Understanding the Central Bank Balance Sheet


The balance sheet of the central bank is critical to everything the central bank does and therefore for the overall economy. The transactions that impact central bank balance sheet include: the issuance of currency, foreign exchange operations, investments of its own funds, emergency liquidity assistance and finally, when it conducts monetary policy operations.

To understand how central bank’s balance sheet works this post covers following topics:

  • Role of the central bank’s liabilities;

  • Changes in central bank’s balance sheet;

  • Components of the balance sheet

  • How does the balance sheet evolve over time?

  • Central bank income

1. Role of the central bank’s liability

The central bank’s liability side — banknotes and commercial bank reserves — are both a form of money in a modern economy and in fact it underpins nearly all other forms of money. It’s also ultimate means of settlements for the economy while when electronic money needs to be transferred between two commercial banks, central bank reserves move across the balance sheet of the central bank with one commercial bank’s reserve account being debited and another being credited. Therefore the central bank provides a transactional means that underpins confidence in commercial bank deposits as a means of settlement.

2. Changes in Central Bank’s Balance Sheet

There are two major doctrines in monetary policies: quantitative targets vs price targets. From 1970s to 1980s quantitative doctrines where more popular — setting fixed reserve ratios to commercials banks. But this approach failed because of two reasons. The first is that it is very hard to control quantity of money in short-term while demand of banknotes and reserves is macro-economical and it is hard to predict, so fixing quantity led to significant market instability. The second is that there is no clear reason why the central bank should try to control with precision the quantity of its liabilities, this approach oversimplifies the role of commercial banks in money creation.

After quantitative targets failed central banks moved to targeting the price of money. The most of today’s central banks have inflation target or a closely related framework (both unemployment and inflation). The foundation of such a framework involve using a short-term interbank interest rate as the operational target of monetary policy. That is central banks target the domestic price of money, which through a broad transmission mechanism influences the ultimate goal: inflation. In dollarized economies some central banks choose to target exchange rates as their monetary policy targets.

During the financial crises commercial banks to settle transactions in commercial bank deposits was threatened. That’s why central banks increased the supply of reserves through various methods to ensure smooth settlement of transaction. Thus in the early stages of the crisis the increase in central bank balance sheet was liability driven. Later on, when liquidity problem was solved but central banks wanted to stimulate the economy they implemented policies of asset purchases aimed to reduce long-term interest rates (booth reducing risk-free rates and spread between risk-free rates and other rates). As these asset purchases were financed by the creation of reserves, central bank balance sheets continued to increase, however, in this instance growth was asset driven.

3. Composition of Balance Sheet

While central banks publish their balance sheets on a regular basis, there is no agreed standard format or frequency. The most common timeframes are weekly, monthly or annual bases publications.

 

 
1_-nD5q75UopSzZQYlSmX1rw.png
 

Liability Side

A) Banknotes — this element covers banknotes issued by the central bank that are in circulation, held by commercial banks or in ATMs. Central Banks provide banknotes on demand to commercial banks and the wider population then obtains banknotes either through withdrawals or from other agents. The process of issuance involves commercial banks printing banknotes in exchange for reserve balances held at the central bank.

 
 

Shot-term demand for banknotes is very volatile:

  • Within the week, demand for banknotes typically increases ahead of the weekend and vice versa is true at the start of the week;

  • Within the month, demand for banknotes depends of how large proportion of population has access to financial services. If a large proportion of the population does not have access to banking facilities, and instead receive their salaries in cash, then the intra-month variation may be more huge.

  • Major holidays such as Christmas or Eid al-Fitr, which also involve gift giving usually lead to an increase in demand for banknotes in the days leading up to them.

There are opportunity costs that limit the demand for cash. In particular banknotes are a zero interest paying asset. The size of this opportunity cost will vary over time depending on the central bank’s interest rate. In periods of low interest rate the opportunity cost of holding banknotes will be lower. In addition banknotes are generally a less safe method for holding value; if the holder of a banknote is robbed then it is often difficult and costly to be compensated.

B) Commercial Bank Reserves — reserves are overnight balances that banks hold in an account at the central bank. Together with banknotes, reserves are the most liquid, risk-free asset in the economy. And they are the ultimate asset for settling payments; Commercial Bank Reserves plays the most critical role in monetary policies thus below let’s elaborate more on major aspects of it.

