Is a central bank threatened with bankruptcy at some point?

When the Swiss National Bank (SNB) publishes its interim report next Monday, some financial politicians will swallow empty. Because it is certain that the SNB will report a gigantic loss on fixed assets for the period between January and September. And if there is no radical trend reversal on the financial markets by the end of the year, the chances that the Confederation and the cantons will receive a profit distribution from the SNB are slim.

Equity is melting

How high the loss will be is still open. UBS economists estimate the deficit for the third quarter at CHF 50 billion. Together with the 95 billion francs in the first half of the year, the total loss at the end of September was almost 150 billion francs. Whether the Confederation and the cantons will be left empty-handed will not be known until the end of the year. However, according to UBS calculations, the annual loss would have to be reduced to CHF 93 billion in the remaining months in order to be able to avert a total loss. That assumes a strong market recovery.

The huge loss comes as no surprise. From an investment policy point of view, almost nothing has worked out in the past few months: the stock markets have literally collapsed; interest rates being adjusted upwards to fight inflation led to losses on bonds; gold barely lived up to its reputation as a hedge against inflation; and the Swiss franc, sought after as a safe haven, strengthened against almost all currencies except the dollar, so that foreign currency investments converted into Swiss francs fell in value.

Losses eat into equity. At the beginning of the year, this capital was around CHF 200 billion. If the annual loss at the end of 2022 was around CHF 150 billion – according to a simulation by UBS from mid-September – equity would still be around CHF 50 billion. However, no one knows whether this would end the melting process. The question therefore arises as to what would happen if the losses continued to increase and ultimately meant that the SNB had completely used up its equity capital.

According to Alessandro Bee, economist at UBS, this scenario is quite conceivable: “If stagflation persists for some time, an SNB with negative equity becomes a possibility,” says Bee. He is thinking of a market environment in which, given rising interest rates, stocks, bonds and gold continue to lose value and the Swiss franc remains in demand as a safe haven currency. “In such an environment, all four components that make up the SNB’s result are negatively affected, which quickly leads to billions in losses,” emphasizes Bee.

No ordinary company

An ordinary company is immediately troubled by negative equity. Because if the borrowed capital exceeds the assets, a company is over-indebted and illiquid. The company loses its ability to act and has to be restructured; it therefore needs fresh equity. If this is not possible because there are no investors, the only option is liquidation and thus bankruptcy. Accordingly, it is essential for companies to have a sufficiently thick equity cushion at their disposal at all times.

But things are different for central banks. It is true that the SNB is also a public limited company that shows a balance sheet and income statement, holds an annual general meeting and pays dividends to shareholders. Apart from that, however, it can hardly be compared with private companies. This is because, as the actual «money machine», it cannot have any liquidity bottlenecks in its own currency. Because thanks to the note monopoly, it has the privilege of being able to draw the required liquidity itself at any time, practically out of nothing.

With this option, the negative equity scenario loses much of its horror. “We could deal with it, but we hope that won’t be the case,” commented the SNB President Thomas Jordan in an interview with the NZZ a month ago about a possible undercapitalization. In fact, the SNB is still able to act even with negative equity. It can implement its monetary policy decisions and is not forced to recapitalize by Swiss law.

Thomas Stucki, the CIO of the St. Galler Kantonalbank and former head of asset management at the SNB, also emphasizes this assessment. “The SNB can meet its obligations in Swiss francs at any time, even if the equity capital is negative, by creating new Swiss francs,” says Stucki. The matter would be more delicate in the case of high obligations in foreign currencies, which is not the case with the National Bank. The SNB expert also does not expect that negative equity would weaken the franc. “That should hardly interest the financial markets.”

A credibility issue

It is by no means unusual for central banks to deal with negative equity. In the Czech Republic, this was the case without interruption between 2002 and 2014 without causing any nervousness in Prague or a loss of monetary policy flexibility. Even the SNB had negative equity in 1971 and 1978 due to the strong appreciation of the franc at the time and the correspondingly high currency losses. However, this underfunding was not disclosed openly; Rather, in 1971 a federal guarantee and in 1978 hidden reserves were used.

There is a reason why the matter was not handled in a transparent manner in terms of accounting: negative equity is not entirely unproblematic for central banks either. Firstly, in such cases it is usually not possible to distribute profits to the Confederation and the cantons. Second, and more importantly, reputation suffers if the condition persists for a long time. For example, “negative equity would imply that the central bank money supply would only be insufficiently covered by assets, which would certainly be detrimental to the credibility of the currency,” they emphasize Economists Aymo Brunetti and Reto Föllmi in an analysis.

Conflicting goals would be programmed. This is the case, for example, when a central bank with a restrictive monetary policy would have to fight inflation, but at the same time would create a lot of new money to clean up the balance sheet. A monetary authority could also come under suspicion of temporarily giving more weight to investment policy than the monetary policy goal of price stability in order to increase capital; for example by attempting to support the value of the foreign currency positions by devaluing the domestic currency.

No obligation to rehabilitate

Whether such suspicions are justified or not is irrelevant. The assumption alone damages credibility. Hence also writes the European Central Bankthat financial independence presupposes that the central banks in the euro area always have sufficient financial resources. If their equity turns negative, the respective member states would have to provide their central bank with an appropriate amount of capital “within a reasonable period of time”, according to the directive from Frankfurt.

A similar obligation does not exist in Switzerland. But the SNB also always emphasizes the need for an adequate equity base. How large the equity – consisting of the provisions for currency reserves, the distribution reserve and the (almost negligibly small) share capital – should be is left open. However, with the sharp expansion of its balance sheet from 2008 and the associated decline in the equity ratio, the SNB gradually increased the allocations to the provisions.

Since 2020, the minimum allocation has been 10 percent of existing reserves for foreign reserves. Some financial politicians would have preferred to see this money in the public coffers in recent years and criticized the provision and reserve policy as being overly cautious. At the moment, however, it is becoming clear to what extent the 965 billion balance sheet and thus equity is exposed to the ups and downs of the financial markets. Even the “natural” bankruptcy protection of a central bank does little to change that.