Issues in Central Bank Finance and Independence

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Conventional economic policy models focus only on selected elements of the central bank balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an "independent" central bank assumes that it chooses money (or an interest rate), unconstrained by a need to generate seignorage for itself or government. While a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy the idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation is a relatively novel idea considered in this paper. If one accepts this potential constraint as a valid concern, the financial strength of the central bank as a stand alone entity becomes highly relevant for ascertaining monetary policy credibility. We consider several strands of evidence that clearly indicate fiscal backing for central banks cannot be assumed and hence financial independence is relevant to operational independence. First we examine 135 central bank laws to illustrate the variety of legal approaches adopted with respect to central bank financial independence. Second, we examine the same data set with regard to central bank recapitalization provisions to show that even in cases where the treasury is nominally responsible for maintaining the central bank financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided central banks with genuine financial support on a timely basis leaving them excessively reliant on seignorage to finance their operations and/or forcing them to abandon policy objectives.


Conventional economic policy models focus only on selected elements of the central bank balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an "independent" central bank assumes that it chooses money (or an interest rate), unconstrained by a need to generate seignorage for itself or government. While a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy the idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation is a relatively novel idea considered in this paper. If one accepts this potential constraint as a valid concern, the financial strength of the central bank as a stand alone entity becomes highly relevant for ascertaining monetary policy credibility. We consider several strands of evidence that clearly indicate fiscal backing for central banks cannot be assumed and hence financial independence is relevant to operational independence. First we examine 135 central bank laws to illustrate the variety of legal approaches adopted with respect to central bank financial independence. Second, we examine the same data set with regard to central bank recapitalization provisions to show that even in cases where the treasury is nominally responsible for maintaining the central bank financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided central banks with genuine financial support on a timely basis leaving them excessively reliant on seignorage to finance their operations and/or forcing them to abandon policy objectives.

I. Introduction

This paper discusses several issues in what might be termed “central bank finance.” A particular focus is placed on the financial structure of the central bank balance sheet and the legal and institutional arrangements shaping central bank and government financial relations. The importance of those relations for central bank financial independence is stressed.

It would appear that the corporate financial structure of central banks has received little explicit attention in recent decades apart from the debate surrounding the establishment of the European Central Bank. The index of Stiglitz’s textbook “Economics of the Public Sector” (second edition) yields but one reference to “central bank” in a footnote on page 26 to the discussion of how to define the public sector. The index of Tirole’s “The Theory of Corporate Finance” yields no mention of central banks.

This neglect of central bank corporate finance may be attributed to several factors which have led to the view that central bank finances can be ignored as they are either: macroeconomically insignificant; properly analyzed only within the consolidated public sector accounts; or irrelevant owing to the central bank’s unlimited ability to create money. Each of these factors will be considered in turn in this paper as the views based on them underpin the dominant tendency to model the independent monetary policy process as the choice of either a money supply or interest rate unconstrained by any requirement that the central bank intertemporal budget constraint be met. This last assumption we have found in many countries to be highly problematic.

The view taken in this paper is that it is necessary to evaluate the corporate financial structure of the central bank as a stand-alone entity, particularly when one is evaluating the monetary policy credibility of an independent central bank.2 That said, for other purposes it is appropriate for the state’s consolidated budget and balance sheet to be the focus of attention and hence the assets and liabilities, as well as the income statement of the central bank are appropriately amalgamated with the fiscal accounts. For example, in evaluating sovereign debt sustainability or the overall fiscal stance, consolidating the operations and balance sheet of the treasury and central bank can be essential.3

These views are controversial, however, as is the substance of the concept of central bank financial independence. The controversy is reviewed in Section III of this paper. In Section II we will discuss why there has been increasing interest in central bank finance in recent years; Section IV considers the results of a review of legal provisions pertaining to these questions; while Section V asks whether treasuries provide financial support to central banks in practice. Section VI provides some ideas as to how financial independence can be safeguarded.

II. The Increasing Relevance of Central Bank Financial Strength and Independence

In part, the impression that central bank finance is a new concept is illusory and reflects a certain innocence or ignorance in certain parts of the world where central banks have been habitually quite profitable and either seemingly financially unconstrained (in a fiat money world) or subject to strict limits on the nature of their balance sheets (under metallic standards). Part of the failure to see the relevance of central bank financial strength is clearly related to the situation in most countries where economic textbooks have been written and published. The U.S. Federal Reserve system has made a profit every year since 1915. De Nederlandsche Bank has made a profit every year save one since 1814. Walter Bagehot, in his classic “Lombard Street,” wrote “Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt” (page 208, 14th ed., 1873). Recent institutional arrangements in the United Kingdom which ensure that the Treasury underwrites the risk attending emergency lending—such as has been the case with Northern Rock as in September 2007—provide even greater assurance of the Bank of England’s financial position.

However, in other parts of the world, central bank financial problems have been quite prominent for decades, in particular, those difficult situations where central bank financial structures have been debilitated by quasi-fiscal operations. Central banks have been unable to meet their most basic functions—including supply of banknotes—owing to financial distress; have changed policy in order to reduce losses; and, in at least one case, the Philippines, have been placed into liquidation.

In a number of cases, the root of long-standing problems has been the provision of credit to ailing banking systems and the respective central banks’ subsequent attempts to issue debt to control their immediate macroeconomic consequences.4 In those situations, central banks have found themselves financially weakened (abandoned rather than independent)—and highly constrained in terms of policy options—whatever the legal or theoretical considerations that suggest that they should have been supported by treasuries. As the current president of the Central Bank of Costa Rica has said “We, the central bank, have a negative net worth…and this remains our greatest challenge.”5

More recently, concerns have been raised about (potential) financial difficulties being registered by advanced country central banks—and in central banks in important emerging financial markets.6 Here it is useful to separate the recognition of financial losses and the actual causes of the losses.