Misconception 1 — reserves and other assets

One of the biggest misconceptions is the idea that commercial banks in aggregate can choose between reserves and other assets. While it is true that an individual commercial bank is free to choose between reserves and other assets, at the system-wide level the quantity of reserves is determined by accounting identities on the central bank’s balance sheet. To understand this idea, consider what happens when an individual commercial bank attempts to reduce its reserve balance. If the commercial bank buys an asset, then while the purchasing bank’s reserve balance has been reduced, the selling bank’s account has been credited by the same amount. If the institution selling the asset does not hold a reserve account at the central bank then its correspondent account at its clearing bank is credited with the balance and that clearing bank’s reserve account is credited with the reserves. Even if the commercial bank attempts to reduce its reserve balance by purchasing an asset in a foreign currency then the reserves will remain in the system. To purchase the foreign asset the commercial bank must obtain the foreign currency: to do this it must exchange its domestic currency (the reserves) for this foreign currency with another bank. The bank providing the foreign currency then receives the reserves. Finally, even when commercial banks increase their lending they cannot reduce total amount of reserves while when borrower spends money deposits and therefore reserves transfers from Bank A to Bank B.

If there is a distinction between required and free reserves, the process of lending can lead to a reclassification of reserves, but not a change in the total quantity.

The only feasible means by which commercial banks can independently reduce the total quantity of reserves in the system is by exchanging reserves for banknotes. However, similar opportunity costs exist for commercial banks in holding banknotes as for individuals.

Misconception 2 — reserves to lend

A further misconception surrounding reserves is that commercial banks require reserves to lend. The process of creating a new loan by a commercial bank involves deposit transfers between commercial banks and reserved also move in return, this simply reflects a credit and debit of different commercial bank account.

Lending of reserves to be held at system wide level was only increased when central banks had fixed reserve ratio. his explanation supports the traditional money multiplier explanation of monetary policy, where the central bank implements monetary policy by varying the quantity of money The money multiplier treats the banking system as a black box through which loans are made in a mechanical way constrained only by central bank provision of reserves. In reality commercial banks and their role in credit creation is far more complex than this. In reality the most central banks uses lagged reserve system. This means that current reserve requirements are imposed on lending measured in a previous period.

Required versus free reserves

Many central banks impose reserve requirements on commercial banks that hold reserve accounts with them. This requires commercial banks to hold a certain balance on their reserve account, either at all times, at a specific point in time or on average over a period. Today there are five potential roles for reserve requirements: monetary policy purposes, liquidity management purposes, structural liquidity purposes, central bank revenue purposes and sectorial behaviour purposes.

  • Required reserves for monetary policy purposes: required reserves can be employed for monetary policy if the reserves are unremunerated or remunerated at a rate of interest that is below the prevailing interbank market rate. The idea was that forcing commercial banks to hold reserves that pays less then market rate creates deadweight on commercial bank lending and it will effect both lending and deposit rates. For example increased reserve requirement will give incentives to increase to the banks their loan rates or decrease deposit rates if bank wants to maintain existing net interest rate margins. The impact of a change in reserve requirements in this framework has an economic effect equivalent to a change in interest rates.

  • Required reserves for liquidity management: reserve requirements can also be applied for liquidity management purposes if commercial banks are free to meet such requirements on average over a period.

  • Required reserves for structural liquidity purposes: The imposition or variation of reserve requirements can be used by the central bank to change or enhance the desired liquidity shortage. As discussed below, central banks will generally prefer to operate with a liquidity shortage, and by using reserve requirements to increase the liabilities side of the asset sheet, they can create or enhance such a shortage.

  • Required reserves for revenue purposes: reserve requirements can also be used for central bank revenue purposes. In the United Kingdom commercial banks over a certain size are required to hold a small unremunerated balance at the Bank of England, known as Cash Ratio Deposits. These balances are then invested by the Bank of England in other assets to earn a return that is used to finance the policy functions of the Bank.

  • Required reserves for sectorial behaviour purposes: finally reserve requirements can be used by central banks to try to influence commercial bank behaviour towards different sectors of the economy. For example a central bank could try to encourage either domestic lending over foreign lending or lending to particular sectors by imposing lower reserve requirements on the desired form of lending.

Capital

In many ways central banks are structured like private corporations. A further point pertaining to central bank capital levels is that while in an accounting and legal sense central banks are structured in a similar way to private sector companies, their ultimate goals vary significantly. While private sector companies are focussed on profits and maximising shareholder value, central banks are focussed on achieving policy goals.

