Central banks’ financial strength is fundamental to financial system’s stability

The strength of central banks in the Arab world plays a key role in ensuring the stability of the financial system and economic performance.

The US Federal Reserve Building in Washington, DC. The financial strength of the Fed and other central banks is increasingly under scrutiny. Saul Loeb / AFP

Central banks’ financial strength has been ignored as a topic by economists for some time now. It was considered insignificant for several reasons. First, it was thought that central banks were primarily different from other financial institutions and did not require any financial strength. Second, central banks have an unlimited and costless ability to create fiat money. Third, there is a considerable perception that central banks are far from the risk of bankruptcy. Fourth, central banks are supported by the country’s treasury or ministry of finance.

However, the performance of central banks has undergone fundamental changes during the past two decades. These adjustments are triggered by shocks to the international economy. These developments weakened perceptions about the financial strength of the central banks.

Recent theoretical and empirical studies argue that central banks need to maintain a sufficient level of financial strength to achieve monetary policy objectives. Evidence from countries around the world proved that large numbers of central banks have suffered losses. The bad news about these losses is that they affect the effectiveness of monetary policy.

Economic analysis shows that central banks achieve losses when they implement a monetary policy that goes far beyond conventional central banking functions. These activities – known as “quasi fiscal activities” – include restructuring weak banks and persuading the central bank to adopt actions already designated to the treasury.

Moreover, some studies have reported that central banks suffer losses because they use their own securities as a tool in open market operations. Under the traditional economic theory, central banks should trade government securities, not their own securities. That has had a large negative impact on central banks, eroding their capital and distorting monetary policy.

It is useful to mention that in an extreme case, the Central Bank of Philippines was placed into liquidation and thereafter, in 1993, a new institution was established under a new act for the central bank. Also, the Czech National Bank accumulated losses equivalent to 200 billion Czech korunas (Dh36.47bn), or 6.7 per cent of nominal GDP, at the end of 2007.

These developments led to these banks losing their reputation, independence and capital. Moreover, the great global recession of 2007 and 2008 added more pressure on the central banking environment and monetary policy.

Central banks in many developed countries – in the United States and European Union – adopted the unconventional monetary policy of quantitative easing (QE).

The QE policy is a new monetary approach and has never been tested completely before. Japan applied this policy for the first time around early 2000 to combat the consequences of the South East Asian economic crisis in 1998.

In a recent study, some economists from the monetary division of the Federal Reserve board of governors projected that the Fed’s balance sheet would contract in 2015. Before the global financial crisis, the size of the Fed’s balance sheet was around US$800bn, today, however, it is around $2.7 trillion. It is forecast to return to a more normal size in 2018 or 2019. The projections imply that the Fed’s transfers to the Treasury will likely decline for some time, and, in some cases, fall to zero. The profits of the Fed reached $78bn in 2011.

Policymakers in many developed countries have very limited economic policy alternatives as a high debt burden reduces flexibility and efficacy. IMF data shows that the debt outstanding as a percentage of GDP last year for the US, Japan, Germany, France, and Britain was respectively 102.7 per cent, 238.1 per cent, 81.9 per cent, 90,2 per cent, and 88.8 per cent. Hence international monetary policy will be more conservative in the future.

Academia has many definitions of central banks’ financial strength. These rely on two main elements: the capital of a central bank, and its profits and losses. Thus the higher the capital and profits, the greater the central bank’s financial strength. The applied studies of the effect of central banks’ financial strength on the economy are very limited. Despite that, the conclusions of these limited studies have added a new dimension to monetary policy: central banks’ financial strength is a necessary condition to achieve price stability. Theoretically, this implies that is a new determinant of inflation.

The meeting of the central bank governors of Arab countries held in Abu Dhabi last September addressed challenges, including credit risks, high unemployment and the problems facing commercial banks in Arab Spring countries. The next agenda of the meeting should include a dialogue regarding the financial strength of central banks in the Arab world. The safety of these institutions is necessary to guarantee the stability of the financial system and economic performance.

Osama Sweidan is an associate professor of economics at United Arab Emirates University