Chapter 3
Components of Central Bank Balance Sheets
As discussed in Chapter 1, understanding the composition and size of a central bank’s balance sheet is at the core of comprehending the strength of an economy, the range of monetary policy decisions that can be explored, and the possible outcomes of these decisions. However, there are no unified standards that dictate how often a central bank balance sheet should be disclosed to the public, how the sheet should be formatted, or which items are to be included on the balance sheet.
Table 3.1: Publication of central banks’ balance sheets in advanced economies, emerging and developing countries
Source: Central Bank Website and World Bank.
Many central banks publish their balance sheets inside their annual report, and usually at a substantial lag from their current real position. To supplement annual reporting, central banks also publish their balance at more frequent intervals as a separate item on their websites. For instance, the Bank of England, European Central Bank (ECB), and the Federal Reserve publish their balance sheets on a weekly basis with minimal lag, while others such as Central Bank of Nigeria and the Hong Kong Monetary Authority publish their balance sheets on a monthly basis. Table 3.1 indicates the publication frequency of central bank balance sheets across a number of advanced and emerging economies.
It is easy to see the variations that can occur in balance sheets. Let’s take Malaysia’s central bank balance sheets for the month of February 2018 in Table 3.2 and compare it to that of Nigeria in Table 3.3. Malaysia’s central bank does not disaggregate its foreign asset holdings as it is reflected in its counterpart balance sheet (Nigeria). In addition, about 80 percent of Malaysia’s central banks assets were held in foreign assets compared to 50 percent in Nigeria. However, deposits by financial institutions accounted for the largest share in their liabilities.
Table 3.2: Malaysia’s central bank balance sheets for the month of February 2018
| Assets | RM |
| Gold and Foreign Exchange and Other Reserves including SDR | 419,549,797,551 |
| Malaysian Government Papers | 4,463,229,458 |
| Deposits with Financial Institutions | 5,598,818,970 |
| Loans and Advances | 7,493,903,885 |
| Land and Buildings | 4,179,614,080 |
| Other Assets | 9,516,489,885 |
| 450,801,853,829 | |
| Capital and Liabilities | RM |
| Paid-Up Capital | 100,000,000 |
| Reserves | 137,234,486,113 |
| Currency in Circulation | 108,303,399,938 |
| Deposits by: | |
| Financial Institutions | 167,881,909,188 |
| Federal Government | 11,105,958,177 |
| Others | 1,112,181,442 |
| Bank Negara Papers | 12,992,576,427 |
| Allocation of Special Drawing Rights | 7,759,395,868 |
| Other Liabilities | 4,311,946,676 |
| 450,801,853,829 | |
Source: Central Bank of Malaysia
Table 3.3: Nigeria’s central bank balance sheets for the month of November 2017(000’ Naira)
| Date | 11/30/2017 |
| Gold | 19,009 |
| Convertible Currency | 12,010,447,867 |
| IMF Gold Tranche | 22,623 |
| Special Drawing Rights | 631,681,317 |
| Total External Reserve | 12,642,170,816 |
| Federal Govt Sect. | 1,667,227,008 |
| Other Securities | 4,330,538,381 |
| Rediscount & Advance | 1,906,224,520 |
| Other Assets | 4,229,102,626 |
| Fixed Assets | 459,108,596 |
| Total Assets | 25,234,371,947 |
| Capital Subscribed | 5,000,000 |
| General reserve | 220,068,958 |
| Other Reserves | 40,764,187 |
| Total Capitalisation | 265,833,145 |
| Currency in Circulation | 1,896,585,425 |
| Government Deposits | 904,622,429 |
| Bankers Deposit | 3,568,164,797 |
| Other Deposits | 16,128,321,448 |
| Subtotal Liabilities | 20,601,108,674 |
| Other Liabilities | 2,470,844,703 |
| Total Equity and Liabilities | 25,234,371,947 |
Source: Central Bank of Nigeria.
3.1Factors Influence the Reporting Frequency of Central Bank Balance Sheets
The level of detail at which balance sheet items are reported differs across countries. These differences are due to accounting practices and local idiosyncrasies. For instance, central banks that implement a floating exchange rate might report their foreign exchange reserves more precisely, perhaps using subsidiary items (creating additional reports to provide more details) for each currency. This contrasts with regimes that fix their exchange rate, thus holding a smaller amount of such assets. Some balance sheet accounts may be uniquely specific to a certain country. For example, the transfer of cash management to the UK Debt Management in 2000 remains as an item on the Bank of England’s balance sheet to this day.
