Central bank capital

In the coming years, central bank capital adequacy will be key because central banks’ profits are under pressure following rising interest rates in response to higher inflation. Interestingly, central banks are not uniformly regulated and there is no consensus on the amount of capital that is considered adequate. In this context, we argue that central banks face several challenges in determining their capital adequacy. First, capital plays an indirect, auxiliary role as central banks cannot default on their own currency. Nonetheless adequate capital is necessary to maintain confidence that the central bank is effective in implementing monetary policy and is able to absorb the corresponding financial risks on a stand-alone basis, independently of the government. Second, different from commercial banks, central banks face “latent risks” in addition to the calculable financial risks from current exposures. These latent risks are financial risks from future exposures, that the central bank accepts under its mandate if needed. Examples are risks from contingent policy measures such as quantitative easing and lending of last resort. The size of these latent risks is proportional to, for instance, GDP or the size of the banking sector. We argue that a central bank’s target level of capital can be calibrated with a confidence level that is lower than that used for commercial banks due to the absence of default risk yet at the same time should take into account latent risks. We propose a set of guidelines to develop such a central bank capital policy.