Opinion: Central banks beyond the bottom line
The true performance of central banks lies in stability, credibility, and independence — not profits or losses
By V Thiagarajan
The bottom line of central banks was at the centre of debate recently, as heavy criticism was directed at the Federal Reserve for incurring expenditure on renovating its premises while simultaneously reporting substantial losses.
At a time when trust in institutions is already fragile and institutional independence is under threat, misconceptions about the central banks’ earnings or losses can create false notions. This article argues against attaching too much importance to the bottom line and seeks to identify the ideal performance metric for central banks.
Central Banks and Society
To set the tone for the discussion, let us recall that Fed had previously disclosed two types of losses — an operating loss of USD 77.6 billion for 2024, down from of USD 114 billion in 2023, and cumulative “unrealisedlosses” of USD 1.06 trillion on its holdings of treasury securities and mortgage-backed securities, up from USD 948 billion at the end of 2023.
The advent of fiat money has made the link between central banks and society more important than the relationship between the central bank and government. Hence, central banks should strive to contribute to social capital by offering predictability, confidence, and credibility while pursuing policies that create socially optimal outcomes. It is all about putting purpose above their performance numbers.
Unlike commercial banks, a central bank’s profits or losses largely represent transfers within the financial system, not the creation or erosion of wealth. The bottom line reflects transfers across sectors, depending on interventions in foreign exchange, interest rates, or liquidity management.
Hence, central banks do not consider their annual financial performance as a key output metric, unlike commercial banks. However, profits are important to maintain a resilient balance sheet and financial independence from government. Ideally, central banks should aim for steady profits over the medium term so their capital grows in line with the economy, helping them handle increasing risks. (Wessels and Broeders, 2022).
Central banks’ profits arise from seigniorage (the difference between the cost of printing and the value of currency) and subsidy by commercial banks through non-interest-bearing cash reserves. The interest paid by the government to central banks on sovereign bond holdings adds to the profit, and much of it circulates back as dividends.
Performance Measurement
If a central bank achieves low and stable inflation, its balance sheet will have little volatility, and the balance sheet should grow as demand for central bank liabilities increases with the volume and value of transactions in the economy.
However, when pursuing exchange rate targets, central banks may build large foreign asset holdings either to prevent devaluation or offset appreciation. The increase in foreign assets can create more central bank money than is naturally needed. Similarly, targeting interest rates involves buying government bonds, which also increases more money in the system.
Rather than passing unrealised gains to governments, central banks should build capital buffers in good times, bolstering resilience during stress periods
Would it make sense for a central bank with large foreign currency reserves to increase their value by triggering a devaluation of its own currency just to generate a windfall or keep interest rates low during high inflation just to preserve low-cost funding and generate profits? Obviously, such actions would be inappropriate.
Excessive market interventions create moral hazard, as the markets remain assured that the central bank will always step in when issues arise and run unhedged risk positions. The ‘central bank put’ is well-known globally. The size of intervention relative to forex market turnover has often been suggested as an indicator of the extent of participation in forex markets. If the central bank’s participation exceeds that of the market, it signals excessive “handholding”.
Best Observed Practices
Central banks should adopt mark-to-market accounting (recording assets at today’s market value) consistent with International Financial Reporting Standards (IFRS) to reflect their true financial conditions. More importantly, they must differentiate income recognition (earnings) from income distribution (spending).
Debate continues over whether the central banks should prioritise profit-making to ease the fiscal worries of the governments rather than focus on their mandates. The most disputed issue is not when central banks should transfer their profits, but how much of these profits should be retained by them to strengthen their balance sheets.
Unrealised gains (eg, when bonds or reserves rise in market value without being sold) should not automatically flow to fiscal authorities. Instead, they should be used to build capital buffers in good times, bolstering resilience during stress periods. Several jurisdictions, including Australia and the UK, already follow such asymmetric rules.
Furthermore, before distributing profits, central banks should use stress tests to assess whether projected income and capital buffers are sufficient under adverse scenarios (IMF 2024). Adrian etal (2024) also emphasise that income distribution rules should be both forward-looking and risk-based to account for the potential losses from unconventional monetary policies while safeguarding financial autonomy and, ultimately, their independence.
Summing up, the profits or losses are not a performance metric for a central bank. These paper losses, also known as accounting entries, should not constrain them from normal activities such as renovating their buildings. What matters is how central banks deliver on their mandates.
(The author is chairman, SYFX Treasury Foundation. Views are personal)
