Lagarde’s insistence at the European Parliament last month that the ECB cannot “run out of money” contrasts with caution amongst National Central Banks in building capital buffers to cover the costs of monetary policy. The Eurosystem consists of the ECB and the national central banks (NCB) of the 19 member states that are part of the euro area. It is a complex setup, and what holds true for countries with a single central bank does not necessarily hold up for the Eurosystem. The debate about the relevance of central bank losses is an example of that.

At the ECB hearing at the European Parliament on November 19th, President Lagarde was asked by MEP Marco Zanni about the consequences for ECB equity of losses relating to holdings under the Asset Purchase Program (APP.) In particular, “what would happen if those losses were to erode the equity of the ECB and how it is possible that the ECB could run also with negative equity”? 

Lagarde’s response, which met with approval from observers on twitter, can be quoted at length:

As the sole issuer of euro-denominated central bank money, the euro system will always be able to generate additional liquidity as needed. So by definition, it will neither go bankrupt nor run out of money. And in addition to that, any financial losses, should they occur, will not impair our ability to seek and maintain price stability. I’m afraid that it’s yet again a fairly simple, straightforward answer, but that’s the reality that we are dealing with, and I don’t speculate on alternative scenarios, because we have a treaty. We are the only issuer, and we are not at risk as a result. 

What’s wrong with this answer? Well, nothing and everything.

By definition, the ECB is indeed the sole issuer of euro-denominated central bank money. And in principle, of course, the ECB can print euros with abandon and cannot go bankrupt. This is true of all central banks when not subject to institutional or legal constraints. Look at Argentina. But it is not clear that the constraints on the Eurosystem, and the National Central Banks (NCBs) that constitute the system, can be so easily side-stepped. Lagarde’s response was slippery, therefore, and avoided a discussion of the true constraints on euroarea monetary policy at this time—and whether these constraints need to be lifted.

Provisioning for interest rate risk

Growing risks due to unconventional monetary policy were explored by the Central Bank of Ireland in their Quarterly Bulletin in 2017. At that time it was the interest rate risk that might accompany the normalisation of interest rate policy that loomed large:

As economic conditions improve and inflation nears its target level, the deposit facility rate and the MRO rate are policy rates that are expected to rise over time. Given that central banks have effectively fixed the interest income on bonds purchased under the APP at low or negative interest rates, this points towards a potential widening spread between rising cost of funds on the liabilities and the low return on the assets… The potential for increasing interest rate mismatches in the context of rising policy rates may result in the cost of associated liabilities being greater than the income from purchased assets, which would, in turn, affect the profitability of central banks. 

As a result, as the authors explain, additional provisions of EUR165 million were taken in their 2016 Annual Accounts. Indeed, they note:

Given the importance of financial independence (and the need for central
banks to generate income to cover their own expenses), central banks in many countries have taken various steps to mitigate these growing risks. While strong capital and reserves provide a source of resilience, the role of risk provisioning has grown in importance for central banks in recent years. In the euro area, both the ECB and many euro area NCBs have explicitly identified these growing risks and many have provisioned for interest rate risk within a general risk provision framework.

So, NCBs have to cover their own expenses—they cannot just print their way out of a financial hole due to monetary policy, as implied by Lagarde. They are aware of the balance sheet impacts of unconventional policy to the point of pre-provisioning. This is anything but the sanguine attitude displayed by Madam Lagarde at the European Parliament last month.

Moreover, this provision for interest rate risk was before the additional unconventional policies initiated since. The ECB is now lending to banks below the deposit rate—that is, has engaged so-called “dual rates.” This creates an additional risk of losses due to the implementation of monetary policy, and creates the strange prospect of a NCB running out of euros. We will address this possibility in Part II of this series.

END.