How deep are the ECB’s pockets?

FT alphaville

The ECB’s exposure to peripheral sovereign debt and a host of other assets of dubious quality has sparked concerns about the central bank’s solvency. The concerns are misplaced. Central banks cannot go bust. The vast majority of the ECB’s obligations are denominated in euros and so, in the case of losses, the central bank can simply print more money.

But money printing on a grand scale could spark inflation. And, while the ECB and the eurosystem central banks have a capital buffer of €80bn, this is relatively small when held up against the size of the eurosystem’s balance sheet, which stands at a whopping €2.7tr — even before tomorrow’s offer of three-year loans is taken into account.

And so, while the ECB won’t go bust, there are some grounds for fears that it does not have pockets deep enough to absorb losses if a sovereign were to default, or a large bank to collapse. If one of those scenarios did occur, then the ECB could find itself in a position of negative capital.

This is no disaster. Many other central banks have found themselves in such a position before. But the ECB regards negative capital as a threat to central bank credibility and independence.

If the ECB and the national central banks could not absorb losses, then it could call on the national central banks to force their respective governments to recapitalise the eurosystem. However, this is hardly likely to be the most popular of measures — particularly in the case where the losses resulted from a sovereign default, as it would essentially represent a bailout of the eurozone periphery by the back door.

However, in a research note published on Monday, Willem Buiter, a former MPC member, and Ebrahim Rahbari, his fellow Citi economist, argue that there is little cause to fear.

By their calculations, the ECB can absorb losses of €3.4tr — 20 per cent more than the size of the central bank’s balance sheet.

How so?

First, rather than counting just the capital buffer, the sum also includes the ECB’s revaluation accounts. The revaluation accounts include unrealised gains on the eurosystem’s holdings of gold, FX, and other investments. If these accounts were combined with the eurosystem’s capital, then the ECB could absorb losses of about €500bn.

But the big difference comes from the second factor: future gains from seigniorage, i.e. the eurosystem’s monopoly on creating euro notes and coins.

The main asset of the ECB/eurosystem is not recorded on its balance sheet…

This asset is the monopoly the eurosystem has on creating euro banknotes and the other components of the monetary base.

Seigniorage occurs because notes can be printed for a fraction of their face value. And the analysis points to the chart below as evidence that, despite the rise in electronic payments, cash is more in demand than ever.

By assuming that this trend will continue, and that real growth will average one per cent and inflation two per cent in the long-term, the paper puts the future gains from seigniorage at “at least” €2tr. When coupled with the outstanding stock of existing euro banknotes, which have a face value of €875bn, that tallies to €3.4tr.

Deep pockets indeed.

Which is all well and good. However, as the research notes, future gains from seigniorage are off-balance sheet, and so the ECB’s accounts would show a loss until the gains were realised. Future gains, then, offer no immediate fix to the issue of negative capital.

Again Buiter and Rahbari do not think this is too much of a problem:

When faced with very large losses on its exposures, the ECB could therefore choose to either realise the loss and continue its only slightly less happy existence with negative equity

The ECB would no doubt disagree with that view. But it is hard to see how the alternative — going cap-in-hand to governments — would wash politically.


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