Despite these differences, a central bank’s balance sheet has a general format as indicated in Table 3.4.
Table 3.4: Generalized form of central bank balance sheets
| Liabilities | Assets |
| Banknotes | Net foreign assets |
| Commercial bank reserves | Net government balances |
| Capital and reserves | Net central bank operations Other items |
Items on the liability side of the balance sheet capture central bank money while items on the asset side are reported in a net format. Each component fulfills a critical responsibility in the functioning of both the central bank and the whole economy. Variations in the balances of these accounts consequently influence the quantity of reserves available to the banking system. Thus, a clear understanding of the wider economy depends on understanding the nature and changes in the components of the central bank’s balance sheet.
3.2Components of Central Bank Assets and their Composition Analysis
This subsection explains various forms of assets that can be held by a central bank and how the composition of these assets can change in response to different situation.
3.2.1Foreign Assets
Foreign assets are expressed in non-local currency. The principal form of foreign assets kept by central banks is foreign exchange reserves. The reasons for holding foreign exchange reserves by central banks include intervention to support the domestic currency, to fulfill external obligations on foreign currency debt (public and/or private), and to cover trade balances.
A central bank can intervene to address the issue of appreciation of domestic currency strength by raising its holding of foreign exchange reserves. To accommodate this, the central bank can intervene by selling domestic assets (likely reserves) in exchange for foreign currency denominated assets, with the consequent balance sheet change illustrated in Figure 3.1. This leads to increasing the supply of domestic currency assets and increasing the demand for foreign currency assets, which (ceteris paribus) alleviates appreciation pressure.
The quantity of foreign exchange reserves accumulated by the central bank dictates its ability to intervene to offset depreciation in the domestic currency (see Figure 3.2). In the case of a depreciating domestic currency, the central bank may intervene by selling foreign assets in exchange for domestic currency denominated assets. This jointly results in a rise in the supply of foreign assets, and a drop in the supply of domestic assets, offsetting depreciation pressure. This has a corollary effect of shortening the central bank’s balance sheet.
The amount of foreign exchange reserves that central banks hold is likely to be proportional to the frequency and magnitude of foreign exchange interventions that a central bank is inclined to make. This is largely based on the territory’s exchange-rate regime. For central banks that follow a free-float regime, reserves may be relatively small; market supply and demand dictate the value of a currency and interventions are usually rare. Other countries, particularly those facing substantial and prolonged appreciation pressures, may hold relatively much larger quantities of foreign reserves. In particularly strict exchange rate targeting regimes, monetary authorities may establish a currency board. The tasks of a central bank currency board focus on ensuring direct convertibility between domestic and a target foreign currency. In this situation, a currency board ensures adequate foreign exchange reserves to satisfy the demand for exchange. Over recent years, there has been a significant rise in the volume of foreign exchange reserves held by central banks, especially in emerging economies.
Foreign exchange reserves are usually kept in the form of liquid and safe assets, such as developed economy cash and government bonds. Naturally, central banks are risk averse and intervention often requires a quick response, which makes it necessary to hold foreign assets that are in wide demand and can thus be quickly liquidated or traded. In addition, central banks decide to hold assets in a foreign currency that is directly critical for trade and investment in their countries. For the aforementioned reasons, the U.S. dollar most frequently forms the majority of central bank foreign reserve currencies, particularly for commodity exporting countries. Furthermore, the central bank may perform some of its balance sheet operations in foreign currency liabilities. This is linked to a number of central bank policies and other factors. In many countries where there is substantial foreign exchange activity, but underdeveloped financial markets, the central bank creates foreign currency facilities to support its commercial banks (which may want to lend in a foreign currency). Since it is not possible for a central bank to create foreign currency, such facilities have to be matched either by expanding existing holdings of foreign currency assets or through agreeing to an exchange line with the central bank of the currency provided.
Foreign liabilities capture the funding of foreign exchange reserves. The central bank needs to decide whether to build foreign exchange reserves through the issuance of domestic currency assets or other means. Any decision on this will have a direct influence on the current exchange rate (as it will lead to a rise in the supply of domestic currency assets and a rise in the demand for foreign currency assets). In order to keep currency neutral, the central bank might exchange for foreign assets through issuing foreign currency liabilities. Then, it can also exchange the received funds for more suitable assets in additional currencies if required.
