March 31, 2020

Jens van ‘t Klooster, KU Leuven and University of Amsterdam

Commentators have raised various concerns over provisions in the $2 trillion US stimulus bill that assign $454 billion to protecting the Federal Reserve against losses. The most basic worry is that losses should not matter to a central bank. Although I agree that a lot ultimately rests on conventions, that is true for many things. This fear of losses, rather than the Federal Reserve Act itself, may ultimately be what stops it from doing what Dan Awrey, Leah Downey and Robert Hockett have rightly said it should: provide at least some of the support now available to Wall Street to the US’s struggling real economy.

In this blog, I will first say something about why it makes (some) sense to spend this money to protect the Federal Reserve against technical insolvency. I then contrast the Federal Reserve’s attitude with what is happening in Europe, where the European Central Bank has historically also been immensely concerned about losses. For now, in launching its Pandemic Emergency Purchase Programme (PEPP), it has given up a lot of its earlier risk aversion.

Let me start with some philosophy: does it even make sense to think about financial risk in relation to central banks? Central banks report on their activities and design their operations assuming the reality of their accounting framework. From this balance sheet perspective, central banks are exposed to financial risk because they hold financial assets. Accounting is crucial for private sector agents because they face budget constraints. If central banks operate on an analogous logic, they face a risk of insolvency in this accounting sense. If the value of their assets drops below the value of their liabilities, they are insolvent.

Central bank budget constraints, however, are not at all like those of the private sector. They are not enforceable through the legal system in the way that budget constraints of economic agents are. Where it comes to obligations to pay in in its own currency, central banks can always just print the money. For this reason, the consequences of insolvency are limited. Indeed, the central banks of Chile, the Czech Republic, Israel and Mexico have operated with negative equity, holding assets valued less than their liabilities, for years. It is true that central banks often have strict legal requirements for controlling and reporting the value of their assets and liabilities.12F Calls to “Audit the Fed,” as critics have rightly pointed out, falsely suggest that the Federal Reserve is currently not audited by an outside accounting firm. Central banks, however, often decide on their own accounting framework. The Fed, in fact, used this power in 2013 to create a new way to avoid net negative equity. A central bank is, hence, somewhat like a firm under historical socialism, where, even if accounting practices were in place, bankruptcy remained a political decision and losses per se would not result in the dissolution of the firm.

The absence of a default risk, however, does not mean that central bank accounting has no practical significance, as central bankers are keen to point out. A central bank with net negative equity may change its behaviour to a more profit-oriented strategy, which may hinder its macroeconomic and financial market roles. Financial market participants and governments may have less confidence in the central bank, threatening its independence and ability to achieve its objectives. Citizens may think all sorts of things. As is the case for all institutions at the pinnacle of the financial system, as Katharina Pistor has argued, the financial constraints that central banks face are more discretionary and depend crucially on their own perceptions, those of other political institutions and those of market participants.

We should not underestimate how serious central bankers take their budget constraints. Risk management informs an important part of the day-to-day operations of a central bank. Many of the key operational decisions turn on whether risks are properly anticipated and mitigated. To give up on that approach in a crisis is difficult. This is illustrated by the Fed’s September 2008 decision to withhold credit from Lehman Brothers, which was based on concerns about losses. Fear of losses is also part of why central bank swap lines, which Elham Saeidinezhad already called attention to, have such a narrow geographic reach. For central bankers, taking on financial risk requires an immense psychological transformation. This, and the $4 trillion in loans that it is meant to unlock, is ultimately what Congress pays for. Eligibility criteria for these programmes may still be way too strict.

To illustrate central bank reluctance and draw some comparisons, consider a European perspective. Here too, central bankers tend to be immensely preoccupied by financial risk. In the past weeks, however, the European Central Bank has made some dramatic moves  that side-line a host of preoccupations that were decisive in its response to the previous crisis (for more detail see my blogs on this here and here).

The ECB’s legal mandate does not say much about risk management beyond a provision that says that credit should be secured by “adequate” collateral. The main issues are for the ECB itself to decide, which initially gives rise to considerable internal fighting over how to deal with risk. In 2005, the ECB resolved most of these debates by committing itself to a strict market-based approach. From then on, the ECB’s collateral policy, also with regard to government bonds, had served to protect it against losses. Moreover, its risk management strategy is meant to follow, rather than shape, market practices. To this end, the ECB makes the collateral eligibility of government bonds conditional on a sufficiently high credit rating issued by Moody’s, S&P and Fitch. In the 2010-12 Eurozone Crisis, this risk management strategy shaped the ECB’s actions and stopped it from taking up a role as lender of last resort to the member states.

The ECB gave up its narrow focus on risk management only partially after Mario Draghi in July 2012 committed to do “whatever it takes.” When in 2014 the ECB started its Quantitative Easing programme, the ECB imposed a range of constraints on purchases to protect itself against losses. For one, government bonds are bought by the national central banks (e.g. the Bundesbank and the Banque de France) to ensure that any default would not impose losses on the ECB itself. Purchases strictly followed the ECB’s capital key, which is determined by population and GDP of individual member states. The ECB also takes various measures to ensure that secondary markets continue to shape risk premia paid by individual member states. Finally, the programme remained burdened by the ECB’s minimum credit rating, which led to the exclusion of Greece and the inclusion of highly-rated corporate bonds issued by Royal Dutch Shell and other fossil fuel companies.

Although the ECB has thus historically been very preoccupied with financial risk in designing its crisis-fighting measures, the recent Pandemic Emergency Purchase Programme constituted a radical break. The key passage from the ECB press release comes at the end:

To the extent that some self-imposed limits might hamper action that the ECB is required to take in order to fulfil its mandate, the [Governing Council of the ECB] will consider revising them to the extent necessary to make its action proportionate to the risks that we face.

Although less pithy than “whatever it takes,” the PEPP’s key provision is more compelling in its implicit philosophy and certainly more powerful. It admits that most limits hitherto applied to ECB tools were self-imposed. Therefore, they can be revised in light of the risk (i.e., the economic dangers from the pandemic) that the Eurozone faces. This kind of recognition at the ECB opens the door to giving up the capital key and other restrictions on the PEPP. For now, it is noteworthy that Greece is already explicitly part of the programme. The ECB also expanded the already uniquely generous eligibility requirements of its collateral framework. It is striking that all these things become possible under its new president Christine Lagarde, who may very well lack the central banker’s intuitive risk aversion. 

Are the Federal Reserve and the European Central Bank on different trajectories with regard to risk? Let’s see when the dust settles.