It admits it owes more than it owns, and if it were a company it’d be bankrupt, but insists this doesn’t matter. I’m sceptical.
In Why the RBA should be abolished – and what could replace it (10 April) I demonstrated that, for more than a century, central banks haven’t fostered stability. Quite the contrary: they’ve created inflation, which has destroyed currencies’ purchasing power, weakened the financial system and thereby fomented volatility. The rising frequency and severity of currency, economic and financial crises has been the consequence.
This wire elaborates this crucial result. It shows that, since the GFC and in an increasingly frantic attempt to sustain an ever more rickety financial system, this country’s central bank, the Reserve Bank of Australia, has become illiquid – and since 30 June of last year, if not before, its liabilities have exceeded its assets.
The Review of the Reserve Bank of Australia, which will be released to the public later today, will probably ignore its deteriorating finances. Its Deputy Governor, too, is unfazed: she insists that can’t go bust – at least not in the sense that private sector entities do. That’s not incorrect, but it overlooks a crucial caveat: when their equity is negative, central banks tend to generate even more inflation – and thereby further exacerbate the boom-bust cycle.
Illiquidity, Insolvency and Bankruptcy
Negative equity is never a good thing, and is almost always a sign of trouble. Insolvency confirms that trouble has arrived, and that bankruptcy likely impends. A company whose liabilities exceed its assets is therefore at risk that it’s not a “going concern.” If its creditors demanded immediate payment, it couldn’t comply – even if it liquidated all of its assets. However, seldom must liabilities be liquidated all at once. As long as such a company can pay its bills and service its debts as they fall due, it can survive. When it doesn’t have the cash, and it can’t sell assets fast enough to generate it, insolvency occurs; and when creditors demand payments it can’t make, bankruptcy results.
“Being illiquid,” noted The Financial Times (“Illiquid, Insolvent, What’s the Difference?” 1 October 2014), “means that you don’t have (current assets) available to meet your current obligations. Figuring this out is straightforward: either you can pay your bills or you can’t.” If you’re insolvent, on the other hand, you owe more than you own. “That too,” reckons FT, “seems straightforward. But while solvency is often discussed as a binary condition – either you are or you aren’t – the reality is more complicated.”
This is particularly true when we’re assessing banks’ solvency. As I detailed in What Causes – and How to Prevent – Bank Crises (27 March), banks raise short-term funds (borrowings and deposits) and use the proceeds to create and acquire long-term assets (loans and securities). That’s inherently risky: depositors can redeem their claims for cash at any time, and creditors do so regularly. “Most of the time,” the FT acknowledges, “creditors and depositors are happy to (sit tight and) earn their interest … But occasionally people will want to get more cash out of a bank than the bank has on hand.”
What happens then? As the FT notes, “banks can sell … assets to raise cash, but (during crises) this probably means taking a loss. Better, if possible, to (pledge) assets as collateral to borrow from others (such as central banks) … The amount of cash a bank can raise depends on how much its assets are worth.” The problem for a bank short of liquidity is two-fold. First, in “normal” times its assets’ values aren’t immutable; they’re matters of opinion. Second, when banks desperately need liquidity these opinions become so cautious that selling assets in order to raise liquidity crystallises insolvency.
The FT concluded:
“Banks, by virtue of their unusual business model, exist in a netherworld between solvency and insolvency. If you have to ask whether a bank can repay all of its creditors all at once, it probably can’t. Government guarantees can provide some stability to this inherently unstable system, but the side effects include excessive risk-taking and unfair transfers to the beneficiaries of those guarantees. We suspect it would be simpler to change the business model.”
That’s exactly what I recently proposed (see What Causes – and How to Prevent – Bank Crises, 27 March), but I’m not holding my breath. Equally, nobody’s going to reform – never mind abolish – central banks anytime soon, so like it or not we must abide their defects.
