ABSTRACT
To analyse the relevance of CBCA in those countries where another country’s currency is legal tender we have to discuss which factors affect central bank capital, and we have to investigate whether there is an optimal level of capital for central banks. In answering those questions, one needs to highlight the main differences between central banks in charge of monetary and exchange rate policy, and central banks without these responsibilities. In the literature, capital needs have been mainly coupled with the existence of the domestic currency and the conduct of monetary policy and exchange rate control. However, the reasons for holding capital are wider. Some are common to private companies, while others pertain to central banks alone. First, there are reasons for holding capital that apply to any central bank. As in the private sector, capital has to cover potential losses. But for a central bank, some potential losses can be incurred as a consequence of the central bank’s institutional mandate. The typical mandate for a central bank comprises conducting the monetary and foreign exchange policy, maintaining a secure payment system and a stable banking sector. So, losses can be incurred in many ways. They could be a consequence of the day-to-day management of the currency reserves,3 or brought about by sterilization operations, or follow from emergency liquidity assistance when the central bank has to grant concessional credit to rescue ailing institutions. These contingent liabilities tend both to reduce the transparency of central bank accounts and to make the assessment of a central bank’s financial position more difficult (Blejer and Schumacher 1998). Despite these potential losses deriving from a central bank’s institutional mandate, central banks may be profitable institutions, in view of their monopoly power. Central banks can enjoy seigniorage arising both from the issue of the currency and from banks’ funds held at low or zero interest with the central bank. In the long run a central bank’s profitability should be secure as long as the demand for banknotes is maintained, the central bank keeps monopoly power over money issuing and the rate of inflation is not too low. There is a link between price stability and financial autonomy. Low inflation ensures adequate demand for money, and demand for money ensures seigniorage (at a given nominal interest rate, at least) and hence financial independence. That, in turn, is key for autonomy and reputation – necessary conditions to achieve price stability. However, lower inflation eventually goes hand in hand with lower nominal interest rates, and seigniorage may be defined as the product of the nominal interest rate and the monetary base. So, lower inflation is likely to reduce seigniorage at least at some point, as was noted in the introduction to this chapter. Second, like a private bank, a new central bank needs capital to fund its start-up costs. Third, capital has also to generate continuing operating income to secure the long-term financing of operating costs. Adequate capitalization matters to ensure income to cover future costs. Finally, the amount of capital signals to stakeholders how well the institution is being managed (though this signal scrambled because central banks may incur losses for legitimate policy reasons). In any case, if the public infers from negative capital that the central
bank is poorly run, it may erode the bank’s general reputation4 (Vaez-Zadeh 1991). Moreover, approaching the government frequently would compromise the actual and perceived autonomy of the central bank. In sum, central bank autonomy can easily be eroded, unless supported by adequate financial strength. The above-mentioned factors govern central banks’ demand for capital. But they differ when the country has no domestic currency of its own. Table 6.1 highlights the main determinants of central bank capital in the two cases. In the second case, identifying potential liabilities and risks facing a central bank is much simpler. But even then one must define the central bank’s relevant overall assets or resources and its potential liabilities in the future.5 Here, the central bank’s demand for capital will vary with: (i) the level and type of risks faced, (ii) past, present and future profitability and (iii) financial arrangements regulating the relationship between the central bank and the government (profit-sharing rules, obligations of the national treasury in case of need, fiscal treatment). The central bank’s risks depend on the number of its functions, the level of development of the financial sector and the prospects for adverse events affecting its financial stability, the exchange rate regime and the level of inflation. Consequently, as far as risk assessment is concerned, we should expect that potential risks should be lower for central banks without a domestic currency given that there is no contingency for monetary and exchange rate policies and banking sector crises. Some situations where a central bank might need to deploy its resources do not apply. Such situations include requests for support to defend the exchange rate, or interventions through sterilization operations to keep the monetary aggregates under control or to inject new liquidity to rescue ailing banks. On the other hand, in order to perform its refinancing function in case of a banking crisis, we would expect a central bank without a domestic currency to hold more capital, provided that it cannot create additional liquidity by issuing a new monetary base. Since the central bank could not create additional liquidity, commercial banks would require more capital, as they lacked access to a lender
of last resort facility. However, even without its own monetary and exchange rate policies, a central bank might risk financial losses on initiatives and policy actions warranted on public interest grounds. Such initiatives include rescuing ailing institutions, safeguarding the payment system, and setting up a credit register. They might be reluctant to act without adequate financial resources to absorb such additional expenses. There are also differences in profitability and financial arrangements. In the absence of a domestic currency, the central bank has no seigniorage to exploit. Without seigniorage the central bank has to rely on government funding, returns from its own capital and any commissions or fees from regulated sectors. There is a much greater role for capital to serve as a means for generating operating income, and a greater need for adequate financial arrangements to protect it. How much equity does a central bank need? For central banks without a domestic currency, and no seigniorage income, a simple rule might calculate the amount of capital by considering the goal of covering operating costs – assuming a particular (real) rate of return. But potential losses arising from carrying out its mandate also needs to be allowed for. The more numerous the central bank’s areas of responsibility, the larger its capital needs. For instance, central banks that manage foreign exchange reserves should have higher levels of capital, as should those that run their own monetary policy. The size of the country may matter. In very small countries it is common to find simple institutional arrangements with only one monetary and financial authority, presumably widening the central bank’s responsibilities. If there are fixed costs and scale economies in operating a fully fledged central bank or financial regulator, a small country’s central bank would need proportionately more capital. For small countries this argues in favour of simpler institutional arrangements for their monetary and exchange rate regimes. It might justify sharing the burden of sustaining the central bank’s finances with others bodies (government; financial intermediaries), with implications for transparency and accountability. What institutional arrangements should define the relation between the government and the central bank? The level of central bank capital is only one aspect of the relationship between them. The nature and extent of a central bank’s financial autonomy is shaped by its relation with the government, and how that is reflected in the structure of arrangements for financing central bank activities, for sharing risks and distributing its profits and losses. There might be direct transfers from the treasury to the central bank, reducing the need for central bank capital. But pre-agreed mechanisms and rules would have to protect central bank financial autonomy. Risk treatment and risk bearing could also be affected. Risky balance sheet items or contingent liabilities could be held by the government, with the government taking over some quasi-fiscal activities from the central bank. The government could take responsibility for providing financial support to banks in difficulties. And if the central bank generates revenues, rules governing its profit distributions would be required. In practice, Ueda (2004) shows that there is a high variance in the levels of capital held by central banks around the world. He presents the ratio of capital to
total assets for a number of central banks.6 This ratio varies widely from country to country. The variance reflects differing motivations ascribed to central bank activities, different kinds and received levels of risks, and different profit and sharing rules with national governments.7 It could also suggest a lack of consensus among central banks about the desirable level of capital.
