Issues in Central Bank Finance and Independence

Abstract

Working Paper 2008-13 May 2008 Abstract: Conventional economic policy models focus only on selected elements of the balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an assumes that it chooses money (or an interest rate) unconstrained by a need to generate seignorage for itself or the government. Whereas a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy, this paper considers the relatively novel idea that an independent could be constrained in achieving its policy objectives by its own balance sheet situation. If one accepts this potential constraint as a valid concern, the financial strength of the 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 banks cannot be assumed, and hence financial independence is relevant to operational independence. First, we examine 135 laws to illustrate the variety of legal approaches adopted with respect to financial independence. Second, we examine the same data set with regard to recapitalization provisions to show that even in cases where the treasury is nominally responsible for keeping the financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided banks with genuine financial support on a timely basis, leaving them excessively reliant on seignorage to finance their operations or forcing them to abandon policy objectives. JEL classification: E42, E58, E63 Key words: independence, capital I. Introduction II. The Increasing Relevance of Central Bank Financial Strength and Independence III. Is Central Bank Financial Independence a Sensible Concept? A. Technical Insolvency vs. Policy Insolvency B. Policy Insolvency--Does the Central Bank Balance Sheet Alone Matter? C. A Digression: Are Central Bank Finances of Macroeconomic Importance? IV. Legal Provisions A. Explicit Recognition of Responsibilities B. Coping with Central Bank Losses or Capital Insufficiency V. Do Treasuries Actually Stand Behind Central Banks? VI. Can Central Bank Financial Independence Be Preserved? References Tables 1. Central Bank Losses in a Group of Western Hemisphere Countries, 1987-2005 2. Hungary: Central Bank Balance Sheet as of December 31, 1995 3. Layers of Central Bank Capitalization 4. Results of the Review of Central Bank Legislation Figures 1. Ratio of Net Foreign Assets to Central Bank Capital (106 Countries--1991, 2001, 20061 2. Ratio of Net Foreign Assets to Central Bank Capital for 106 Countries 3. Median Return on Average Assets in a Sample of 91 Central Banks 4. U.S. Federal Reserve System 5. Bank of Canada Appendix I. Is the Central Bank Responsible for the State's Obligations, and Vice Versa? I. INTRODUCTION This paper discusses several issues in what might be termed central finance. A particular focus is placed on the financial structure of the balance sheet and the legal and institutional arrangements shaping and government financial relations. The importance of those relations for financial independence is stressed. It would appear that the corporate financial structure of 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. …