Regarding the recognition of financial losses, the general movement toward greater financial transparency in central bank financial accounts has been apparent over the past 15 years.7 This has been accompanied by improved clarity in world accounting standards for corporations in general. Of particular relevance in this respect is the gradual adoption of International Financial Reporting Standards (IFRS) for corporates, which has spread to certain central banks.

A key element of IFRS is the requirement that foreign exchange revaluation changes be brought to the profit and loss account of the entity in question. As most central banks—as an essential element of their institutional roles—have large net exposures to foreign currencies, the adoption of IFRS brings with it the possibility of volatile income and balance sheet statements. Even in those countries where IFRS has not been adopted, there has been a worldwide trend to adopt mark-to-market and/or fair value accounting for assets and liabilities. Thus central banks which previously might have revalued their assets infrequently or at arbitrary values, are increasingly recognizing asset price volatility.

Whereas in the past, central banks might have set aside revaluation losses and/or accumulated losses in opaque asset accounts, they are now more likely to reflect these losses in the profit and loss accounts and in equity. Thus the risks coming from heightened exposure in particular to foreign exchange revaluation losses have become more apparent. The combination of this trend with mechanical rules for distribution of central bank profit that were designed for a less volatile environment raises an important corporate finance issue that will be touched upon later.

Apart from the increased recognition of volatility, central banks have become more exposed to volatility and under increased profit pressures. Volatility has risen as central banks have accumulated large volumes of foreign exchange reserves, in absolute terms and as a proportion of their assets. This has been the case particularly in countries experiencing current and capital account surpluses—energy exporters and high real growth exporters in Asia. This increase in the exposure of central banks to exchange rate volatility has been noted both by researchers and the financial press8. This accumulation of foreign exchange reserves has exposed those central banks both to potential revaluation losses were their currencies to appreciate against the major international reserve currencies and to cash flow losses. The cash flow losses result from the issuance of central bank debt to sterilize the local currency counterpart of foreign exchange purchases when exchange rate appreciation has been resisted. The global rise in the magnitude of capital flows, in relation to the size of central bank balance sheets, has increased central bank balance sheet leverage. These factors have contributed to a rise in the risks inherent in the balance sheet and consequently to a rise in the risk that central bank capital—as conventionally defined—may be exhausted. (See Figures 1 and 2)

Figure 1.
Figure 1.

Ratio of Net Foreign Assets to Central Bank Capital

(106 Countries—1991, 2001, 2006)

Citation: IMF Working Papers 2008, 037; 10.5089/9781451868999.001.A001

Source: International Financial Statistics
Figure 2.
Figure 2.

Ratio of Net Foreign Assets to Central Bank Capital for 106 Countries

Citation: IMF Working Papers 2008, 037; 10.5089/9781451868999.001.A001

Source: International Financial Statistics

Another factor behind the concern regarding central bank finances has been a global decline in inflation and consequently declining central bank income from the inflation tax9. With a reduction in the quantity of non-interest bearing money, lower inflation, and rising foreign exchange sterilization costs and revaluation risks, the prospects of central bank losses have increased. Somewhat preceding this decline in inflation in many countries has been a reduction in the quantity of unremunerated reserve requirements and lessened taxation of the financial system. Globalization of capital flows has played a part in this, beginning in the 1970s with the development of the Eurodollar market largely motivated by the desire to avoid restrictive U.S. regulations. This enhanced competition for U.S. domiciled banking activity eventually was met with reduced regulation. The globalization of currencies and ease of cross-border financial transactions is now a world wide phenomenon. Indeed the spread of sophisticated financial products and enhanced technological capacity to transfer funds across borders is seen by some to be the root cause for the worldwide decline in inflation.10 Thus the capacity of the central bank to impose taxes on its regulated financial sector has been reduced.

There has been a global trend of increased central bank corporate leverage and risk, potentially larger contingent liabilities arising from growth in domestic and international financial markets coupled with the central bank’s role in providing lender of last resort financing, rising sterilization expenditures, and declining income. Evidence of the magnitude of the last factor is provided in Figure 3 below.

Figure 3.
Figure 3.

Median Return on Average Assets in a Sample of 91 Central Banks 1/

(Median Value)

Citation: IMF Working Papers 2008, 037; 10.5089/9781451868999.001.A001

1/ Countries with less than 3 observations in each subperiod were eliminated from the sample.Source: Calculations with data from Bankscope.

Examining the median is intended to provide a global overview of trends and clearly masks different situations in different countries. Perhaps the most prominent case of recent concern has been that of Japan where the deflation problem reached its most profound level since the Great Depression era.11 In other countries the situation remains quite comfortable but the trend is also evident in Figures 4 and 5.

Figure 4.
Figure 4.

U.S. Federal Reserve System

Citation: IMF Working Papers 2008, 037; 10.5089/9781451868999.001.A001

Source: Board of Governors of the U.S. Federal Reserve System, Annual Report, various issues.
Figure 5.
Figure 5.

Bank of Canada

Citation: IMF Working Papers 2008, 037; 10.5089/9781451868999.001.A001

1/ Includes C$5 million in capital and C$25 million in the “Rest Fund.”Source: Bank of Canada, Annual Report, various issues.

