By W.A Wijewardena –

Fuss over Central Bank’s reduced level of profits

A few years back, when the Central Bank’s senior officers were summoned before the Parliamentary Committee on Public Enterprises, commonly known as COPE, the members of the Committee were inquisitive about the Central Bank’s making a lesser amount of profits in the year in question compared to the previous year. The Committee had been guided by a report filed by the Auditor General.

The Committee was perplexed when it was explained to them that a good central bank is not supposed to make profits, unlike other organisations; central banks can make profits just by making book entries, those book entries invariably lead to an increase in money supply and through it an increase in inflation rate and therefore good central banks which are expected to keep inflation at a low and stable level do not target for profits but allow profits to arise in their normal monetary policy operations.

By the same token, if a central bank has increased its profit levels through its domestic operations, it means that the particular central bank has caused inflation in the economy by expanding its asset base and it is not a good barometer of evaluating the performance of a central bank.

Logic difficult to understand

Many outside central banks, and sometimes some of those inside central banks, are unable to grasp this logic. That is because they tend to equate a central bank to other businesses in an economy which is not correct.

A central bank acquires assets by creating liabilities

A central bank is a unique creature because it can create its own assets which bring profits to it by creating its own liabilities. For instance, if a central bank wants to lend money to a commercial bank, it can simply do so by making double entry book entries. It will create an asset account titled ‘loans to commercial banks’ and debit that account with the amount of the loan.

Simultaneously, it will credit the proceeds of the loan to the current account of the relevant commercial bank which that bank maintains with the central bank. Thus, this transaction increases both the assets and liabilities of the central bank. An ordinary business organisation cannot do this. If it wants to lend to another, it has to exchange its cash holdings, an asset of the business, for a loan, thereby making only a readjustment of assets. It does not increase or decrease its total assets or total liabilities.

Commercial banks constrained by lack of cash

How does this differ from commercial banks which also grant loans by making book entries? The difference is that when the borrower wants to withdraw his loan proceeds, the commercial bank should have cash in its vault to pay him. If another customer has not placed a deposit with it, it cannot meet the borrower’s request.

But for a central bank it is not an issue. It can open its vault and allow the borrowing commercial bank to withdraw the entirety of the loan. When the cash is over in the vault, it is simply placing another order with the currency printer to replenish the exhausted stock.

For this reason, central banks though they issue money do not have a cash balance and the unissued currency in the vaults is not an asset of a central bank. Only when that currency is issued, it will come to the balance sheet of a central bank, not as an asset, but as a liability. This magic cannot be performed by commercial banks because they cannot print and issue currency.

Central banks lend governments just by making book-entries

Similarly, if a central bank wants to buy a Treasury bill from the government, it does so simply by debiting its Treasury bills holding account and crediting the government account which it holds for the government thereby increasing both assets and liabilities simultaneously.

When the government uses that money for making payments, what happens is the debiting of the government account and crediting the central bank’s currency issue thereby making only an adjustment on the liability side of the central bank’s balance sheet. This process leads to creating new money when a central bank acquires assets and that new money leads to increase the money supply of the country in multiple terms since what is created by a central bank is used by other banks as seed money to create multiple deposits and credit.

Want more profits? Buy more assets

Hence, if a central bank wants to make more profits, all it has to do is to buy more Treasury bills, lend more to banks or simply buy assets in the market which will generate incomes. But a central bank does that at the expense of creating higher inflation in the economy.

US Fed is in the game of buying assets

This can be explained from the recent practices of the Federal Reserve Bank of USA commonly known as the Fed. In a bid to provide stimulation to the economy, it started to buy from the market government securities at the rate of $ 85 billion a month. These purchases as well as other loans it had granted to problem banks have caused the Fed’s assets to go up from mere $ 800 billion in mid-2008 to $ 3.9 trillion by end August 2013.

These are the Treasury securities which the private sector had already bought from the US Treasury and kept in the form of securities which can be converted to liquidity only if they are sold back in the market. However, if they are sold to private people again, then, it amounts only to a recycling of the money already in the system. But when the Fed buys them, it does so by the same book entries, that is, debiting the securities account and crediting the securities selling bank’s account. It then leads to creating the seed money which was discussed earlier and will bring about an increase in money supply.

US money multiplier has fallen below 1

Fortunately for USA, the money multiplier relating to narrow money supply – that is, dollar notes and current account balances of US citizens – is less than 1 due to the overcautious approach of banks in lending. Hence, the seed money stock is more than the narrow money supply but it can change dramatically as it had been a few years back when banks gain confidence in lending one day and at that time, according to historical data, money supply will increase by about 3 times the seed money stock. In comparison, in Sri Lanka where money multiplier is 6, money supply will increase by six times when the Central Bank of Sri Lanka creates a ‘seed money unit of one rupee’.

Fed causes securities prices to increase and pockets out the profits

When the Fed buys Treasury securities from the market, the demand for these securities will go up raising their market prices and in turn reducing the market yields of those Treasury securities. When the Fed re-values those securities at the end of the year to prepare its accounts, a procedure known as marking to the market price of assets, the Fed earns a book profit in the form of a capital gain.

This capital gain it has earned through its own action namely by buying securities in the market. When it buys more securities, higher the price of those securities and higher the profits it would have made. On top of these capital gains, it will earn interest at the fixed coupon rate of these securities every year adding to its profits. Thus, the Fed is making profits just by sitting and making book entries at its will.

But it is not ethically commendable

But its profit making has caused potential increase in US inflation and a fall in the value of the dollar in the international markets. Hence, on ethical grounds, the Fed does not deserve any commendation for making profits. Neither do the other central banks for the same reasons.