3.3Components of Central Bank Liabilities and their Composition Analysis
In this section, we look at different components of central bank liabilities in a consensus way. We also discuss how different economic activities can influence each of these components.
3.3.1Banknotes
This item includes banknotes issued by the central bank that are circulating through the economy, either being held in vaults by commercial banks, in automatic teller machines (ATMs), or by individuals. These banknotes are circulated through commercial banks in some countries (note that money in circulation excludes notes printed but still held by the central bank or those returned to the central bank). This allows commercial banks to withdraw banknotes in exchange for reserve balances held at the central bank. The wider population has access to banknotes by directly withdrawing notes from commercial banks or indirectly from other agents. Most price targeting economies will supply banknotes on demand to commercial banks. The volatility of banknote demand in the short term has been attributed to seasonal variables, at weekly, monthly, and yearly periods.
3.3.1.1Drivers of Short-Term Volatility of the Demand for Banknotes
On a weekly basis, the demand for banknotes increases as the weekend approaches and decreases at the beginning of the week as businesses deposit cash at commercial banks. A rise and a fall in banknote balances occurs days before and after the weekend as commercial banks prepare for the usual outflow and inflow of notes around a weekend.
Monthly fluctuations in banknote demand depend on the share of the country’s population that has access to banking facilities. Within-month volatility will be low if a large proportion of the population obtains their salary in the form of commercial bank deposits. Conversely, within-month volatility will be high if a large share of the population lacks access to banking facilities, necessitating the payment of salaries in cash. This implies that the demand for banknotes will be more pronounced around common payment dates, and will then decline as people expend their wages and invariably return to commercial banks.
Banknote demand also rises around public holidays, significantly during Christmas or Eid al-Fitr. In addition, countries with popular tourist destinations might witness a rise in demand for banknotes around the peak tourist season.
3.3.1.2Drivers of Long-Term Volatility of the Demand for Banknotes
The long-run relationship between demand for banknotes and nominal gross domestic product (GDP) has been established. As both the value and volume of payments in an economy rise, banknote demand also increases over time. Other long-term drivers of banknote demand include the opportunity cost of holding cash and payment technology. The amount of this opportunity cost differs based on the central bank’s interest rate. Under low interest rate conditions, the cost of holding banknotes (as an alternative to depositing the cash in a bank account) will be lower due to reduced interest yields. However, carrying bank notes or keeping cash at home can be risky; the person holding large amounts of physical cash may be robbed. Receiving compensation for cash losses arising from theft is often extremely problematic. Furthermore, attempts to safeguard banknotes pose an additional cost, for example, the cost of buying a safe.
Money held in electronic form is significantly more difficult to steal. Even in the situation of bank robberies or electronic fraud, the loss of physical banknotes is not attached to specific accounts, and banks insure against these losses so individual account holders would not suffer personal cash losses if their bank branches were robbed. In addition, in many nations, the government insures bank deposits up to a certain limit, in the case of bank failures. For instance, the Federal Deposit Insurance scheme of the United States insures balances up to US$250,000. However, agents may prefer to hold cash and bear the risks if there is low trust in commercial banks, fearing losses of liquidity in the banking system may result in the inability to withdraw funds. These aggregated factors, complemented by growth in the informal economy, are responsible for a rise in demand for cash in many countries through a global financial meltdown, despite declining nominal GDP growth.
Payment technology also determines demand for banknotes. Advances in payment technology in the form of debit cards, contactless payments, and mobile phone technology have changed the means of settling transactions that traditionally settled in cash. However, demand for banknotes continues to rise despite predictions that cash would become increasingly marginalized as a means of settlement due to technological advances. The effect of payment technologies on cash balances is more pronounced in developing countries. In Kenya, M-Pesa, a mobile application for payment services, has recorded tremendous progress by including a significant proportion of the rural population into its payment technology, and has allowed individuals to hold smaller amounts of physical cash.