The last explanation for the increased attention being paid to central bank finances is simply that it is a by-product of the increased attention being given central bank independence in general during the last two decades. A particularly prominent example of this is the delineation by the European Union of financial independence as one of the key components of central bank independence. The creation of the European Central Bank led to considerable thinking about central banking best practice in general and to central bank independence in particular.12

The European Union, through the European Monetary Institute (the precursor to the European Central Bank) has stressed the importance of central bank financial independence as an element in overall independence.13 That this issue is taken seriously can be seen in the determination by the Commission of the European Communities that Swedish legislation in 2002 “…is assessed not to be compatible with the Treaty and the ESCB Statue”14 and in the Opinion of the European Central Bank expressed on proposed government amendments to the Suomen Pankki Act (Finland’s central bank).15 In both cases, the fiscal relationship between the State and the central bank was not deemed sufficiently well-defined to ensure that the central bank would always have adequate financial resources to meet its obligation under the Treaty.

III. Is Central Bank Financial Independence a Sensible Concept?

A. Technical Insolvency vs. Policy Insolvency

The point of analyzing financial issues as they pertain to central banks is not with a view to assessing profitability. The graphics provided in Section II are useful as indicators of central bank financial stress, but they are not particularly useful unless they have some correlation with policy performance. The preliminary econometric evidence suggests that central bank financial strength is so correlated.16 Supportive evidence is also available in numerous case studies.

However, there are important voices suggesting that the concept itself—central bank financial strength—is not sensible. Either because a central bank—having the power to create money—need not worry about its financial situation and/or the treasury will always stand behind it with its capacity to tax.

A particularly cynical view is that the treasury always controls central bank finances, whatever the law or practice might suggest. Hence the “integrated public finance” view is valid always and everywhere. Buiter (2006) argues that although a central bank may be able to resist, for a time, attempts by the treasury to appropriate its assets, ‘Ultimately, a determined treasury will be able to overcome such obstacles, be they conventions, laws or constitutional arrangements, provided there is popular political support for such depredations.”17

The view that central bank and treasury finances are inextricably intertwined appears prevalent in U.S. official circles. For example, Alan Greenspan has remarked, “When there is confidence in the integrity of government, monetary authorities—the central bank and the finance ministry—can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligation of private issuers as they see fit…. Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into risk less claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the monies we have today, can produce such claims without limit.”18 (Emphasis added)

This is quite an unequivocal and strong form of the integrated central bank and government view. Both currency and deposits at the central bank—the entire monetary base—are considered to be the direct liability of the government.

A different perspective—but arriving at the same conclusion that the central bank’s financial situation should not be a cause for concern—is found in a statement of Laurence H. Meyer before a U.S. congressional committee: “Creditors of central banks however are at no risk of a loss because the central bank can always create additional currency to meet any obligation denominated in that currency.”19

A third view, coming from a still different perspective was expressed by the U.S. General Accounting Office after assessing the appropriate level of Federal Reserve System capital: “We found no widely accepted, analytically based criteria to show whether a central bank needs capital as a cushion against losses or how the level of such an account should be determined.”20

These statements raise a number of interesting issues, the most important of which is not whether the government/central bank can meet its temporary liquidity requirements in local currency but whether other government commitments would be violated—in real terms—were the central bank to exercise its power, i.e., create enough money to meet all of its (and government’s) securitized and monetary obligations.

Viewed as an integrated whole, the point, as Sims (2003b) has shown, is that there are clear limits to a government’s, and central bank’s, ability to commit to an inflation target in the absence of a fiscal anchor.21 From the viewpoint of an independent central bank the point is that the actions necessary to avoid its own financial default circumscribe the strength of the policy outcome the central bank can orchestrate—even supposing it has no financial commitment to its shareholder(s) and no domestic currency liquidity constraint.22 Thus the interesting focus of analysis is not whether the central bank can avoid technical insolvency but whether the central bank can meet its policy commitments given its financial situation.23

This distinction between technical insolvency and policy “bankruptcy” can be traced back a considerable time. As cited above, Bagehot (1873) argues essentially that no one even dreams the Bank of England could be insolvent. But later in the book he notes that the Bank of England’s Banking Department had failed three times. How to reconcile this with the safety of the capital? The answer lies in the power of the government to change or suspend the law governing the conversion of Bank of England obligations into specie (gold or silver coins or bullion). Thus the Parliament’s ability and willingness to suspend the law, not the Bank’s ability to create claims, is what protected the Bank’s capital. Which brings us back to the original point, that if the ultimate policy goal was to maintain convertibility and liquidity in the market, had not the Bank failed, even though, with the suspension of conversion, its capital was preserved?

B. Policy Insolvency—Does the Central Bank Balance Sheet Alone Matter?

If we accept that policy insolvency is the more relevant concept this does not necessarily imply that the central bank financial situation—independently—is worth analyzing. Indeed, the question posed above, in the integrated view, would likely be answered in the negative. That is, were the central bank to arrive at a situation where its policy decisions were being impacted by its financial condition, the treasury would, could, or should always assist.

Goodhart (1999) outlines the view that the central bank balance sheet does not matter and it is noteworthy that—in a fiat money environment—he emphasizes the importance of the financial backing of the state to achieve central bank objectives, not the ability of the state to renege on its commitments. “CBs in some countries, mainly in Latin America, have actually become technically insolvent (using generally accepted accounting principles) as a result of losses incurred on loans in support of the domestic financial system. But such insolvency does not make much difference because what stands behind the liabilities of the CB is not the capital of the CB but the strength and taxing power of the State.”24

Buiter states this view even more forcefully. “The concept of a financially independent central bank is therefore, in substance, vacuous, whatever the formal legal status of the central bank…. First the inflation target has to be financeable by the state, that is, the consolidated central bank and government. Second, when monetary policy is institutionally delegated to the central bank, the treasury has to ‘stand behind’ the central bank.”25

However, for a number of countries, this is not a valid assumption and such a distinction between monetary regimes—there are those where the state explicitly or implicitly stands behind the central bank and those where it does not—is the essential starting point for the analysis in Sims (2003a). The following two sections of this paper discuss the international experience on this point from first a legal then empirical/historical perspective.

