How the Bundesbank did not have ‘negative equity’ in the 1970s

Over the years I’ve heard many talk about the story the Bundesbank having ‘negative equity’ in the 1970s. Since that’s not exactly what happened I thought I’d post on this.

What happened was that the Bundesbank had a shortfall of reserves, i.e. they fell below the required level. This would, normally, lead to negative equity. Given, however, that it’s a bit awkward to have one’s central bank being technically insolvent they used a neat accounting trick.

Central banks distribute their earnings to the Treasury, where the amount depends on the state of the economy. Rules are different from country to country; sometimes it’s a fixed amount plus a percentage of earnings, sometimes it’s earnings minus operating costs, etc. [The Fed for example pay a ‘voluntary transfer’ to the Treasury.] This means that central banks have an equity buffer. It also means that if central bank have persistent losses that buffer can disappear. There are different ways to manage that, here for example is how the ECB does it:

In the ECB’s case, losses can be covered by appropriating the monetary income that would otherwise remain with the Eurosystem’s national central banks. This requires a decision of the Governing Council. To date, whenever confronted with such a choice, the Governing Council has always decided to cover the ECB’s losses with the monetary income of the NCBs, even when in some of these years the NCBs have also suffered losses.

That’s one way. What if central banks go through the buffer? Well that’s what happened in Germany in the 1970s. Instead of asking for an equity injection, the Bundesbank booked on the asset side of the balance sheet a reduction in future distributions of earnings. The Fed did the same thing recently:

The Fed has recently clarified that losses that lead to shortfalls in the reserves (the “surplus”) relative to their required level (see footnote 83) would be registered as an asset that represents the amount of the reduction in future transfers to the Treasury that is needed to rebuild reserves. With this practice, which is allowed by US GAAP (on the presumption that future earnings are sufficiently certain that the claimed value of the asset will be realised), accounting equity would not fall in the face of a temporary negative shock to earnings.

That’s what the Bundesbank did in 1970s, too. It’s not available to every central bank because not every central bank can retain earnings, is sure of having a positive income and so on, but there you have the story.

In fact, of  more colourful cases, we have Costa Rica (1980s), Peru (1980s), Thailand (after 1997), Hungary (1990s)* trying the same thing. The result was a little different, though. It’s not a trick for everyone.

Related reading:
What level of financial resources do central banks need? – BIS

 

* From the BIS: “In these cases, such treatments confused analysis of the underlying economic situation, and contributed directly to a worsening of the central banks’ finances by allowing continued distributions to the government despite significant and growing financial weakness.”

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