SUERF's McCauley: Shrinking the Eurosystem’s footprint without offshoring the euro

08 November 2023

Foisting central bank losses onto euro area commercial banks by not paying interest on banks’ reserves with the Eurosystem would be an own goal. If large unremunerated reserves are required, banks and depositors would respond by shifting euro deposits offshore.

Euro area central banks are reporting losses as they pay banks 4% but collect only 1% on trillions of euros of bonds bought to spur growth with lower yields. Once central banks exhaust their capital, they may need to go cap in hand to their governments. Recently, the ECB ceased to pay interest on commercial banks’ 1% required reserve against deposits. Now some propose jacking this up tenfold to stanch central bank losses. With fat profits and rich, dividends, commercial banks can easily pay, it is said.

Foisting central bank losses onto euro area commercial banks by not paying interest on banks’ reserves with the Eurosystem would be an own goal. If large unremunerated reserves are required, banks and depositors would respond by shifting euro deposits offshore. Only immobile depositors would pay the tax, and the tax base and revenue would fall short. Undercapitalized domestic shadow banks would gain an edge over banks. Financial stability in the euro area would suffer.

An alternative approach would shrink the Eurosystem’s footprint without offshoring the euro or driving business out of regulated banks. Governments could book gains on their central banks’ holding of government bonds. Government debt as usually measured would fall.

The Eurosystem’s almost €4 trillion of excess bank reserves,1 the liabilities corresponding to large-scale bond purchases, have begun to produce large central bank losses. Losses arise from the payment of 4% interest on these excess reserves, given that the corresponding assets are bonds yielding something like 1%. A negative 3% net interest margin on a €3.6 trillion portfolio makes for a €108 billion negative cash flow. This is distributed unevenly around the Eurosystem, since each national central bank bought its own government’s bonds to avoid debt mutualisation (arising, for example, from Bundesbank buying Republic of Italy bonds), which was much dreaded in places. Ironically, the Bundesbank’s cash flow is suffering from the particularly low German bund yields in its portfolio, reflecting bunds’ benchmark status. The Bank of Italy is in relatively better shape since Italian bonds yielded more.

Graph 1: Eurosystem’s liabilities in billions of euro

Source: Schnabel, “Back to normal? Balance sheet size and interest rate control,” 2023.

Foisting these central bank losses onto commercial banks in the euro area by not paying interest on banks’ claims on the Eurosystem would lead to harmful unintended consequences. If large unremunerated reserves are required, banks and depositors would respond to the implied cost by shifting euro deposits offshore, out of the euro area. The cost would also allow undercapitalized and illiquid domestic shadow banks with no lender of last resort to outcompete well-regulated and well-backstopped banks. Both unintended consequences would undermine financial stability in the euro area.

An alternative approach outlined in this SUERF Policy Note would shrink the Eurosystem’s footprint without offshoring the euro or driving intermediation away from well-regulated banks. Governments could book gains on their central banks’ holding of government bonds, thereby reducing conventionally measured government debt.

Let it be clear what the proposed bond swap does and does not do.2

• As compared to using large unremunerated required reserves to soak up excess liquidity, the bond swap would not burden the banking system with a tax. Since this tax would likely fall on less well-off depositors in a regressive fashion, the bond swap is by comparison a good thing.
• As compared to the status quo, the proposal only “solves” the problem of ongoing central bank losses by crystallising them. This too is a good thing. Such losses would be crystalised even as the government realised a corresponding gain, clarifying the nature of the losses. And getting the losses into the rear-view mirror would prevent discussion of them, and untoward responses to them, from confusing the monetary policy debate and impairing its implementation.3
• Again, as compared to the status quo, the swap reduces central bank bond holdings and thereby cuts off the risk of still larger losses from any further rate hikes. This too is a good thing. It would lower the risk of not making a necessary hike because it would increase central bank losses.
• As compared to quantitative tightening (QT) with active bond sales into the market, the swap does not force an already fragile global bond market to digest more duration. This too is a good thing even if such fragility owes to US developments, as asserted in last week’s ECB press conference.

All in all, precipitating offsetting gains and losses within the public sector makes sense. It requires no revenue to be raised from the private sector. It leaves no unintended consequences to be discovered. It would deepen the euro area’s capital markets and enrich the menu of euro investments for official reserve managers...

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