Central bankers face a balance sheet reckoning

Central banks’ balance sheets have exploded in size since 2008. After interest rates started rising last year, several of those institutions have reported losses.

That’s not a problem, we’re told, since central banks are not bound by ordinary accounting rules. Recent research, however, finds that financial crises are more likely to occur after periods when their balance sheets have massively expanded. Besides, losses erode both the credibility and independence of monetary authorities, making it harder for them to fulfil their inflation-fighting mandate.

In recent years, the typical central bank has combined the asset growth and asset-liability mismatches of the Silicon Valley Bank with the leverage of Lehman Brothers and the balance-sheet opacity of Enron.

The expansion of balance sheets is unprecedented.

According to a new paper by Niall Ferguson and colleagues, published by Stanford University’s Hoover Institution, central bank assets relative to GDP are at multiples of their historic average and nearly twice the previous peak reached during World War Two. The Federal Reserve’s assets of $8.5 trillion sit on a mere $42 billion of capital.

Last year, the Fed reported its first loss since 1915. A number of other central banks from Australia to Sweden are in the red.

Central bank accounts are the stuff of headaches. Some use fair-value accounting, with changes in the market value of their securities reported in the profit and loss account.

Others don’t mark their assets to market, even for securities that they aren’t intending to hold indefinitely.

The Bank of England uses conventional financial reporting standards, but holds securities it acquired through quantitative easing in a special purpose vehicle, The Bank of England Asset Purchase Facility Fund. Central bank profits are usually distributed to the government – the Fed has handed more than a trillion dollars to the US Treasury since 2000 – but losses are retained on the balance sheet.

The Fed actually records its losses as “deferred assets,” which means that however much it loses it can’t slip into negative equity.

Central banks are not like ordinary banks, we are told. They don’t exist to make profits or avoid losses, but to conduct monetary policy.

Their earnings are immaterial. Solvency in the conventional sense doesn’t apply to them. Since they have no depositors, they can never suffer from bank runs.

Since they create their own liabilities — in the form of money — they can never run short of funding. Several central banks, including those of Israel and Mexico, have in the recent past successfully operated despite having negative equity.

Whether it’s good practice for central banks to inhabit this Alice-in-wonderland world is another matter. In “The Reckoning: Financial Accountability and the Rise and Fall of Nations”, the economic historian Jacob Soll suggests that the rise and fall of nations and empires is reflected by their changing attitudes to accounting.

Poor book-keeping, he says, leads to “financial chaos, economic crises, civil unrest and worse.”

The Medici family in Renaissance Florence thrived when their bank’s books were kept in good order, but the family’s power collapsed when they neglected the accounts and took undue risks.

Likewise, the failure of the French House of Bourbon to maintain proper accounts contributed to their eventual overthrow, says Soll.

Accounting is not just an essential feature of capitalism. It also ensures that governments are held accountable as far back as the Dutch Republic of the seventeenth century. According to Adam Smith the Bank of Amsterdam – the world’s first central bank, founded in 1609 – ran smoothly because its books were balanced.

The fact that central banks until the twentieth century were required to redeem their notes in gold forced them to keep orderly accounts.

As Anne Murphy writes in “Virtuous Bankers: A Day in the Life of the Eighteenth-century Bank of England”, the zero balance produced by doubleentry book-keeping conveyed a sort of virtue.

There’s something inherently troubling about the modern central bank’s cavalier attitude towards accounting.