C. A Digression: Are Central Bank Finances of Macroeconomic Importance?

In discussing the financial situation of the Federal Reserve System, the Bank of Canada or the European Central Bank, the magnitudes would seem worthy of no more than a footnote to the general fiscal accounts. Fed profits average about ¼ of one percent of GDP and the profits/losses of the European Central Bank, during its brief existence, have remained less than 0.03 percent of Euro-area GDP in absolute value. Threats to central bank financial independence could well seem extremely speculative in many countries. Within a “reasonable” range of observed situations in mature industrial country central banks, the disturbances to the local equilibrium wherein resides central bank financial strength are hardly enough to lead anyone to question whether they will impact policy objectives.

If the Federal Reserve or the European Central Bank were to experience minor perturbations in the strength of their balance sheets, fiat money could cover them either immediately or through the retention of future seignorage. But it is dangerous to extrapolate too far from the local equilibrium when experience is no guide.

Goodfriend (1994) has noted that Congress does have the power to reduce Fed surplus and that “If carried far enough, stripping the Fed of its liquid assets would obviously interfere with its ability to conduct monetary and credit policy. Equally important, however, it would undermine the Fed’s financial independence by denying it enough interest income to finance its operations without having to ask Congress for appropriations or resorting to inflationary money creation.”26

The financial status of the Bank of Japan has been the subject of rather intense debate in recent years particularly owing to the balance sheet risk it has undertaken as part of its quantitative easing policy associated with prolonged deflation. In Latin America, Asia, Africa, and in Eastern and Central Europe, central banks have found themselves in considerable financial distress, usually owing to the delayed impact of quasi-fiscal operations—often in direct relation to the provision of credit in situations of a systemic banking crisis.

The prolonged impact of such operations in certain countries can be seen in Table 1.

Table 1.

Central Bank Results in a Group of Western Hemisphere Countries, 1987–2005

article image
Sources: Leone (1994); IMF staff reports; Central Bank of Argentina; Central Bank of Guatemala; Central Bank of Paraguay; Central Bank of Uruguay; and Central Bank of Venezuela.

Numbers for 2005 are preliminary.

Number for 2005 is IMF staff estimate.

For years after 2002, only includes Bank of Jamaica cash losses, excluding Bank of Jamaica Special Issue Bond.

In Uruguay, central bank losses averaged 3 percent of GDP in the late 1980s. The central banks of Chile and Guatemala have made losses for close to two decades consecutively. Venezuela made losses for 12 out of 13 consecutive years, Uruguay made losses for 14 consecutive years, Jamaica 9.

Losses frequently arise when, to borrow from Buiter’s terminology, in the midst of a banking crisis the central bank with its “short-term deep pockets” provides risk-laden credit and thereafter hopes to be recapitalized by “The treasury, the agency of the state with the capacity to tax [with] long-term deep pockets.“27 This effect can be seen in a number of countries during the 1980s and subsequent spikes in the data more recently—for example, the Dominican Republic in 2003–05.28

From a theoretical perspective Sims (2003a) notes that in general equilibrium models—“..uniqueness and stability of the price level depends on beliefs of the public about how the system would react in the face of extreme circumstances like very high inflation, severe financial instability, or deflations in which the zero lower bound on nominal interest rates is approached.”29 That is, under stress, the expectations of the public as to how the central bank will respond to an extreme deterioration in its financial position will determine the effectiveness of macroeconomic stabilization efforts.30

In reality, many countries have found themselves in “extreme circumstances” and their experience suggests that neither the Fed nor the ECB situations are representative of the issues facing a number of developing or emerging market central banks on a daily basis.

In the Dominican Republic, following efforts to contain the liquidity expansion following the recent banking crisis, central bank domestic debt amounts to 22 times central government domestic debt. In Costa Rica, the central bank has made losses for over two decades consecutively as the structure of the balance sheet reveals a huge imbalance among interest bearing liabilities and interest earning assets.31 Periodic partial recapitalizations have not been sufficient to reverse the overall trend.

The negative equity problem of the Central Bank of Chile can be traced back to the financial crisis of 1982 the cost of which has been estimated at 33 percent of GDP. Initially the cost was borne entirely by the central bank but in 1987 the government made a partial recapitalization. This issue was not faced again until 2006 when the Congress approved a transfer of up to 0.5 percent of GDP per annum for a period of 5 years. The central bank has estimated that this capital infusion would advance the date at which it would have positive equity from 2041 to 2026, that is, by fifteen years. The central bank received US$606 million as the first part of this partial recapitalization on December 27, 2006.

In Honduras and Nicaragua the ratios of central bank domestic debt to central government domestic debt are 2.4, and 1.4, respectively. During a one year period—August 2000 to 2001—the Central Bank of Nicaragua issued 20 percent of GDP in dollar-indexed domestic debt to resolve four bank failures. These bonds subsequently had to be restructured in an agreement with the private sector holders. Monetary stabilization bonds account for 57 percent of the liabilities of the Central Bank of Korea (end-2005); Bank Indonesia certificates 19 percent, and Bank of Jamaica certificates of deposit 61 percent.

In a number of countries it can safely be said that the central bank is both the manager and obligor of the sovereign’s domestic debt. In those cases the conflict of interest that is usually present between the government and central bank—raising interest rates to influence inflation leads to higher sovereign debt service cost (at least in the short run)—is observed within a single institution.

