Why is Financial Strength Important for Central Banks?

Abstract

Central bank financial strength matters at least for two reasons: First, the availability of financial resources enables the central bank to perform its tasks independently. Second, market expectations could be influenced by a financially weak central bank, which could compromise monetary policy credibility (Blejer and Schumacher, 1998, Stella, 2002). Some studies focus on the role of central bank capital as a buffer against financial risks (Stella, 1997, Bindseil et al. 2004). It is, however, not all that matters. Capital depends on the accounting and profit distribution rules of the central bank. As there is a remarkable diversity of practice in these areas among central banks, this means that what capital represents in one central bank is very different from what it represents in another (Stella, 2003). Furthermore, the composition of (on and off) balance sheet items and therefore, the financial risks to which the central bank is exposed is very heterogeneous. The chapter, therefore, will focus on two particular balance sheet items that bear financial risk to central banks, so called junk assets and sterilization instruments. Junk assets have been accumulated due to some form of government financing for example as the result of the participation of the central bank in the restructuring of the financial system or as the result of financial support to the government, staterelated banks or enterprises. These assets have in common that they bear no return or a return below market rates and therefore expose the central bank to substantial credit risk. Sterilization instruments are market-based means through which the central bank will conduct sterilized intervention in face of capital inflows, if it does not want to permit an exchange rate appreciation or an induced and possibly inflationary increase in base money (Mackenzie and Stella, 1996). The central bank, thus, aims at two goals, an exchange rate target and internal price stability. Sterilization, however, incurs costs, the difference between the interest cost paid by the central bank and the interest earned on the foreign assets acquired with the foreign exchange purchase. It therefore also exposes the central bank to financial