On the capitalisation of central banks

In contrast to commercial banks, there are no rules or clear guidelines for central
banks’ capital adequacy. Although central banks cannot default as long as they have the right to issue legal tender, capital adequacy is important to be a credible, independent monetary authority over a medium-term horizon. Central banks face several challenges in determining their capital adequacy. First, the amount of capital only plays an auxiliary role in central banks’ effectiveness. Second, central banks face “latent risks” in addition to the regular calculable financial risks. These latent risks are difficult to quantify because they stem from contingent policy measures such as quantitative easing and lending of last resort. Latent risks are related to GDP and the size of the financial sector in the economy. We argue that a central bank’s target level of capital (1) can be calibrated with a confidence level that is lower than that used for commercial banks and (2) is proportional to for instance GDP as a proxy for the latent risks. We propose a set of guidelines to arrive at such a central bank capital policy. Capital adequacy will get significant attention over the coming years as many central banks have to draw on their buffers following rising interest rates in response to higher inflation.