The central bank as debt issuer also raises governance problems. In particular, while government debt issues are usually subject to legislative approval, debt issues by central banks may not be so constrained.32 Here the implicit nature of government backing may allow the central bank to issue in its own name under the general securities law of the country. Operational links with banks—frequently the largest holder of domestic government debt—facilitate marketing and establishing the infrastructure (if no market already exists) as well as potentially compounds the governance issue. Furthermore, in many countries that have witnessed a sharp rise in domestic debt it has been precisely the provision of large amounts of central bank securities to an insolvent banking system which has enabled the rapid but often illusory “deepening” of the market. The banking system—which may also be regulated by the central bank—then becomes dependent for its survival on the full and timely service by the central bank of their largest single performing asset.

These are a few examples of central banks who have been constrained in their operations following what might be classified as a heavy engagement in quasi-fiscal operations. The fact that such operations usually take place in the context of government fiscal distress suggests why it is particularly innocent to assume that government will “stand behind” the central bank in a timely way to ensure that policy commitments are met. The power to tax, often cited as the ultimate guarantor of the currency, is unlikely to be employed precisely during those extreme circumstances when the central bank would require backing for its operations. Indeed, it is precisely during those circumstances that the inflation tax is seen as an efficient tool and price stability a dispensable luxury. Experiences worldwide suggest that Buiter’s treasury’s “deep long pockets” may be quite deep and in the end—or at least during a very material time frame—potentially empty.

IV. Legal Provisions

A. Explicit Recognition of Responsibilities

The first issue to be considered here is whether in legislation pertaining to the central bank there are provisions noting whether the government is in some sense responsible for the central bank’s financial liabilities and vice versa. We examine this in two ways. First, among the general provisions in the legislation treating relations with the fiscal authorities, second in those sections of the law that deal with the financial structure of the central bank and how capital deficiencies would be resolved. The findings, based on a review of 135 central bank laws, are summarized in Appendix 1 (Table 4) below.

Appendix 1 shows that there is a diversity of legal views world wide with, in particular, a diametrically opposed bi-model distribution. Examples supporting the views expressed by Greenspan, Lindsey, Goodhart and Buiter, which suggest that the treasury stands behind the central bank include El Salvador: “All the obligations of the Central Reserve Bank of El Salvador shall be assumed by the State through the Ministry of Finance, which may offset them against obligations existing in its favor.”33 Croatia is a second example, “obligations of the Croatian National Bank shall be guaranteed by the Republic of Croatia.” The Act on the Central Bank of Iceland states that “All obligations of the Central Bank are guaranteed by the State Treasury.”

A very different sentiment is expressed in a number of countries where the law explicitly states that, in general, the central bank is not responsible for the liabilities of the state and the state is not responsible for the liabilities of the central bank. One interesting commonality in this respect can be perceived in a number of the laws in the countries comprising Estonia, Latvia, Lithuania, Russia and other states of the former Soviet Union. This could be the result of the fact that most of the laws date from a similar era when this was deemed to be an important feature of central bank independence; the particular political and economic realities shared by those countries at the time; or a peculiarity of the distribution of state assets and liabilities following the dissolution of the Soviet Union.

If one takes, for example, the Law on the Bank of Lithuania, it stands in stark contrast with the notion that the government stands behind the central bank and vice versa. “The State of Lithuania shall not be liable for the obligations of the Bank of Lithuania, and the Bank of Lithuania shall not be liable for the obligations of the State of Lithuania.” Similarly, the law on the National Bank of Tajikistan: “The Republic of Tajikistan shall not be liable for the obligations of the National Bank of Tajikistan, except for those assumed with consent of the Madjlisi Oli of the Republic of Tajikistan or the President of the Republic of Tajikistan.”

Although most central bank laws are not explicit on this issue, the review summarized above and provided in Appendix 1 shows that it cannot be assumed that the state is legally responsible for the central bank’s obligations which suggests that the latter’s independent financial strength is a consideration when considering its ability to fulfill its mandate.

B. Coping with Central Bank Losses or Capital Insufficiency

Indirect responsibility for central bank liabilities can be inferred from provisions in the central bank law governing how central bank losses or capital insufficiency would be addressed. Many central bank laws have such provisions although the procedures are defined with different levels of specificity.

Some countries have general clauses, such as Kuwait “If the General Reserve Fund, in any years, is insufficient to meet the losses of the Bank, or if it can not be used to meet the losses, the Government shall cover the deficit.” A slightly more specific phrase can be found in the Bank of Korea Act: “Any loss incurred by the Bank of Korea during any fiscal year shall be offset from the reserves and, should these be insufficient, the deficiency shall be made-up by the Government in accordance with the Budget and Accounts Act.”

The Bank of Korea Act points to the potential issue of requiring further legislative approval for a recapitalization, for instance through the annual budgetary process. Some country laws specify that further approval is not necessary and hence appear to be closer to “automatic” recapitalization. Take the Central Bank of Kenya Act: “The amount of any net losses of the Bank in any financial year which is in excess of the sums standing to the credit of the general reserve fund of the Bank shall be charged upon and paid out of the Consolidated Fund without further appropriation than this Act.”

The Reserve Bank of New Zealand Act specifies particular losses that are to be covered by Government reflecting the particular agency arrangement the latter has with the former regarding the management of the country’s foreign exchange reserves: “The Minister shall, without further appropriation, pay to the Bank out of the Crown Bank Account the amount of any exchange losses (whether realized or unrealized) incurred by the Bank as a result of dealing in foreign exchange under sections 17 and 18 of this Act”.

