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Research How central bank losses can be handled

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2005
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In normal circumstances, a central bank should be able to operate at a profit, based on seigniorage—the net revenue it earns as the issuer of the national currency. For various reasons, however, a number of central banks across the world have recorded losses over the past two decades. Why should this raise concerns, and what can be done about it? A recent IMF Working Paper lays out principles and practices for handling central bank losses.

Central bank losses can arise in several ways. They can stem from day-to-day operations—when operating expenses exceed operating income—or when revaluation losses on assets and liabilities (including currency revaluations) occur. Central banks have also incurred losses in connection with activities that go beyond their conventional functions of stabilizing the country’s currency and domestic price level. The central banks of Bolivia, Chile, The Gambia, Guyana, Jamaica, Madagascar, Peru, the Philippines, and Turkey, for example, incurred significant losses during the 1980s and 1990s as a result of various quasi-fiscal activities, such as the provision of subsidies or price guarantees, and costs associated with financial sector restructuring. In a number of these cases, the accumulated losses were equivalent to a significant proportion of GDP before they were addressed.

Even good policies may see losses

In recent years, the pursuit of sound policies by many central banks—in both developing and advanced economies—has contributed to historically low inflation and interest rates, including on liquid assets denominated in reserve currencies. The associated low yields on international reserves, together, in some cases, with currency revaluation losses, have negatively affected the profits and capital positions of a number of central banks. In 2004, for example, the European Central Bank (ECB) incurred net losses of some €1.6 billion largely from an appreciation in the external value of the euro. This saw write-downs (of some €2.1 billion) of the euro value of the ECB’s holdings of foreign reserve assets because of revaluations. Financial buffers established by the ECB and its member central banks absorbed these losses, and the net worth of the ECB remained positive. Elsewhere, the Reserve Bank of Australia recorded revaluation losses of $A 1.4 billion in its 2005 financial year. These losses reduced net profits to some $A 74 million. They were fully absorbed in a reserve of unrealized profits, which acts as a financial buffer for foreign currency losses, and net worth remained positive.

In many countries, the costs of implementing monetary policy, in combination with low yields on international reserves, have also affected central bank profits negatively. Typically, this has occurred when the financial cost of liquidity absorption has exceeded income earned on the international reserves acquired. The negative financial impact can be worse when central banks do not have access to an adequate supply of government securities and must, instead, use central bank bills to absorb liquidity.

Why disclosure is important

A central bank incurring net operating losses is, in effect, creating liquidity, because it is transferring more cash to external entities than it is receiving. Failure to address these losses, or any ensuing negative net worth (when the value of a central bank’s assets falls below its liabilities), is likely to interfere with monetary management and jeopardize the central bank’s independence and credibility.

Revaluation losses do not have the same liquidity effect as operating losses but signal the possibility of future outflows as losses are realized. These losses need to be recognized promptly so that appropriate financial buffers can be established. Ignoring such losses in the hope that they may be reversed is not good practice.

To ensure transparency, net losses and their impact on central bank net worth must be properly disclosed in the income statement and balance sheet, respectively. In those cases where losses reduce net worth below legally mandated levels or result in negative net worth, remedial action will be required to ensure that the central bank has adequate financial resources to cover the costs of its policy responsibilities.

The need to adequately cover central bank losses and negative net worth is now recognized in the laws of many countries through provisions for government support. Usually, this support takes the form of a budgetary appropriation by the central government in either cash or government securities to recapitalize the central bank.

Going out of business?

The notion of insolvency (or negative net worth) for a central bank differs from that pertaining to commercial enterprises, although similar accounting rules usually apply. Unlike insolvent commercial enterprises, a central bank with negative net worth will not experience the sanction of official liquidation. Its legal status as a specialized monetary agency, in effect, enables it to continue to increase liabilities after this would have ceased to be an option for a commercial enterprise.

While central banks do not “go out of business,” resolution strategies for addressing negative net worth may see significant changes in a central bank’s policy and functional responsibilities. In some cases, as in the Philippines in 1993, central banks have been reestablished with a new legal identity and powers. In many cases, such changes have formed part of a broader program to restore the health of the financial system or ensure macroeconomic stability.

Circumstances may arise in which the government is unable to recapitalize the central bank. In these cases, the bank should be prepared to disclose its net worth to the public and to take actions to restore and maintain net worth over time. Such disclosure provides assurance that management is taking action and also alerts the financial sector, and the public in general, that the central bank will need to adopt a stringent and prudent approach to any further creation of credit or extension of central bank financial support.

Preserving central bank financial health

Experience has shown that, left unresolved, central bank losses are more likely to worsen over time than to correct themselves. As a corollary, the fiscal costs are also more likely to increase than decrease. Measures used to address threats to a central bank’s financial position have included

• avoiding overburdening the central bank with tasks that go beyond responsibilities for monetary and financial stability;

• having the government assume responsibility for any quasi-fiscal costs of the central bank;

• identifying the causes of losses to remove or limit their potential to lead to future losses;

• establishing sound budgetary and financial controls over central bank operating expenditures;

• properly resolving accumulated losses as one means of restoring operating earnings;

• adopting risk-management policies that take into account the potential impact of global macroeconomic developments, and other contingencies;

• establishing adequate financial buffers; and

• developing a communications policy to explain to the public the nature and potential impact of central banking risks and measures used to protect the bank.

Central bank legislation can help in ensuring that adverse financial results do not distract the central bank from its prime objectives. Typically the legislature must include

• the use of financial buffers to cover operational losses and other risks. The level of these buffers may be set as a multiple of capital or, preferably, as a percentage of the central bank’s monetary liabilities. Distributable profits are directed first to establishing or maintaining required levels. If profits are insufficient, then negotiable securities that bear interest at market-determined rates may be required; and

• measures to address negative net worth—when losses have exhausted all capital and reserves—or net worth ratios that are below mandated levels. When such points are reached, the government would need to issue to the central bank negotiable securities that bear interest at market-determined rates. This process restores balance-sheet solvency, provides an additional source of earnings to cover policy and operating expenses, and thereby reduces the scope for further operating losses.

Sound accounting practices are essential

There is some debate about which specific accounting standards should apply to central banks. Ultimately, the proper identification and measurement of any losses, and of their impact on net worth, and the selection of resolution strategies, must be based on information produced in accordance with a sound and credible set of accounting standards.

The use of widely recognized standards ensures accurate recognition and valuation of the financial assets and liabilities that are the “stock in trade” for monetary and exchange rate policy implementation. These same standards also allow external auditors to attest to the truth and fairness of the information contained in a central bank’s financial statements. The choice becomes paramount for a central bank seeking to explain the financial outcomes—good or bad— of policy choices that are driven by the pursuit of economic policy goals rather than by financial gain.

Copies of IMF Working Paper No. 05/72, “Central Bank Losses and Experiences in Selected Countries,” are available for $15.00 each from IMF Publication Services. Please see page 364 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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