Maintaining Central-Bank Financial Stability Under New-Style Central Banking
54 Pages Posted: 18 May 2015 Last revised: 26 May 2015
Date Written: May 2015
Since 2008, the central banks of advanced countries have borrowed trillions of dollars from their commercial banks in the form of interest-paying reserves and invested the proceeds in portfolios of risky assets. We investigate how this new style of central banking affects central banks' solvency. A central bank is insolvent if its requirement to pay dividends to its government exceeds its income by enough to cause an unending upward drift in its debts to commercial banks. We consider three sources of risk to central banks: interest-rate risk (the Federal Reserve), default risk (the European Central Bank), and exchange-rate risk (central banks of small open economies). We find that a central bank that pays dividends equal to a standard concept of net income will always be solvent—its reserve obligations will not explode. In some circumstances, the dividend will be negative, meaning that the government is making a payment to the bank. If the charter does not provide for payments in that direction, then reserves will tend to grow more in crises than they shrink in normal times. To prevent this buildup, the charter needs to provide for makeup reductions in payments from the bank to the government. We compute measures of the financial strength of central banks, and discuss how different institutions interact with quantitative easing policies to put these banks in less or more danger of instability. We conclude that the risks to financial stability are real in theory, but remote in practice today.
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