For example if a central bank were to undertake a programme of quantitative easing it would be buying government debt at what will likely be low yields (high prices) as investors seek safety over risky assets. Such a situation would likely occur in a period of depressed growth in the economy with inflation either undershooting or being forecast to undershoot its target. A mark of success for such a programme would be economic recovery and inflation back closer to target. When the economy recovers, the yields on government debt will tend to increase (prices fall) as investors once again choose to purchase riskier assets and policy rates are raised. When the central bank comes to sell its bond holdings it will likely do this at a loss. Despite the financial loss it has been socially optimal for the central bank to undertake this programme as it has achieved its policy goal of encouraging growth and/or meeting its inflation target.

Assets

A) Foreign assets: Foreign assets (and liabilities) are those denominated in a non-domestic currency. The main form of foreign assets held by central banks is foreign exchange reserves. Central banks hold foreign exchange reserves for a variety of purposes including intervention, the need to meet external obligations on foreign currency debt (public and/or private) and to cover trade balances.

  • When a central bank intervenes to counter appreciation in the domestic currency all other thing being equal it will increase its holding of foreign exchange reserves. The central bank will intervene by selling domestic assets (likely reserves assets in GEL) in exchange for foreign currency denominated assets.

  • Foreign exchange reserves are also a prerequisite for a central bank being able to intervene to offset depreciation in the domestic currency. The central bank will intervene by selling foreign assets in exchange for domestic currency denominated assets (securities or domestic currency denominate reserve assets)

In addition to foreign currency denominated assets, the central bank may also carry on its balance sheet foreign currency liabilities. First, In many economies where there is significant foreign exchange activity, but underdeveloped financial markets, the central bank may provide foreign currency facilities to its commercial banks. As a central bank cannot create foreign currency in the same way it can create domestic currency, such facilities must be matched either by existing holdings of foreign currency assets or an agreed swap line with the central bank of the currency provided. Second, to get more foreign currency reserves the central bank may issue foreign currency liabilities in exchange for foreign assets.

 
 

B) Government Balances: Where government deposits funds at the central bank these appear as liabilities. Fundamentally such accounts are identical to reserve accounts, although they may be treated differently within the central banks operational framework, they may not be subject to reserve requirement or remunerated in the same way. When the government increases its balance at the central bank, through collecting taxes or issuing debt, it does so at the expense of the balances of commercial banks: when it reduces its balance, through expenditure or paying salaries, it does so by increasing the reserves available to commercial banks.

If over time government spending is not financed by taxation, debt sales or borrowing from commercial banks the central bank will lend to offset the deficit in the fiscal account. In doing so the central bank increase the reserves accounts of commercial bank for government loan. The offsetting asset will be an entry due to the central bank from government (government bond security). There are many instances through history where this direct monetisation of government debt has led to high inflation and poor macroeconomic outcomes.

 
 

c) Central Bank Operations: Given the nature of a balance sheet, the quantity of commercial bank reserves available to the banking system as a whole is determined by changes in the remaining elements of the central bank’s balance sheet. The majority of changes are independent from central banks influence and they require some mechanism to respond to these changes to ensure that the optimal quantity of reserves is available to the banking system. It is through central bank operations that the central bank controls the availability of reserves to the system. Operations that provide reserves to commercial banks will show as assets of the central bank while operations that reduce the amount of reserves held by commercial banks will appear as liabilities.

Types of central bank operation

  • Supply Liquidity: Central bank operations can take a variety of forms. Operations to supply liquidity to the market include both active (open market operations) and passive (standing facilities, bilaterally) operations. Central banks can also choose to operate across a range of maturities, from the outright purchase of long-maturity assets down to the overnight repo of securities.

  • Absorb: A choice facing central banks in the face of surplus liquidity is whether to accept the surplus of liquidity or to move to a shortage of liquidity. If the central bank accepts the surplus of liquidity it can choose to use a range of maturity instruments to absorb enough liquidity to bring the market back to balance, that is, to the point where market prices are in line with policy. In that case even the shortest-term operations are on balance liquidity absorbing. If the central bank chooses to move to a shortage of liquidity it will absorb, usually through longer maturity operations a quantity of liquidity greater than the size of the liquidity surplus leaving a shortage of liquidity that the central bank can meet through short maturity liquidity providing operations. In that case the short-term operations will on balance be liquidity providing

Securities

From a balance sheet perspective, when a central bank lends to a commercial bank it creates a fresh asset, but what exactly is the asset it holds? If the central bank were to lend unsecured to the commercial bank then the asset would be a claim on the commercial bankHowever, it is almost unheard of for a central bank to lend to commercial banks in an unsecured manner. Instead for risk management purposes central banks will take collateral to protect the central bank against the possibility of loss resulting from credit and market risk. Therefore the asset on the central bank’s balance sheet is the collateral taken in return for the provision of reserves.