The RBA’s Rising Illiquidity
The RBA, like other central banks, does some key things that commercial banks can’t. Equally, and like all banks, it takes deposits, extends loans, facilitates payments and buys and sells assets. Its financial statements summarise these transaction and their results. Using weekly data, Figure 1 plots the RBA’s liquidity – that is, its current assets and investments as a percentage of its total assets.
Figure 1: RBA’s Current and Non-Current Assets as Percentages of Total Assets, Weekly, 1994-2022
Three results are most noteworthy:
- From 1994 to the GFC, the RBA’s assets became increasingly liquid – that is, current assets, which it could sell immediately, comprised a rising (up to 80%) percentage of its total assets.
- During and after the GFC and until the Global Viral Crisis, liquidity fell steadily, to ca. 40% by early 2020.
- Since 2020, liquidity has collapsed: today, current assets comprise just 10% of the RBA’s total assets – and relatively illiquid “investments” approximately 90%.
As one crisis has succeeded another, the RBA’s balance sheet has become ever less liquid – and is now as illiquid as Silicon Valley Bank’s was just before it failed.
Insolvency “Negative Equity”
Tables 1 and 2 summarise the RBA’s most recent (30 June 2022) financial statements. In 2021, its loss exceeded $4 billion; in 2022, it exploded eightfold to more than $36 billion.
Table 1: the RBA’s Statement of Comprehensive Income (Millions of $A)
How has the RBA managed to lose so much money? It earned more than $8 billion of interest from the securities it owns, and relatively small amounts from other sources, but “losses on securities and foreign exchange” totaled almost $45 billion.
What are these securities? A large majority (ca. 77% in FY22) are Commonwealth Government bonds. Their duration is apportioned among short-term (up to 12 months, 9% of the total), medium term (1-5 years, 59%) and long term (more than five years, 32%).
The notes to the RBA’s financial statements state that “interest rate risk is the risk that the fair value … of financial instruments will fluctuate because of movements in market interest rates. The RBA faces interest rate risk because most of its assets are financial assets that have a fixed income stream. The (market) valuation of such securities … falls if market rates rise. Interest rate risk increases with the maturity of a security. Interest rate risk on foreign assets is controlled through limits on the duration of these portfolios.” But interest rate risk on Australian bonds apparently isn’t.
How in the year to 30 June 2022 did the RBA manage to generate a loss of almost $45 billion on its portfolio (whose size, as Table 2 shows, grew to $538 billion from $475 billion in 2021) of Australian government bonds? How, within the space of a year, did its equity of $23 billion so quickly become “negative equity” of $12 billion? The sharp rise of interest rates caused its bonds’ valuations to plummet.
Table 2: the RBA’s Statement of Financial Position (Millions of $A)
But isn’t that exactly the widely-accepted reason that caused the bankruptcy of Silicon Valley Bank? Michael Barr, the Federal Reserve’s Vice-Chair for Supervision, testified to the U.S. Senate on 28 March that the failure of SVB is “a textbook case of mismanagement … SVB failed because the bank’s management did not effectively manage its interest-rate and liquidity risk …”
If that’s true, hasn’t the RBA incurred a massive loss (which could rise further in the year to 30 June 2023) because it, too, has mismanaged interest-rate risk? Isn’t the RBA’s massive loss also “a textbook case of mismanagement”?
Commenting on Barr’s testimony, The Wall Street Journal (“The Fed Passes the Buck on Bank Failures,” 28 March) tartly concluded:
“One certainty in politics is that the Federal Reserve will never accept responsibility for any financial problem … Michael Barr played that self-exoneration game before the Senate as he blamed bankers and Congress for SVB’s failure. (His) act is simply unbelievable.”
The RBA Reckons Its Negative Equity Doesn’t Matter
Unlike most central bankers, the RBA’s deputy governor, Michele Bullock, isn’t evasive. Quite the contrary: rather than babble the usual obfuscations and central bank Esperanto (Alan Greenspan is its undisputed all-time champion), she’s refreshingly frank. According to The Sydney Morning Herald (“Reserve Bank Reveals $37 Billion Loss, Largest in Its History,” 21 September 2022), she rightly reckons “if the RBA were a commercial operation, it would (be) wound up because of the loss caused by … its $300 billion bond-buying program … The surge in interest rates here and around the world means the RBA is now sitting on a huge valuation loss on those assets.”
