Does the ECB/Eurosystem have enough capital?

‘Enough capital for what?’ should be the question prompted by the title of this post. The short answer, amplified below, is “enough capital to be able to engage in effective monetary policy, liquidity policy and credit-enhancing policy (including quantitative easing or QE), without endangering its price stability mandate.”

Let’s consider the conventional balance sheets of the ECB and of the consolidated Eurosystem (the ECB and the 16 national central banks (NCBs) of the Euro Area.

The most recent publicly available balance sheet of the ECB is in the 2008 Annual Report, published in April 2009.  It is reproduced here:

Balance sheet of the ECB on 31 December 2008 and 31 December 2007

Assets (€ bn) Liabilities (€ bn)
2008 2007 2008 2007
Gold & Gold Receivables 10.7 10.3 Bank notes in circulation 61.0 54.1
Claims on non-euro area residents in foreign currency 41.6 29.2 Liabilities to euro area residents in euro 1.0 1.1
Claims on euro area residents in foreign
22.2 3.9 Liabilities to non-euro area residents in euro 253.9 14.5
Other assets 14.3 11.3 Liabilities to euro area residents in foreign currency 0.3 0.0
Intra-Eurosystem claims 295.1 71.3 Liabilities to non-euro area residents in foreign
1.4 0.7
Other liabilities 20.5 9.4
Intra-Eurosystem liabilities 40.1 4.0
Capital & reserves 4.1 4.1
Profit for the year 1.3 0
Total 383.9 126.0 Total 383.9 126.0

It is clear that if the ECB were all there is to the Eurosystem, the Euro Area would be in trouble.  The ECB has negligible capital (€ 5 billion subscribed, rather less than that paid in; even if we add capital and reserves to 2008 profits, we only get €5.4 bn.  With assets of €3839, that gives the ECB 71 times leverage at the end of 2008, a number that would impress even Deutsche Bank. The previous year, the ECB had 48 times leverage.  On its own, the ECB looks like an overblown pawn shop.

Fortunately, the balance sheet of the ECB by itself is effectively irrelevant and uninformative as to the financial strength of the Euro Area monetary authority.  In 2008, about 75% of the assets of the ECB consisted of intra-Eurosystem claims (the left hand lending to the right hand).

What is informative is the consolidated balance sheet of the ECB and the 16 NCBs of the Euro Area – the Eurosystem.  This consolidated balance sheet of the Eurosystem is available monthly:

Consolidated financial statement of the Eurosystem as at 8 May 2009

Assets (EUR millions)
1 Gold and gold receivables 240,817
2 Claims on non-euro area residents denominated in foreign currency 159,299
3 Claims on euro area residents denominated in foreign currency 123,101
4 Claims on non-euro area residents denominated in euro 21,359
5 Lending to euro area credit institutions related to monetary policy operations denominated in euro 653,352
6 Other claims on euro area credit institutions denominated in euro 26,453
7 Securities of euro area residents denominated in euro 292,405
8 General government debt denominated in euro 36,790
9 Other assets 241,523
Total assets 1,795,099
Liabilities (EUR millions)
Totals/sub-totals may not add up, due to rounding
1 Banknotes in circulation 759,502
2 Liabilities to euro area credit institutions related to monetary policy operations denominated in euro 264,137
3 Other liabilities to euro area credit institutions denominated in euro 436
4 Debt certificates issued 0
5 Liabilities to other euro area residents denominated in euro 139,090
5.1 of which General government 130,717
6 Liabilities to non-euro area residents denominated in euro 177,993
7 Liabilities to euro area residents denominated in foreign currency 1,548
8 Liabilities to non-euro area residents denominated in foreign currency 11,407
9 Counterpart of special drawing rights allocated by the IMF 5,551
10 Other liabilities 159,644
11 Revaluation accounts 202,952
12 Capital and reserves 72,840
Total liabilities 1,795,099

A central bank can go broke (become insolvent) despite its ability to ‘print money’ (issue currency and/or create (electronically) deposits owned by commercial banks and other eligible counterparties that are generally accepted as final means of payment) if it has a sufficiently large stock of liabilities denominated in foreign currency and/or a sufficiently large stock of index-linked liabilities.  Neither condition would seem to apply to the Eurosystem.

A shortage of foreign exchange assets or credit lines is not going to be a material problem for the Eurosystem. As of May 8, 2009, the net position of the Eurosystem in foreign currency (asset items 2 and 3 minus liability items 7, 8 and 9) was EUR 263.9 billion. The ECB is also able to create reciprocal or one-sided swap arrangements with all other serious central banks. As far as I know, the Eurosystem does not have any significant amount of index-linked liabilities.

No, the Eurosystem will not encounter the ‘Iceland problem’. It will always be able to create euro base money (either by issuing additional euro currency or by increasing euro bank reserves and similar deposits held with the Eurosystem by eligible counterparties) by any amount required to maintain its solvency. It is, however, possible that the amount of additional base money that would have to be created to maintain the Eurosystem’s solvency could endanger the ECB’s price stability mandate, operationalised as a rate of inflation, measured by the HICP, below but close to 2 percent per annum in the medium term.

So the question is: does the Eurosystem have enough capital to be able to risk significant capital losses in its monetary operations, liquidity operations and credit enhancing operations (including quantitative easing), without endangering its price stability mandate?