Central banks should make profits but use them to build reserves

Then, the question arises “shouldn’t a central bank make profits at all?” The answer is no. They should definitely make profits in the case of foreign reserves they manage on behalf of the nation. There, the profits they earn comes not from money creation but from conscious investment decisions they have made by taking into account the risk involved in each type of investments. In these operations, central banks should consciously target for the highest level of profits they could make but without putting the nation’s foreign reserves to unnecessary risks.

As for domestic operations, profits are not targeted by a central bank but they arise in their ordinary monetary policy operations. In those operations, what a central bank should seek is to avoid making losses because if a central bank makes losses, those losses have to be financed by the country’s taxpayers. A central bank should avoid that possibility by all means.

Governments have no first right for central bank profits

But after a central bank’s operations have resulted in profits and since those profits have arisen due to its acquiring assets by creating inflation in the economy, the laws governing central banks have prescribed a special procedure for treatment of those profits.

According to these procedures, governments do not have absolute right to get those profits as the owners of central banks. They are entitled to use those profits only after all other requirements have been met and if there is still a surplus remaining for transferring to the government.

Special procedure to appropriate central bank profits

In terms of those procedures, after ascertaining profits, a central bank should use its profits to meet the losses if any in the issue of currencies in the past and build internal reserves in sufficient amounts. The government has a right to use only if any further surplus remains after meeting the first two obligations.

This particular procedure has been prescribed to avoid the potential moral hazard problem because if the government has the first right to its profits, then, a government intending to use that to the maximum may get the central bank to create inflation and transfer the profits to the government.

Internal reserves are to protect the currency

Why has it been prescribed that a central bank should first use its profits to build internal reserves? That is because today’s central banks issue currency without any backing of foreign exchange assets or gold and therefore there is no safety for the currency they issue.

In the case of a currency board system which Sri Lanka had before it got its Central Bank in 1950, there should be a 100% backing of the currency it issues with foreign exchange balances. Hence, the entirety of the currency which a currency board has issued is backed by valuable foreign exchange. Countries like Singapore and Hong Kong still have currency boards to issue currencies in their respective regions.

In the case of central banks, there is no legal requirement to back the currencies they issue by such foreign exchange balances and therefore, they could misuse their power to issue more currencies than necessary and thereby grow like an inverted pyramid. But the ultimate result of such a strategy is inflating the economy.

To prevent central banks from getting into that trap, legal provisions have been made in the laws governing them to transfer their profits to such internal reserve accounts until such time they are considered adequate to protect the currencies they issue. Hence, it is an anti-inflationary measure introduced in central banking laws.

Study by Anil Perera and others

Three scholars, Anil Perera of the Central Bank of Sri Lanka and presently at Monash University, Australia, Deborah Ralston of Australian Centre for Financial Studies and Jayasinghe Wickramanayake of Monash University in a recent paper titled ‘Central bank financial strength and inflation: Is there a robust link?’ and published in the 2013 XXX issue of Journal of Financial Stability have examined this issue. For convenience of exposition, it is hereafter called the PRW Study.

Having used the data relating to selected advanced and emerging countries that include Sri Lanka as well, they have found a significant and robust negative relationship between central bank financial strength and inflation.

What it means is that if the balance sheet of a central bank is strong enough with high internal reserves, that central bank is in a stronger position to conduct its monetary policy effectively and push inflation down.

Higher the net-worth, stronger the central bank

The PRW Study has recognised the limited availability of studies on the subject so far because it is still an unexplored area of study to establish the link between the central bank balance sheet and inflation. Having defined the strength of the central balance sheet as the size of the net-worth of a central bank – that is, the component of the assets of a central bank backed by its capital and internal reserves – the Study goes on to establish the link via the degree of independence enjoyed by a central bank.

While profits are useful in improving the net-worth of a central bank they are not essential since it could be improved by periodical allocation of funds by the government through annual budgets. A central bank with an improved financial net-worth is in a position to implement aggressively inflation-fighting policies at the cost of incurring interest expenditure by issuing its own securities if the available government securities in its stock are insufficient to eliminate the entirety of the excess liquidity in the banking system. the PRW Study argues that a weak central bank is unlikely to do so unless it is supported by a grant from the government.

High net-worth frees a central bank from government controls

This is where the size of the net-worth and the independence of the central bank come to the picture. If the central bank is not independent from the government, it also cannot adopt a robust monetary policy without government’s blessings.

When governments are bent on placing economic growth on a higher priority than inflation, it is unlikely that a central bank will get those blessings. Hence, both the independence and the size of the net-worth helps a central bank to carry on its monetary policy stance unabated and undiminished.

Important lessons from study by Anil Perera and others

PRW Study presents several valuable lessons for central banks to follow.

First, if a central bank desires to act independently, it should build up its net-worth to really gain that capacity. The legal requirement for the Central Bank of Sri Lanka is to build up the net-worth up to a level equivalent to 15% of the value of its domestic assets. But under the

Central Bank Modernisation Project implemented between 2000 and 2005, the Bank decided to increase that value to 100 percent of the domestic assets voluntarily. The Bank achieved this target by 2004.

Second, it throws new light on the importance of being careful about the balance sheet and profit allocation of a central bank.  If the net-worth is insufficient, a central bank should not transfer its profits haphazardly to the government however much pressure is exercised by the Treasury to grab those profits.

Third, central banks advise commercial banks to have capital adequacy to meet the depositors’ liabilities in the event of the failure of such banks. Now, PRW Study gives some valid reasons for central banks to follow the same advice before it is passed on to the commercial banks.

Advice to central banks: Gain independence by strengthening the balance sheet

In summary, central banks should not target for a particular level of profits but allow profits to arise in the course of their normal operations. While they should not make losses, they should use the profits to build their net-worth to a sufficient level so as to gain independence to carry on monetary policies robustly.

*W.A. Wijewardena can be reached at waw1949@gmail.com