How the losses are covered can be as important as when. Some central bank laws specify the type of transfer that is to be received. In Cape Verde: “If the Bank incurs a net loss…[it] shall be applied to the General Reserves, and if the latter should prove insufficient…the balance of the loss should be transferred to unappropriated earnings; After the submission, by the Bank, of a report…confirming the balance of the cumulative losses, the Government shall deliver to the Bank, within a maximum period of 60 days, funds, negotiable instruments that are dated and on market-determined terms and conditions and at market-determined exchange rates, in the amount or amounts necessary to make up the deficit.”

In other countries the law specifically calls for the provision of securities of a very different and/or more ambiguous nature. In Fiji “The Minister…shall cause to be transferred to the ownership of the Reserve Bank non-negotiable non-interest bearing securities issued by the Government …for the purpose of preserving the paid-up capital from any impairment…” In Malawi, “…any devaluation losses shall be covered by promissory notes of the government on such terms and conditions as shall be agreed upon between the Minister and the Bank.” The Bank of Namibia Act calls for revaluation losses to be covered by “…non-negotiable securities to the extent of the deficiency, on such terms and conditions as the Minister and the Board may agree upon.” The Central Banking Act in Papua New Guinea states that the Minister may create and issue to the Central Bank “non-interest bearing non-negotiable notes for an amount not exceeding any payment made by the Minister to the Central Bank out of the Consolidated Revenue Fund.”

In some cases the securities are to be serviced out of future central bank profits, such as United Arab Emirates “…the Government shall cover it [net debit balance] by issuing non-interest bearing, negotiable Treasury Bonds, which shall in turn be returned out of any net profits realized in subsequent years.” In Rwanda “…the Government will issue Treasury Bills not negotiable and non interest-bearing, for an amount equivalent to the debit balance of revaluation account. These Treasury Bills will be refundable by deduction from the Government share of Bank profits according to a schedule agreed upon with the Minister having finances under their competency.”

V. Do Treasuries Actually Stand Behind Central Banks?

The basic answer to this question is frequently no, at least not on a timely basis.

Examples of this phenomenon abound with the motivations/rationales falling into several different categories. One is that some states simply do not fulfill their legal obligations. Jácome and Parrado (2007) note that “In practice, this legal mandate has not materialized in the Dominican Republic and Nicaragua…”34

A second reason is that although the law might provide in general terms for the necessity of a recapitalization, the actual transfer of resources from the treasury would usually require legislative approval. That is, as most countries require legislative approval to spend public funds, a general commitment to maintain the capital of a public enterprise cannot override a requirement that the legislature specifically authorize such an expenditure prior to its occurrence.

In some laws, this notion is recognized explicitly, e.g., in Guatemala the central bank law calls for the Minister of Finance to submit, within the subsequent year’s budget request, the amount necessary to recapitalize the central bank.35 It does not, and seemingly could not, mandate a future congress to authorize the requested expenditure whatever the amount, whenever it occurs and for whatever the reason. Foreseeing possible future fiscal problems, the Central Bank of Venezuela law (2001) states that if fiscal resources are not sufficient to provide a budget allocation to make up for losses, the National Assembly shall authorize a special issue of national public debt under market conditions to do so (see Table 4).

Third, as suggested by the review of law in Section IV, central banks have frequently been “recapitalized” with treasury obligations with virtually no value. The Central Bank of Honduras (BCH) has been “capitalized” three times with nonremunerated long-term debt.36

At its founding, in 1950 the BCH received a 50 year non-remunerated government bond to cover its newly mandated monetary liabilities to the extent that these exceeded the assets of the monetary board that it replaced. Interestingly the government never used its own resources to redeem the bond. The 1996 amendments to the central bank law required the central bank to redeem the bond out of its own reserves. In 1997, the BCH received another 50 year non-remunerated bond to cover its accumulated losses as of end-1996. The nominal value was 5.4 billion lempira, equivalent to 1.1 percent of 1996 GDP. However, valuing a payment of 5.4 billion lempira to be received in 2047 at 1997 prices using as a discount rate the average return on Honduran government bonds during the period 1997–2003 yields a value of 0.0006 percent of GDP. In 2005, the BCH received a third non-remunerated 50-year bond, with 25 years grace, to cover losses accumulated during the years 1997–2003.

A not infrequent technique is to provide the central bank with a security the debt service on which is to be paid out of the central bank’s own retained earnings. Taking this security at an arbitrary par value may allow the treasury to meet its obligation under the law but provides neither an asset under IFRS nor any positive cash flow in the immediate future.37

Central banks highly exposed to foreign exchange fluctuations are particularly prone to decapitalization from a mechanical asymmetric profit transfer rule. Profit transfers in years with significant revaluation gains are not balanced by years in which large revaluation losses are suffered since there often is no provision for treasury coverage in that eventuality. Considerations such as these recently led the Netherlands to amend the central bank dividend policy.

Legal provisions determining when and how profits are transferred to the treasury can be exceptionally important. In this respect most central banks pay a mechanical proportion of profit to the treasury on an annual basis. Many laws are silent as to how to treat losses, leaving the central bank prone to decapitalization. There are no recognized standards for central bank capital, nor is the Basel risk-weighted asset to capital ratio applied.38

How can central banks run consistent losses but continue to show positive capital? It is quite common in central bank laws to have a mandated nominal capital for the central bank. In addition to this statutory capital it is also customary to have a reserve account(s). Equity would normally be considered to be the sum of capital and reserves. Most commonly, reserves are accumulated from retained earnings. If we presume that reserves cannot go below zero as a lower bound, there are three basic ways in which central banks can sustain losses in excess of equity yet continue to show positive capital.