The Eurosystem already has taken a lot of private sector credit risk exposure on its balance sheet.  It accepts as collateral in repos and at its discount window (the marginal lending facility), most private securities (including most asset-backed securities except those that have derivatives as underlying assets) rated BBB- or better.  That includes a lot of rubbish.  Commercial banks throughout the Eurozone (including subsidiaries of Lehman Brothers and of the now defunct Icelandic banks) have repoed with the ECB.  When three banks went belly-up in late 2008, the Eurosystem was exposed to potentially dodgy collateral to the tune of about €10 bn and provisioned about € 5 bn.

With assets of € 1,795 bn and capital and reserves of € 73 bn, the Eurosystem has 24,6 times leverage.  A decline of just four percent in the value of its assets would wipe out its capital.  That does not look like a terribly comfortable position, as the quality of much of the assets it has accepted as collateral from Euro Area banks is likely to be uncertain at best.

Unlike the US banks and the UK banks, Eurozone banks have barely made a start on recognising the toxic and bad assets they are exposed to, on balance sheet or off-balance sheet.  I won’t this time single out Iberian banks as likely suppliers of vast quantities collateral consisting of dodgy residential mortgage-backed and commercial-mortgage-backed securities to the Eurosystem.  Being given the evil eye by the Governor of the Central Bank of Iberia is no laughing matter.  And in any case, the Irish banks are likely to have saddled the Eurosystem with collateral that yields to no other Eurozone nation in awfulness.  We know of the dreadful state of most of the German Landesbanken, the fragility of the bailed-out Commerzbank, the opaque balance sheet of Deutsche Bank, the precarious state of the remaining large listed Benelux banks, the exposure of the Austrian banks to Central and Eastern Europe etc. etc.  If any of these banks had good collateral, they would not give it to the Eurosystem.  They would sit on it.

Even before the Eurosystem starts to buy private securities outright (as it is planning to do with high-grade covered bonds, Pfandbriefe, to the tune of € 60 bn), it is certainly within the realm of the possible (or even likely) that it would suffer losses on its assets of €73 bn or more, before this crisis and this contraction are over.

That, of course, would not endanger the solvency of the Eurosystem, which has the present discounted value of current and future seigniorage income (the interest earned (or saved) by being able to borrow at a zero rate of interest through the issuance of currency and through mandatory reserve requirements).

The monetary base issued by the Eurosystem (not all of which is held in the Euro area) is just over a trillion euros.  Eurozone GDP at current market prices in 2008 was about € 9.2 trillion.  So the monetary base is about 11 percent of GDP.  If long-run nominal GDP growth in the Euro Area is four percent per annum (two percent real GDP growth and 2 percent inflation), then, assuming for simplicity that the demand for base money does not depend significantly on the rate of inflation for low rates of inflation), the Eurosystem would be able to issue another 0.43 percent of GDP worth of additional base money each year ($40 bn worth of base money in 2009) withough putting upward pressure on inflation or driving it above the inflation target, assumed to be 2 percent to make the arithmetic easy.

This is likely to be an overstatement of seigniorage revenues at a rate of inflation consistent with the price stability mandate for two reasons.  First, the demand for base money is likely to be boosted significantly and unsustainbly by the extreme liquidity preference of banks and households following the collapse of interbank markets and other ready sources of liquidity.  Also, a large but unknown share of euro notes is held outside the Euro Area, both for legitimate and illegitimate purposes.  This demand for euro currency will not depend on Euro Area income growth, inflation and interest rates.

Even if the ‘normal’ euro seigniorage as a share of GDP at a 2 percent rate of inflation is only 0.2 percent of GDP, the capitalised value of the current and future stream of seigniorage, assuming that the long-term nominal interest rate exceeds the long-term growth rate of nominal GDP by one percentage point, would be 20 percent of Euro Area annual GDP.  That would allow the ECB to absorb quite massive losses to its balance sheet, which as it happens equals 19.5 percent of Euro Area annual GDP.

A complete blow-out of the balance sheet of the ECB is unlikely, to say the least.  Admittedly, we have to set against the present value of current and future seigniorage the present discounted value of the cost of running the Eurosystem.  The ECB is lean and mean, but many of the NCBs are over-staffed, bloated organisations.  I have not been able to find data on the current and capital costs of the Eurosystem, but it seems unlikely to alter the conclusion that with its monopoly of the issuance of currency in the Euro Area, and its tax on eligible bank deposits (aka reserve requirements), the Eurosystem is so wildly profitable that it can withstand very large capital losses on its conventional financial balance sheet.

Things are different in that regard for the Bank of England and the Fed, where, under normal circumstances, base money is a much smaller fraction of annual GDP than in the Euro Area – typically no more than 4 or 5 percent.  The maximum losses these central banks can sustain without having to either increase base money issuance to a volume that generates inflation above the (implicit or explicit) target, or knock on the door of the Treasury for compensation for their capital losses are therefore less than a quarter of the losses the Eurosystem can tolerate.

That is just as well, since the ECB and the Eurosystem ‘swim naked’: there is no Euro Area fiscal authority that, explicitly or implicitly, stands ready to act as the recapitalisor of last resort for the Eurosystem.  As the Euro Area develops financially, and as its Southern Fringe becomes less tolerant of tax evasion and the grey and black economies, the demand for base money will shrink as a share of GDP.  This would tighten the intertemporal budget constraint of the Eurosystem and make it more likely that it will have to look for a Euro-Area fiscal indemnity for capital losses incurred in the pursuit of its monetary, liquidity and credit easing objectives.  But that is likely to become an issue only with the next financial crisis, a couple of decades down the road.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website