“If any commercial entity (has) negative equity,” Bullock added, “assets would be insufficient to meet liabilities and therefore the company would not be a going concern. But central banks are not like commercial entities. Unlike a normal business, there are no going concern issues with a central bank in a country like Australia.”
That’s because a central bank can conjure money ex nihilo – out of nothing. If a private individual or company tried this trick, it’d face prosecution for counterfeiting. But because the central bank does it, it receives plaudits from its acolytes in the universities and mainstream media!
In case we missed it the first time, Bullock reiterated it: “since it has the ability to create money, the (RBA) can continue to meet its obligations as they become due and so it is not insolvent. The negative equity position will, therefore, not affect the ability of the (RBA) to do its job.”
Bullock expressed the RBA’s official position regarding its negative equity. Its most recent Annual Report stated that position: “The rise in bond yields that has accompanied the stronger economy and higher inflation has resulted in significant valuation losses on the Bank’s holdings of government bonds. As a result, the Bank has recorded an accounting loss of $36.7 billion this year, which has reduced its equity to negative $12.4 billion. This negative equity position does not affect the Bank’s operations or its ability to operate effectively or perform its policy functions.”
The RBA’s job and policy functions, I hasten to add, are to create inflation; as a result, over time it destroys the currency’s purchasing power and foments economic and financial instability. In these respects, and as I detailed in my previous wire (Why the RBA should be abolished – and what could replace it, 10 April), it’s certainly succeeded!
The Annual Report continues: “The Board expects that the Bank’s capital will be restored over time due to positive underlying earnings and capital gains when bonds mature. Accordingly, it has not sought a capital injection (that is, bailout) from the government. Instead, the Board’s strong expectation is that future distributable earnings will be retained by the Bank to restore its capital, rather than paid as dividends to the government. The Treasurer has indicated his support for this approach, noting the situation will be reviewed each year.”
Figure 2: Federal Reserve System, Multiple of Total Assets to Equity, Weekly, 2002-2022
The Federal Reserve, too, is bleeding massively: since September, it’s generated gob-smacking operational and MTM losses of at least $1 trillion – and perhaps as much as $1.3 trillion. As a summary measure of its weakening finances – and growing policy extremism – over the past 20 years, Figure 2 plots its leverage, that is, total assets as a multiple of net assets (equity). In What Causes – and How to Prevent – Bank Crises, I noted that SVB’s leverage on 31 December was an astronomical 164: Atop every $1 sliver of equity, SVB heaped a colossal $164 of assets. If the value of its assets fell by just 0.6% – which they did – its equity would disappear and it’d be bankrupt.
Compared to the Fed’s recent leverage, SVB’s was moderate! During the six years before the GFC, the Fed’s leverage fell steadily and cumulatively halved (from 41 to 22). From September to November 2008, in sharp contrast, it zoomed to 53. In December 2015, the Fed raised its policy rate unexpectedly and for the first time in seven years – and the resultant sudden decrease of bond prices crimped its assets and thus caused its leverage to soar from 77 in November to 114 in December. During the next five years, its leverage remained roughly stable. Then, as a consequence of its monetisation of trillions of dollars of U.S. Government debt issued as a panicked reaction to the COVID-19 pandemic and lockdowns, the Fed’s leverage skyrocketed to 220 in February 2022. Over the past year, it’s receded slightly – to 205 on 22 March.
A ratchet effect is evident: the Fed’s leverage infrequently falls and typically rises – and soars during crises. How high can it rise? The more relevant question, it seems to me, is: what damage upon the economy and financial markets will the Fed’s ever higher leverage wreak?
