history. Before the global financial crisis, they always had small balance sheets and were typically profitable. This was because currency, their biggest liability, did not earn any interest, and because they could invest the proceeds from issuing currency in interest-bearing government debt. The majority of the profit was paid out as dividends to governments.
But the issue, which may appear abstruse, is much more practical today with central banks having taken on so much more balance sheet risk, like using big-picture asset purchases to stimulate a quicker recovery from the GFC and pandemic.
Managing risk
This additional risk has been incurred at a cost of huge losses, having bought long-term bonds on low interest rates and then having had to raise interest rates sharply. While the losses are not the best measure of the social value of central banks action, which shortened the duration of the recessions and improved financial stability, they do suggest that caution should be used in considering how to reduce balance sheet risk more efficiently.
Reading central bank bylaws does not provide much guidance on what to do. Most have their authorized capital stated in a fixed figure, one that becomes irrelevant as time passes because of inflation. Few make adjustments in their capital—according to inflation or gross domestic product—in order to keep it relevant.
Not surprisingly, current laws regarding the dispersal of central bank profits are also very mechanical. They order in some cases exactly how much profits should be distributed or kept behind, resulting in too much or too little capital. Ideally, those rules compel banks to keep profits behind until they have a minimum of capital. But legal requirements vary widely—from 8 percent to 20 percent of base money—and levels have little rationale. On the other end, some central banks have no regulations on capital and leave it to the discretion of their boards of directors on how they should approach managing risks. Regardless of how they choose to go about it, though, central banks are not very forthcoming about making their methodology publicly known.
There is a more effective way. The answer is to make capital cushions more focused on "policy solvency"—with the ability of the central bank to fulfill its mandate in a world of substantially greater balance sheet risk. This requires consideration of several factors, including institutional purposes and activities.
Shock absorber
In specific terms, stress-testing can help a central bank to make an estimate of the scale of the capital that would allow it to survive huge but plausible shocks without pushing capital to such low levels as to erode its credibility and independence. To this end, IMF staff developed a quantitative model, building on 2015 research by Robert E. Hall and Ricardo Reis, that allows testing how capital would evolve in a model sensitive to interest rate risk, credit risk, and foreign exchange risk. A stress test would also take into account inflation and other more generic economic dynamics, and how these would affect capital.
This approach can also be used to ascertain when a capital injection through retained profits is acceptable—or how and when to return profits without maintaining capital levels. Some central banks may desire such a risk-based approach, provided that they believe that a reduced capital level could limit their independence. Others may view little risk of impinging on their credibility or independence, and would like to leave things as they are with current policy for returning capital. But even here, they could see stress-testing as a way of enhancing transparency on the likely effects of balance sheet operations such as quantitative easing, and welcome for the sake of public accountability.
Source: IMF