Maintaining Central-Bank Financial Stability Under New-Style Central Banking

54 Pages Posted: 18 May 2015 Last revised: 26 May 2015

See all articles by Robert E. Hall

Robert E. Hall

Hoover Institution and Department of Economics, Stanford University; National Bureau of Economic Research (NBER)

Ricardo Reis

London School of Economics & Political Science (LSE); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: May 2015

Abstract

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.

Suggested Citation

Hall, Robert E. and Reis, Ricardo A.M.R., Maintaining Central-Bank Financial Stability Under New-Style Central Banking (May 2015). NBER Working Paper No. w21173. Available at SSRN: https://ssrn.com/abstract=2607362

Robert E. Hall (Contact Author)

Hoover Institution and Department of Economics, Stanford University ( email )

Stanford, CA 94305-6010
United States
650-723-2215 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
650-723-2215 (Phone)

Ricardo A.M.R. Reis

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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