But Others Aren’t So Sure
Does the RBA’s negative equity matter? Willem Buiter is no outsider. Quite the contrary, he’s a graduate of Cambridge and Yale universities, and has held academic posts at those institutions as well as Princeton and LSE. He’s also been an external member of the Bank of England’s Monetary Policy Committee and Citigroup’s Chief Economist. In “Can Central Banks Go Broke?” (Policy Insight No.24, Center for Economic Policy Research, May 2008) he concluded:
- “Central banks can go broke and have done so, although mainly in developing countries.
- “As long as central banks don’t have significant foreign exchange-denominated liabilities (the RBA doesn’t) it will always be possible for (a) central bank to ensure its solvency though monetary issuance (seigniorage).
- “However, the scale of the recourse to seigniorage required to safeguard central bank solvency may undermine price stability. In addition, there are limits to the amount of real resources the central bank can appropriate by increasing the issuance of nominal base money.
- “For both these reasons, it may be desirable for the Treasury to recapitalise the central bank should the central bank suffer a major capital loss as a result of its lender of last resort and market maker of last resort activities.”
In plain English, point #3 means “the larger is the torrent of liquidity the central bank unleashes in order to counteract its illiquidity, the greater is the resultant consumer or asset price inflation.” And in point #4, “recapitalise” means “rescue.”
The Sveriges Riksbank (Swedish Central Bank) agrees. “Does Central Bank Equity Matter for Monetary Policy?” (Staff Memo, December 2022) summarises major literature in this area. It concludes, firstly, that “both theoretical arguments and practical experience suggest that financial results or equity do not limit the scope of monetary policy, at least not in the short term.” Secondly, however, “there is a risk that a weak financial position of a central bank may have consequences for monetary policy, although these need not arise in the short run.” Finally, “for the sake of their independence and reputation, central banks “may require a certain level of equity.”
What are the possible consequences? “A central bank may be forced to abandon a policy of low inflation if its equity becomes too low … Thus, there is a risk that the central bank would pursue an overly expansionary monetary policy leading to high inflation if it needs to generate more revenue and profits.” An IMF Working Paper published in 2008 “presented empirical studies, based on a large number of countries, which show a link between high inflation and a weak financial position of the central bank.”
On the other hand, “the risk that equity may become too low could affect monetary policy even before such a situation arises. For example, … the central bank’s consideration of its … equity may lead it to act more forcefully against increases in inflation than it otherwise would, so that inflation rises less and does not erode real capital.”
Anticipating and Rebutting a Superficial Criticism
Thanks to the sharp rise over the past year of central banks’ policy rates, and the resultant increase market interest rates, the financial system is facing eye-popping mark-to-market losses on fixed-rate assets. These include the RBA’s loss of more than $A50 billion since 2021, the Federal Reserve System’s loss of $1 trillion or more – and according to some estimates, the U.S. commercial banking system’s loss of ca. $US 2 trillion. Losses on Bank of America’s held-to-maturity bond portfolio grew to more than $116 billion at the end of September; the realisation of those losses would erase 43% of its total equity.
Never mind Buiter and the Swedes, most central-bank officials insist: ultimately this isn’t and won’t be a problem – least of all not for central banks. First, and as Michele Bullock has stressed, a central bank can create money out of thin air; accordingly, it will always meet its obligations as they become due. The RBA might be insolvent under private-sector accounting standards, but it’s not a private sector entity and thus doesn’t follow those standards.
Secondly, and as the RBA’s Annual Report states, “The Board expects that the Bank’s capital will be restored over time due to positive underlying earnings and capital gains when bonds mature.” In other words, today’s huge unrealised “paper” losses won’t become actual losses because its currently-underwater securities will be held to maturity and redeemed at 100 cents on the dollar.
This latter contention, Alex Pollock and Paul Kupiec observe (“How High Interest Rates Turn ‘Paper Losses’ into Real Ones,” The Wall Street Journal, 12 April), “is appealing yet superficial. The notion that these are ‘simply paper losses’ doesn’t hold up in the real banking world (or even in the unreal central banking world), where investments are financed with short-term borrowing.”