The demand for banknotes denominated in the domestic currency is also driven by the confidence level in the central bank. If people have low confidence in the central bank’s ability to protect currency value from inflation or devaluation, they will explore other channels to settle transactions that do not involve using the domestic currency. This often leads to dollarization (named such because the U.S. dollar is often the most common currency employed, but could potentially be any foreign currency employed), when another country’s currency circulates either in an unofficial manner or semiofficial way alongside the domestic currency as a means of settling transactions. Change in the volume of dollarization over time is a significant moderator for the demand of domestic banknotes.
3.3.2Commercial Bank Reserves
Reserves are regarded as overnight balances that banks hold in an account at the central bank (Clews, Salmon, and Weeken, 2010). In addition, these balances form a claim against the central bank. Reserves and banknotes are the most liquid and risk-free assets in the economy. They are used in settling payments and enabling banking transactions among clients of different commercial banks directly or indirectly by conducting transfers between reserve accounts at the central bank. Reserves are viewed as a current account balance held by commercial banks at the central bank, conceptually similar to current account balances held by individuals at commercial banks. There are many misconceptions surrounding the function of reserve balances, despite the crucial economic role that reserve balances play.
3.3.2.1Misconceptions Regarding Commercial Bank Reserves
All commercial banks can decide to pick between reserves and other assets. This implies that the aggregate amount of reserves held at the central bank at any period is determined by commercial banks. Though this determination is only possible for individual commercial banks, system-wide levels of reserves depend on accounting identities on the central bank’s balance sheet. This clarification is better understood if we consider what occurs when an individual commercial bank decides to reduce its reserve balance.
3.3.3Capital
The structure of the central bank’s balance sheet is similar to private corporation balance sheets in several ways. According to Cukierman (2010), central banks share some similar features, in terms of legal aspects and accounting principles. Central banks place capital on their balance sheets as practiced in the private sector institutions. The capital buffer or net worth based on the gap between the value of total assets and total liabilities is identified as the channel through which the central bank absorbs losses (which is based on the value of the capital).
However, regulatory capital requirements are not applicable to central banks. This contrasts with commercial banks and other financial institutions, which are required to hold capital buffers in direct relation to the size and riskiness of their lending activities, as stipulated by international and domestic regulations. There are no such regulations applied to central banks. Furthermore, private institutions can only raise required amounts of capital through accumulating retained earnings or transacting with financial markets to increase additional funds (for example through share offerings). Although central banks are not constrained by official capital requirements, there is some debate as to an optimal level of capital that should be held by central banks. The capital portion of the balance sheet should not be ignored as consistently operating under negative equity conditions can have serious implications for the integrity of the central bank.
3.3.3.1Debate on Optimal Capital Level for Central Banks
Several works have attempted to determine the optimal level of capital for a central bank. The conclusion of Cukierman (2010) and Derbyshire (2010) is that there is no simple correct answer. Stella (2010) observed that central banks’ policy choices are limited by the size of their capital. In addition, she stated that central banks loosen policies in order to prevent huge losses for reputational or political reasons. The optimal capital level for a particular central bank is influenced by factors related to the situation it faces, as well as institutional and political structures.
Certain policy goals might create scenarios where the central bank has to lose money or take greater risks to attain socially optimal results. For instance, a central bank might implement a quantitative easing program by purchasing government debt with likely low yields (high prices) as investors want safety over risky assets. This may happen in an era of economic recession in the country, with inflation either undershooting or being forecast to undershoot its target. Economic recovery and closing inflation targets are indicators for the success of such a program. On the other hand, when the economy recovers, the yields on government bonds have a tendency to rise (prices fall) as investors decide to buy riskier assets and policy rates are increased. When the central bank intends to sell its bond holdings, it will likely trade at a loss. It will be socially optimal for the central bank to implement this program as it has attained its goal of enhancing growth and/or achieving its inflation target, despite the financial loss. The former deputy governor of the Bank of England, Charlie Bean, states that quantitative easing and the asset purchase facility (APF) are aimed at attaining macroeconomic objectives such as hitting the inflation target without stimulating undue volatility in output. The failure of the APF in solving these overall macroeconomic costs or benefits creates the need to evaluate the impact of quantitative easing on demand and inflation.
Questions
- What are the components of central bank assets and liabilities?
- What is non-monetary liability in the central bank balance sheet?
- How does banknote circulation influence inflation in the economy?
- What are the short-term and long-term drivers of volatility of the demand for banknotes?
- What are the misconceptions related to commercial bank reserves?