Willem H. Buiter
Willem H. Buiter, a former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England, is an independent economic adviser.
NEW YORK – The European Central Bank recently reported its first annual operating loss since 2004. Its losses for 2023 amounted to €1.3 billion ($1.41 billion), following the release of €6.6 billion from its provision for financial risks. In its accounting treatment of this loss, the ECB is relying on the same misleading fudge as the US Federal Reserve Board, which has conjured up a “deferred asset” category to deal with excessive losses.
As the ECB press release explains, this loss “will be carried forward on the ECB’s balance sheet to be offset against future profits.” This means that a loss was entered as a positive asset, even though the sensible alternative would have been to enter it as negative retained earnings in the shareholders’ equity section on the liabilities side of the balance sheet. Total net equity – the sum of paid-up capital, any amounts held in the financial-risks and general-reserve funds, the revaluation accounts, any accumulated losses from previous years, and any profit/(loss) for the year – should be on the liabilities side of the balance sheet.
The Fed, too, enters losses that would take its net equity below a threshold value either as a positive asset (the “deferred asset”) or as a negative liability on its balance sheet. In its own words:
“The Federal Reserve Act requires the Reserve Banks to remit excess earnings to the US Treasury after providing for operating costs, payments of dividends, and any amount necessary to maintain surplus. During a period when earnings are not sufficient to provide for those costs, a deferred asset is recorded. The deferred asset is the amount of net earnings the Reserve Banks will need to realize before their remittances to the US Treasury resume.”
Following this logic, why not allow a shareholder-owned private company to include losses that would take the firm’s capital below some threshold level as a deferred asset (or a negative liability) on its balance sheet? After all, the privately owned company is obliged to remit excess earnings to its shareholders after accounting for operating costs, debt service, and any amount necessary to maintain a surplus. The corporate deferred asset would be the amount of future net earnings the company would need to realize before payment of dividends to its shareholders can resume. Obviously, this would be economic and financial nonsense.
At least the ECB properly reports the profit/loss when it discloses changes in its total net equity. Net equity was €51.6 billion at the end of 2022 and €44.5 billion at the end of 2023. Most securities held by the ECB and the Fed are valued not at market prices but at amortized (historical) cost. For the ECB, this includes all financial instruments held for monetary-policy purposes. At the end of 2023, securities held by the ECB under the Securities Markets Program, the Asset Purchase Program, and the Pandemic Emergency Purchase Program were worth €39.9 billion less at market value than at amortized cost, leaving the ECB with positive equity of €4.6 billion with assets priced at market value. At the end of 2022, there would have been €7.9 billion negative equity at market value.
These fair-value discounts are surprisingly low. I have not been able to obtain cumulative unrealized losses for the Eurosystem, but the Fed’s cumulative unrealized losses on its System Open Market Account (SOMA) holdings were $1.3 trillion as of September 30, 2023. The deferred asset on that date was $105.9 billion. The Fed’s reported total reserve bank capital of $42.7 billion therefore turns into a “fair value and no deferred asset” amount of -$1,365.1 billion.
What do these central banks say about this? According to the ECB, it “can operate effectively and fulfill its primary mandate of maintaining price stability regardless of any losses.” The Fed not only makes the same assertion, but also adds that losses cannot be a threat to its solvency: “Negative net income, and the corresponding creation of a deferred asset, do not affect the Federal Reserve’s ability to conduct monetary policy or meet its financial obligations.”
True, since the ECB and the Fed have negligible foreign-currency-denominated liabilities, they can always print domestic currency to meet their financial obligations. But if the losses are large enough ($1.3 trillion of realized losses would be a serious matter), the seigniorage required to avoid insolvency could threaten price stability.
Equally, if losses are large enough, the only way the central bank can meet its financial obligations and its price-stability mandate is by receiving a net financial transfer from its beneficial owner(s). For the Fed, this would be the US Treasury. For the ECB, it would be the 20 eurozone member-state central banks and their beneficial owners (i.e. national fiscal authorities).
But the US Treasury has no bailout or recapitalization agreement with the Fed (unlike the Bank of England, which has an exemplary recapitalization agreement with His Majesty’s Treasury). Similarly, national central banks across the eurozone may not be able to recapitalize the ECB without increasing their seigniorage on a scale that threatens price stability (a move that would have to be authorized by the ECB Governing Council). Moreover, the willingness and ability of eurozone national fiscal authorities to come to the rescue of their national central banks and the ECB are ultimately unknown.
Both the ECB and the Fed should abandon their deferred-asset nonsense, work out recapitalization agreements with their beneficial owners, and prepare for large realized losses.