Before proceeding to complex reality, let’s start with simple fundamentals. Suppose that in 2021, when the Fed’s funds rate was near zero, you borrowed $10,000 at 5% and used the proceeds to buy seven-year U.S. Treasury securities yielding 2%. Today the securities’ remaining term is five years and, thanks to the Fed’s rate increases, the securities’ market price has dropped to $8,700. That’s an unrealised loss of $1,300 and a 13% decline of market value. This, Pollock and Kupiec reckon, “is about the same as the year-end mark-to-market discount the Fed has disclosed on its long-term investments.”
Like the Fed and RBA, you may believe that this $1,300 unrealised loss is merely a “paper” loss because you’ll hold the securities to maturity. If so, you’re neglecting the fact that you, like the Fed, used debt to finance the purchase.
If the cost of finance remains 5% for the next five years, you’ll receive a 2% yield ($200 per year) but will pay 5% ($500 per year) to service your debt. Holding the securities thus entails a real (cash, not paper) cost of $300 per year. Over the next five years, the total cash cost – that is, loss – will be $1,500 (15% of your original investment) even though they matured at par.
Let’s now consider more complex realities. The Fed’s holdings of Treasury and mortgage securities, Pollock and Kupiec note, totaled ca. $8.4 trillion in December. Their average yield was roughly 2%. $7.2 trillion have remaining maturities of more than one year; of these, the maturities of $4 trillion exceed 10 years and the average time to maturity is roughly five years. These long-maturity securities have generated most of the Fed’s current mark-to-market losses.
On the liability side of its balance sheet, “the Fed has issued $2.3 trillion in outstanding currency … that can be used to fund part of the $7.2 trillion in long-maturity assets. The remaining $4.9 trillion are financed with floating rate deposits and reverse-repurchase-agreement borrowings on which the Fed now pays about a 4.9% interest rate.” The zero-interest-bearing currency that funds $2.3 trillion of these 2% fixed-rate assets generates ca. $46 billion of annual net interest income. The remaining $4.9 trillion of assets also yield 2% – “but this income is more than offset by the 4.9% cost of financing these assets and, on balance, (costs) the Fed $142 billion.”
The Fed’s fixed-rate, hold-to-maturity investments currently cost it $96 billion annually. Assuming for simplicity that their funding costs remain stable, and adding its $9 billion of yearly non-interest expenses, for the next several years the Fed can expect an annual operating loss of about $105 billion – not counting the losses and gains on the trillions of dollars worth of additional assets it’ll purchase. That’s a total additional (that is, in addition to its current loss of $1-1.3 trillion) loss of ca. $525 billion.
This example simplifies a complex situation. “But it nevertheless correctly demonstrates the economics of large mark-to-market losses on leveraged fixed-rate assets held by the Fed and many banks … If short-term interest rates continue to rise, the loss will be larger. Lower rates would stem the bleeding, but as long as they exceed 2%, … our example will generate a cash operating loss.” Pollock and Kupiec conclude:
If any institution, including the central bank, borrows short-term to finance long-term fixed-rate investments, large mark-to-market losses aren’t (costless) “paper” losses. They’re a forecast that holding investments to maturity is going to be extremely expensive.
The Highest Cost of All
During and since the GFC, central banks haven’t been independent. Quite the contrary: they’ve dutifully obeyed governments’ expansion of the state towards – and, I suspect, perhaps even beyond – the limit of affordability. Consequently, they’ve transformed Australia, the U.S., etc., into different kinds of nation. Bluntly, these countries and plenty of others are living well beyond their means – and thus unsustainably.
Figure 3 plots the Fed’s total assets as a percentage of Gross National Product (GNP) since 1914. The Fed, which was created at the end of 1913, bulked small (ca. 5% of GNP) during the First World War and the 1920s. Its assets doubled to 11% of GDP during the early years of the Great Depression, continued to rise (to 20% in 1939) during the latter years of the Depression, and approached 25% during the Second World War. During the next 35 years the percentage receded, and during the quarter-century 1980-2005 it fluctuated between 5% and 6%.