In addition to risk management purposes, collateral choices, coupled with the form of central bank operations, are made with the knowledge that such choices can have a significant impact on both the functioning of the central bank and the wider economy. From a central bank perspective collateral choices impact on central bank income and exposure to credit and market risks, while for the wider economy choices have both a portfolio balance and liquidity impact. These impacts are summarised below. In practice, there are costs and benefits to all of the choices and central banks in practice will utilise a range of such operations and collateral.

When a central bank absorbs liquidity from the market there is no impact on the asset side of the balance sheet. On the liability side the operation coverts commercial bank reserves into other liabilities. However if central bank absorb by providing collateral it sells assets issued by another issuer then the commercial bank will hold that asset as collateral instead. The decision to provide collateral to the commercial banks or leave them with an unsecured claim on the central bank is not made for risk reasons but wider market functioning reasons.

Off-balance sheet swap

Not every operation the central bank conducts will necessarily appear on its balance sheet. For example, during the global financial crisis that began in 2007 the Bank of England created a facility known as the Special Liquidity Scheme (SLS). The SLS was designed to take illiquid, legacy mortgage-backed securities from commercial banks and swap them for liquid treasury bonds created by the UK Debt Management Office with the aim of reducing commercial bank funding costs. As these transactions were a pure collateral swap they did not appear on the Bank of England’s balance sheet.

 
 

How does the balance sheet evolve over time?

A liability driven central bank balance sheet grows through time as demand for central bank liabilities increases. As discussed above such growth reflects an increase in nominal GDP, as both the volume and value of transactions in an economy increase and commercial banks increase the supply of credit. With growth in demand for such liabilities, the central bank, to ensure payments are made and operational targets are met, must respond by supplying the required reserves through operations. Therefore a liability driven central bank balance sheet will be characterised by a majority of central bank operations on the asset side of the balance sheet. Such a situation is commonly referred to as a shortage of liquidity.

On the other hand an asset driven balance will grow as a result of policy decisions made regarding the asset side of the balance. Growth in any of the main asset classes potentially outstrips growth in demand for central bank liabilities. The liabilities of the central bank are then either characterised by the presence of excess free reserves or operations to absorb such reserves. Such a situation is commonly referred to as a surplus of liquidity.

When there is a shortage of liquidity, commercial banks are forced to borrow from the central bank, potentially at penalty rates, otherwise reserve requirements will not be met and interbank payments would not be made. As a result when the central bank is lending money to commercial banks it is able to choose the terms on which it deals, such as the assets it takes to match its liabilities. This allows the central bank to limit the level of risk it is willing to be exposed to. In these circumstances, operations should earn central banks money.

When there is a surplus of liquidity, then depending on the overall size of the surplus commercial banks may need to transact with the central bank in order to meet reserve requirements and make interbank payments. The central bank therefore may be in a weaker position to dictate the terms on which it transacts with the market. In this situation, operations can cost the central bank money.

When there is a shortage of liquidity therefore, the central bank will always lend enough to the market to obtain balance, but when there is a surplus of liquidity it is harder for the central bank to drain enough to obtain balance and with excess liquidity central bank has less monetary tools.

4. Central bank income

The structure of the central bank’s balance sheet also plays an important role in determining the central bank’s income. Ultimately income is the difference between what is due on liabilities and what is earned on assets

 
 

Seigniorage income The main source of central bank income is from what is known as seigniorage. Seigniorage is simply the difference between the income earned from its face value and the cost of producing it. The cost of producing banknotes is relatively small. Despite significant investment in security features and the costs of running the printing press and the distribution network, the cost of the average banknote is a fraction of the face value of the note. In addition, once banknotes go into circulation they are a zero interest paying liability. Unlike banknotes there is no physical cost to producing reserves, the central bank can create reserves simply by pressing a key on a keyboard to credit a commercial bank account. However, unlike banknotes reserves are often an interest paying liability. Many central banks remunerate required reserves, to ensure that reserves do not play a monetary policy role. The rate of remuneration is often in line with policy rate and/or the prevailing market rate, taking away the opportunity cost to commercial banks from holding reserves. On electronic reserves magnetite of income or loss depends on asset class quality, when there is liquidity shortage central bank require quality assets when there is surplus then it might get low quality assets.

5. Fed Policy Instruments