The first point to recognize is that most central banks have not fully implemented IFRS, in particular, fair market valuation of assets. Thus the accounting system may allow the non recognition of losses through the use of historical cost of acquisition for valuation. This practice was widespread also in commercial banking before recent changes in worldwide accounting best practice. For central banks, the original motive was consistent with a desire not to distribute unrealized gains on assets to the government as that is akin to monetary financing. A number of central banks continue to account for gold at cost of acquisition.

The second method is the use of revaluation or adjustment accounts which do not impact equity. This accounting can either be mandated in law or be permitted by the accounting policies followed by the bank. A number of countries utilize such revaluation accounts which were originally conceived as protecting the central bank from being forced to distribute unrealized gains. This is a variant of the first principle—one recognizes the revaluation but does not take it into the profit and loss account. Hence large changes in real net worth are reflected in the asset or liability revaluation accounts but do not impact equity.

Sometimes the motivation for this treatment is out of a commitment to the law. If the law states that capital must be a certain nominal figure, it could be deemed illegal for the Board or chief accountant to adjust this figure. The only way to make the balance sheet balance is then to take the accumulated losses on to the asset side of the balance sheet. (Rather than lowering capital, a liability, below the legal minimum one creates instead an “asset” of rather dubious value).39 Sometimes this asset is noted on the balance sheet as a claim on government—regardless of whether the government recognizes it at such. Obviously the central bank is not in a position to dictate terms on such an asset and invariably it is not serviced on time and in full by government. In other cases, there may be a legal remedy for the central bank that establishes its claim on government for accumulated losses and eventually the bank is provided real assets as part of a recapitalization at some distant point in the future.

One example of the use of revaluation accounts was the National Bank of Hungary (NBH) before its recapitalization. Revaluation losses by end-1995 had reached 37 percent of central bank assets, far in excess of capital (see Table 2).40 Despite these large revaluation losses the NBH continued to transfer profit to the Ministry of Finance.41

Table 2.

Hungary: Central Bank Balance Sheet as of December 31, 1995

(In billions of forints)

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Source: National Bank of Hungary Annual Report 1995, Statistical Annex, pages 224–25.

VI. Can Central Bank Financial Independence Be Preserved?

In many cases the exposure of the central bank to losses comes primarily from its role in putting its capital at risk by intervening in a systemic crisis to provide liquidity to financial institutions and/or their depositors and other creditors.42 Whether central banks should do so is another matter and indeed there are good reasons for central banks to avoid this and other “quasi-fiscal” activities.43 Given that government financial responsibility for such operations is often slow to be assumed, outright prohibition of them may be the best course of action to preserve independence. This has led some countries to restrict or limit the central bank’s ability to be involved in such operations. For example, the central bank law enacted in Peru in 1992 expressly prohibited the activities that had been associated with the hyperinflation of the late 1980s.

In the case of Peru just described, and in others, changes in legal arrangements reflected broader political changes and those, of course, could be reversed. However, presuming an underlying consensus for independence, legislatures may enable central bank independence for a reasonable period of time, for example three to five years, under most reasonable circumstances. Broaddus and Goodfriend (1996)44 discuss the U.S.: “Congress has long recognized, however, that the pressure of budgetary politics could tempt future Congresses to press the Fed at least implicitly to help finance federal expenditures through inflationary monetary policy. Consequently, the Fed has been made financially independent—its operations are funded from the interest payments on its portfolio of securities—and the Fed has wide discretion over the assets it holds.”

The current financial structure of the Fed thus obviates the need to be overly concerned about its financial strength or with provisions to ensure it beyond the Treasury guarantee of Federal Reserve Notes. The U.S. does, however, explicitly recognize contingent liabilities to other financial institutions. One example of this is the capital obligation of the U.S. to the International Bank for Reconstruction and Development, commonly known as the World Bank.

The World Bank has both paid in and callable capital but most lending is financed with funds borrowed in international capital markets. Should the Bank be unable to cover credit losses with its capital and retained earnings, members are committed to pay in further capital to avoid a default on outstanding Bank bonds. “Over and above the $2 billion in capital that the United States has already paid in, the country has agreed to pay in another $30 billion in callable capital should such an event materialize.... The Congress has appropriated about $7.4 billion for that purpose, so the Treasury could provide up to that amount without additional Congressional action.”45

While the prospect of the U.S. being required to provide more than $7.4 billion in callable capital to the World Bank is quite improbable, the U.S. approach bears a resemblance to that discussed above in the cases of the Reserve Bank of New Zealand and the Bank of Kenya—a legislatively delegated budgetary authorization for central bank recapitalization.

With these examples in mind we might posit three “stages” or “layers” of central bank financial independence (see Table 3). The first being capital on hand, that is, the current strength of the balance sheet represented by equity properly valued. The central bank could exhaust this equity without any outside involvement.

Table 3.

Layers of Central Bank Capitalization

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The second would be a legislatively pre-authorized transfer of liquid funds to cover specified losses or a general remedy for capital deficiency. To activate this stage would require a technical decision or judgment by the treasury, but not an act of the legislature.

A third stage would be a specific legislative commitment—without pre-authorized budgetary authority—to cover a larger capital deficiency. To activate this stage would require both treasury consent and budgetary approval by the legislature (in the form of a budgetary appropriation).

The U.S. and Canada are cases where the strength of the central bank balance sheet eliminates the need for explicit consideration of stages 2 and 3. Many countries have a stage 3 solution in place, but, to the authors’ knowledge, only Malawi, New Zealand and Kenyan legislation have elements of stage 2. What some countries do have, however, either formally or informally, is a mechanism to suspend profit transfers when the balance sheet is in some sense deemed inadequate, e.g., equity is negative. In others, the profit transfer is negotiated or agreed with the Ministry of Finance depending both on the central bank’s and Ministry’s financial need at the time.

