"Star trek"-economics and the risk of insolvency: The role of central bank capital

Usually, the financial performance of central banks (CB) tends to draw little attention on a global scale. However, the financial crisis and subsequent (unconventional) policy interventions by various CB have resulted not just... [ view full abstract ]

Usually, the financial performance of central banks (CB) tends to draw little attention on a global scale. However, the financial crisis and subsequent (unconventional) policy interventions by various CB have resulted not just in balance sheets expanding to record levels but also lead to changing asset compositions. Such interventions have undoubtedly intensified the debate about central bank financial statements. If the public wants to finds reasons for criticism, then an easy target may be central bank’s balance sheets, and more specifically, central bank capital. Since the Swiss National Bank (SNB) has capped the currency peg against the Euro at the beginning of 2015, the SNB recorded substantial capital losses of around 50bn CHF. Further losses might even lead to negative capital levels in the future, as experienced by the Czech national bank in the last years. This puts the role of CB capital, its determinants, and the potential risk of CB insolvency in question. While there exists comprehensive research about the economic implications of negative CB capital, as for example the impact on inflation rates, there exist little evidence about the role, importance and appropriate level of CB capital from a financial reporting and accounting perspective. Some CB, as for example the Reserve Bank of New Zealand, actively manages its capital buffers with respect to its assets in order to mitigate credit and marked risks. Others argue that the level of CB capital is less important and that it is possible to operate a CB under negative capital. Hence, this paper is a first attempt to shed light on the following two research questions, particularly from a financial accounting and reporting perspective:

• What is the role and importance of CB capital in OECD countries?
• What are the consequences of negative CB capital levels (i.e. balance sheet insolvency)?

This paper is based on a comprehensive literature review and cross-sectional evidence of all 36 OECD CBs, thereby scrutinizing CB financial statements and relevant documents (e.g. laws, regulations) to elaborate the different roles, targets and managing aspects of capital levels of OECD CB. First results show that CB capital targets remain largely undefined and there is no recognized practice for calculating appropriate capital levels of CB. Also, the importance and role of CB capital levels widely differs within OECD CB. In particular, we find that the risk and implications of negative capital might be severely underestimated, both in academic and practice.