DP10741 Maintaining Central-Bank Financial Stability under New-Style Central Banking
Since 2008, the central banks of advanced countries have borrowed trillions of dollars
from their commercial banks in the form of interest-paying reserves and invested the
proceeds in portfolios of risky assets. We investigate how this new style of central
banking a ects central banks' solvency. A central bank is insolvent if its requirement
to pay dividends to its government exceeds its income by enough to cause an unending
upward drift in its debts to commercial banks. We consider three sources of risk
to central banks: interest-rate risk (the Federal Reserve), default risk (the European
Central Bank), and exchange-rate risk (central banks of small open economies). We
nd that a central bank that pays dividends equal to a standard concept of net income
will always be solvent|its reserve obligations will not explode. In some circumstances,
the dividend will be negative, meaning that the government is making a payment to
the bank. If the charter does not provide for payments in that direction, then reserves
will tend to grow more in crises than they shrink in normal times. To prevent this
buildup, the charter needs to provide for makeup reductions in payments from the
bank to the government. We compute measures of the nancial strength of central
banks, and discuss how di erent institutions interact with quantitative easing policies
to put these banks in less or more danger of instability. We conclude that the risks to
nancial stability are real in theory, but remote in practice today.