The problem with implementing these solutions is that there is no agreed technical trigger indicating central bank capital inadequacy—nor can there be. As the real issue is not technical insolvency but policy solvency and its credibility, the appropriate degree of central bank financial strength is both policy-dependent and a political issue. However, once an appropriate level or range in a given country, at a given time, is determined, institutional design can play an important role in preserving it.

Appendix I. Is the Central Bank Responsible for the State’s Obligations, and Vice Versa?

Table 4.

Results of the Review of Central Bank Legislation

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The authors would like to thank Claudia Jadrijevic for excellent research assistance and Alejandra Naughton, Ulrich Klüh, Jerome Vandenbussche, Christopher Sims, and other participants at a seminar at the Federal Reserve Bank of Atlanta for comments.


By independent here we mean neither constrained to pay specific dividends to government nor the recipient of automatic treasury coverage of losses.


A good recent example is the Dominican Republic. See


Francisco de Paula Gutierrez, as interviewed in Central Banking, Vol. XV, No. 4, May 2005, page 82.


See The Economist (2005). Sims (2003a) points out the higher relative exposure to foreign exchange revaluations of the ECB compared to the U.S. Federal Reserve. Stella (1997) suggests that the (then) capital policy of the Bank of Norway arose to shield capital from this volatility.


The global decline in inflation has undoubtedly slowed the erosion of central bank seigniorage (i.e., income from the monetary base at zero inflation) caused by technological innovation away from the use of cash and unremunerated balances at central banks, but this has not been sufficient to reverse the clear overall trend.


See Goodfriend (1994), Olivier and Svensson (2004), Okina (1999), Cargill (2005), Sims (2003a).


See Legal Aspects of the European System of Central Banks, ed. Amicorum and Zamboni Garavelli, European Central Bank.


EMI (1998) “Convergence report” if an NCB (national central bank) is fully independent from an institutional and functional point of view, but at the same time unable to avail itself autonomously of the appropriate economic means to fulfill its mandate, its overall independence would nevertheless be undermined. In the EMI’s opinion, NCBs should be in a position to avail themselves of the appropriate means to ensure that their ESCB-related (European System of Central Banks) tasks can be properly fulfilled. Page 295.


European Central Bank, 15 October 2003 (CON/2003/22) and 20 January 2004 (CON/2004/1).


While we agree with this statement, we do not agree with the notion that in situations where there is, or has been, political support for central bank independence, laws, institutional arrangements and central bank financial strength are irrelevant for credibility and policy outcomes during a meaningful time horizon. In the long run, of course, all laws, arrangements and constitutions can be modified.


Statement of Laurence H. Meyer, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, May 3, 2000, page 7.


Ize (2005) provides an insightful discussion of the situation facing the Central Bank of Costa Rica.


Charles A. E. Goodhart, Myths about the Lender of Last Resort, International Finance 2:3, 1999, page 348).


How Robust is the New Conventional Wisdom in Monetary Policy? Willem H. Buiter, paper presented at the 2006 Central Bank Governors’ Symposium ‘Challenges to Monetary Theory’, (Bank of England) June 23.


Journal of Money, Credit and Banking, vol. 26, No. 3 (August 1994, part 2).


Buiter (2006) “How Robust is the New Conventional Wisdom in Monetary Policy?” Page 44.


Unfortunately, obscure accounting treatments have often led to a delayed recognition of losses. See Stella (2002).


Sims (2003a) Fiscal Aspects of Central Bank Independence, page 3.


See JPMorgan. Japan Markets Outlook and Strategy, January 24, 2002.


Sims (1999) discusses the interesting case of Grover Cleveland’s issuance of debt for essentially monetary policy purposes without consulting Congress.


This provision dates from the era prior to the full dollarization of the Salvadorian economy and the elimination of the national currency.


The Quest for Price Stability in Central America and the Dominican Republic, Luis I. Jácome and Eric Parrado, IMF Working Paper, WP/07/54, page 6.


This replaced Article 83 of the old Central Bank of Guatemala law which stated that the State, through the Ministry of Finance, shall absorb the accumulated cost of monetary, exchange rate and credit policies through the emission of long term public debt with an interest rate of zero (author’s translation).


There is an imbedded option value similar to that with tax losses carried forward.


The Fed is extremely unusual in that it calculates and transfers to the U.S. Treasury profits on a weekly basis. Owing to revaluation losses on its admittedly small foreign reserve holdings, it has registered a loss (for a week) occasionally.


At the Central Bank of Ecuador such assets were known in the 1990s as “perdidas activadas” which translates roughly as “assetized losses.”


In South Africa (2003) and Peru (1988), similar accounts reached 28 percent and 25 percent of total central bank assets, respectively.


See NBH Annual Report 1995, Section V, “Resolutions by the General Meeting.”


Apart from explicit liquidity intervention in crisis situations, many central banks hold significant off-balance sheet contingent liabilities in the form of daylight overdrafts in the inter-bank payments system.


J. Alfred Broaddus, Jr., and Marvin Goodfriend “Foreign Exchange Operations and the Federal Reserve,” Federal Reserve Bank of Richmond Economic Quarterly Volume 82/1 Winter 1996.


The Costs and Budgetary Treatment of Multilateral Financial Institutions’ Activities, statement of Douglas Holtz-Eakin, Director, Congressional Budget Office, before the Committee on Banking, Housing, and Urban Affairs, United States Senate, May 19, 2004.

Issues in Central Bank Finance and Independence
Author: Åke Lönnberg and Mr. Peter Stella