Figure 3: Total Assets of the Federal Reserve System, Percentage of GNP, Bi-Annual, 1914-2022
The Fed’s assets expanded rapidly during the GFC (reaching 15% of GNP in December 2008) and for several years thereafter (rising as high as 24% in June 2014). During the next five years they fell modestly (to 19% in June 2019) and then once again exploded upwards as a result of the COVID-19 panic. The Fed’s total assets are presently equivalent to 36% of U.S. GNP – more than one-third the size of the entire U.S. economy, an amount that greatly exceeds the heights they scaled during the Great Depression and Second World War. The situation in Australia isn’t much different (Figure 4).
Figure 4: RBA’s Total Assets as a Percentage of GDP, Quarterly, 1969-2022
In a purportedly capitalist nation, how large can a central bank’s balance sheet grow relative to the overall economy? At what point does the government’s debt, which the central bank accommodates, transform the economy into an appendage of the state? How long can central banks wage a conflict that erupted at the start of the GFC, has no name but whose duration and impact upon their balance sheets significantly exceed the Great Depression’s and World War II’s?
The ultimate purpose of today’s central banks is to “monetise” governments’ enormous budget deficits. It’d be comical if it weren’t so serious: in order to mask politicians’ and governments’ growing inability to honour their promises (that is, their bankruptcy) central banks’ actions become ever more extreme – and gravely weaken their finances. As a result, central banks may require bailouts from bankrupt governments!
The Wall Street Journal (10 April) notes: “The path of least resistance (that is, high deficits) yields tangible benefits (political power) in the present, with costs (which are too numerous to mention) that are mostly deferred to the future. And the longer we go down this path, the harder it becomes to turn back. ‘How did you go bankrupt?’ Bill Gorton asks the wastrel Mike Campbell in Ernest Hemingway’s The Sun Also Rises. ‘Two ways,’ Campbell replies. ‘Gradually, then suddenly.’” WSJ continues: “Our fiscal course is in the ‘gradually’ phase. We don’t know whether or when ‘suddenly’ will come, but it would be reckless to assume that it won’t …”
On 13 April, The Australian quoted Thomas Sowell: “as long as we keep expecting politicians (and, I hasten to add, central banks that accommodate them) to give us something for nothing, we should also continue to expect financial crises.”
In What Causes – and How to Prevent – Bank Crises (27 March), I showed that bank failures aren’t unusual. Indeed, given the implicit but fundamental rule of banking regulation (“heads bankers win, tails taxpayers lose”), regulators certainly allow – and perhaps tacitly encourage – banks to become illiquid and to sail close to insolvency.
This wire has shown that much the same is true of central banks. Like the governments whose enormous deficits they monetise, they’re bloated and dissolute. Central banks don’t fail in the same way that corporations do; yet they can and do fail. Their financial statements make it obvious: the Fed and RBA have failed.
Since the GFC, they’ve resembled deranged traffic managers: their suppression of rates to unprecedented lows has removed financial speed limits; and their monetisation of huge deficits has changed to green the lights at economic intersections. Given their crazed actions, crashes are simply a matter of time.
The Review of the RBA, which will be released to the public later this morning, will utterly ignore these profoundly fundamental issues. The RBA itself freely acknowledges that it owes more than it owns; it’s also increasingly illiquid. These aren’t indicators of bankruptcy, but they do signify trouble – and the potential of even greater difficulties in the future. If it were a listed stock, it’d be a prime candidate for short-sale.
Do the RBA’s massive losses and resultant “negative equity” matter? Like so many risks in financial markets, they don’t until they do: if its losses persist and its equity becomes even more negative, the risk rises that the RBA once again panics by (1) pushing the monetary accelerator through the floor, or else (2) engaging the emergency brake.
Either way, the RBA, Fed and other central banks will resolutely continue to do what activist central banks have always done: exacerbate the boom-bust cycle. And that certainly matters.