The trend over the last few decades for greater independence of central banks has raised the question of their financial independence. There has been increasing discussion on whether central banks require capital and if so, how much? The central bank (CB) mainly has two functions: print currency notes that are held by the public, and issue deposits to commercial banks. These are liabilities for which it does not have to pay any interest. At the same time, it purchases financial assets in the form of domestic and foreign government bonds on which it gets interest. As the cost of printing currency is on average 1/7th of the net interest income, the result is a large net interest.

Any time the CB issues currency, undertakes foreign exchange operations, investments, conducts monetary policy operations, or provides liquidity assistance, its net worth is impacted. For central banks, much like commercial banks, the capital buffer or net worth on balance sheets allows them to absorb any potential losses. This means that it’s net worth impacts its ability to achieve monetary policy objectives, which include keeping the inflation rate within the set target. But there are no rules that dictate the amount of capital a central bank must possess. And different countries have taken different approaches based on their unique circumstances.

Up until the 1980’s, CBs in most countries weren’t as independent as we know them to be today.

CBs usually served under the government. They had myriad roles like financing government expenditure, maintaining financial stability, ensuring stability of prices and stimulating economic activity. But they did not have independence. The 90’s and 2000’s saw a trend in favour of independence for central banks to improve long run economic performance. This resulted from a consensus that a central bank independent from the government would be more capable of conducting a credible monetary policy. Market expectations that are more responsive to its actions will make it easier to achieve the monetary policy objectives. The main role of the CBs became the maintenance of price stability, although it was still expected to safeguard financial stability in the economy.

When central banks served as an arm of the Ministry of Finance/Treasury, the level of CB capital and rules for distribution of profits to governments weren’t of consequence. As and when CBs across countries were allowed to set a monetary policy without interference from the government, these questions came under contention.

When capital becomes sufficiently negative, there are two ways for the central bank to move forward: it has to either be recapitalised; or it has to cover losses on a cash-flow basis from the government. In latter case, which is most common, the government can insist it have discretion over the time and magnitude of the transfer, which effectively places the monetary policy in its hands. Now, the former case may seem more appealing. However, in countries that have negative capital as well as budget deficits, concerns for government interference resurface with recapitalisation as well. A government that is cash-strapped itself would not be able to render a large amount of capital to a CB in need. This was seen in the case of Argentina, where CB losses were 23.5% of the GDP in 1989 and in Jamaica, where losses were 53% of the GDP from 1988 to 1991. Financing these losses implied abandonment of monetary policy objectives that were conflicting with the government’s objectives.

In contrast to all these issues plaguing banks with negative capital, central banks with positive amounts of capital and legal independence have been able to resist such pressures. Moreover, it is during banking crises that the CB’s demonstration of its ability to maintain financial stability becomes of utmost importance. A market that believes the central bank may change its policy to avoid losses undermines its credibility. This deters investors and delays restructuring of distressed assets, suppressing fiscal revenue and growth in the process. Indeed, in cases like Peru, Bolivia, and Chile, recapitalisation has led to a gradual improvement in financial position. But it is important to note that in these case studies, recapitalisation was brought about in conjunction with new central bank laws and economic reforms that sought to restore the public’s faith. So, it appears that if credibility is important for success of the monetary policy, the central bank must be financially strong.

The next question that arises is how much capital do CBs need?

Mr Peter Stella in a paper written in 2005 identified four different ways that central banks have determined their level of capital:

1. An absolute nominal value of capital. (e.g. Bank of Canada)

2. A target ratio of capital to another central bank balance sheet item. (e.g. Bank of Japan)

3. A target ratio of capital to a macroeconomic variable. (e.g. US Federal Reserve)

4. Based on the perceived risks to the solvency of the bank.

Here, the optimal level of capital depends on a large number of factors, such as the macroeconomic environment, how vulnerable the CB is to large financial shocks, its historical legacy, policy obligations (like a fixed or pegged exchange rate) and the volatility of profits.

(e.g. Reserve Bank of India, Reserve Bank of New Zealand)

It also follows that in developing countries and countries with narrow capital markets, the CB should have larger capital. Countries where governments have frequent or constant budget deficits and those with fixed or pegged exchange rates should pursue the same path. It is only after taking into consideration policy objectives, such as price or exchange rate stability, can an ideal level of capital be determined. The determination of the minimum financial strength should also take into account the exposure to risk. Finally, a mechanism and sufficient resources must to be available to absorb the risk.

After the determination of an ideal level of capital, profit in excess of what is required by the central bank has to be transferred to the government. This is another source of discord. Usually the amount to be transferred is decided by both the parties before the budget for the year is set. In some cases, such as Japan, the government decides the quantum. Governments want a higher surplus in order to reduce fiscal deficit or provide assistance to distressed financial institutions, while CBs want to be cautious and keep reserves from profits for unforeseen risk. A debate follows on whether the CB is holding more capital than it requires.

There is little doubt that clear rules for allocation of profits would alleviate some of the strain between the CB and the government. Since the amount is subject to much fluctuation, it is also advisable to have a committee that reviews the surplus distribution policy. The rules should also contain contingencies for cases in which CB capital becomes negative. Clearly specified and transparent principles will safeguard the bank’s independence in the event that CB capital is seriously depleted. Most important of all, it would enhance the credibility of commitment to price stability on the part of both the government and the CB in the public eye.