Signs And Wonders


As Jaime Caruana, former governor of the Bank of Spain and general manager of the Bank for International Settlements, admitted 12 years ago before a gathering of Asian central bank governors, the issue of a central bank balance sheet “may sound arcane” but understanding it could be crucial in making appropriate public policy especially during crisis times.

Only central banks issue legal tender notes and they are the lenders of last resort. For us in the Philippines, it is enough that we are told that the bank notes we use in our daily transactions are liabilities of the Bangko Sentral ng Pilipinas (BSP) and are guaranteed by the Government of the Philippines. It is the ability of central banks to create monetary liabilities that support their role in bailing out banks in distress, or even in extending loans to the government as the BSP did during the pandemic.

Caruana cited the deep financial crisis in 1907 as having prompted the US Congress to establish what is now known as the Federal Reserve System. By forming the Fed, Congress expected it “to use its balance sheet to promote a currency that would be ‘elastic’ in meeting the needs of a growing economy.”

A central bank balance sheet simply shows us both its net foreign and domestic assets against its liabilities consisting of one, monetary liabilities or reserve money consisting of currency in circulation — the notes and the coins we use — and reserves of banks; two, non-monetary liabilities such as central bank securities — like the newly launched BSP securities of different maturities; and, three, equity capital — in the case of the BSP, its capital stock of P50 billion and any future topping up to P200 billion as prescribed by its charter.

When central banks issue currencies, conduct reserve management, extend credit to both banks and governments, and conduct monetary policy operations, their balance sheets move. Of course, the migration to inflation targeting from monetary aggregate targeting as monetary policy framework might have reduced the interest of economists and central bank practitioners in the balance sheet of central banks.

Thus, when we talk of expanding the central bank balance sheet, we refer to the so-called various channels of monetary policy transmission that would have some impact on money supply, credit, and inflation.

In the case of our local monetary authorities, they could also extend credit to the banks through the rediscounting facility, overdraft credit line facility, and fully secured emergency loan facility. Finally, the BSP is also authorized to extend provisional advances to the National Government (NG) as short-term financing. Under this authority, the BSP extended loans of P540 billion during the pandemic to help fund the enormous expense involved in cash transfers, fund support to business, vaccination, and other health peripherals.

But during the Global Financial crisis in 2007-2009, many central banks transitioned to unconventional monetary policy measures like quantitative easing that resulted in the huge expansion of their balance sheets. As they faced the global financial meltdown, many commercial banks began to hoard their own reserves instead of extending credit in interbank markets for self-insurance. They knew very little about the financial standing of their potential counterparties. Without a liquid interbank market, there was a clear potential for market jitters and ultimately, financial impasse.

What the central banks did was to inject excessive reserves to ensure that funds were available in the market, and settlement could proceed without snags. Central banks then started to purchase various assets to reduce long-term interest rates and motivate domestic demand and economic growth.

There were mistakes made since the US Fed’s creation in 1907. For instance, during the Great Depression, major central banks failed to use their balance sheets to reduce the long-term interest rates, mitigate the increasing frequency of bankruptcies, and avoid the prolonged depression. Lessons were also learned during the Asian financial crisis of 1997-1998 on the need to accumulate more foreign exchange assets for self-protection against a future crisis. This was to be the first line of defense before accessing regional and international safety nets.

Focus returned to the enlarged central bank balance sheets which have become more subject to market volatilities. Any movement in the value of foreign assets or an increase in interest rates could weaken the asset side without a corresponding adjustment on the liabilities side.

Ultimately, central bank capital could be put at risk because this is the channel for absorbing their potential losses. There is a good likelihood that the market could always question the capability of the monetary authorities in delivering on their mandates of price and financial stability, and, in the case of the BSP, efficiency of payments and settlements. Without doubt, if the central bank enjoys a stronger financial standing, it can truly focus on promoting macroeconomic and financial stability, without having to be constrained by the consequences of profit and losses on its balance sheet.

While central banks are not subject to regulatory capital requirements like their commercial counterparts, their flexibility in managing their capital base could be quite limited. Commercial banks could always retain their earnings or engage in capital-raising exercises in the capital markets. Central banks cannot.

But the BSP is in a dual bind. Authorized by its newly amended charter to raise its capital from P50 billion to P200 billion, this could only be done by using its annual dividends to recapitalize itself. Instead of authorizing outright budgetary allocation for higher capitalization, the amended charter provides for the use of its dividends for recapitalization. This is expected to take between six and years.

The second challenge to a quicker recapitalization of the BSP is the potential impact of the Maharlika Investment Fund (MIF) bill to be signed by the President anytime soon. Under this bill, the BSP dividends would be assigned to the MIF to fund the NG’s P50-billion contribution to its seed fund. By this route, full recapitalization would be prolonged to some 14 years.

What is the ideal level of central bank capital?

Central bank literature does not find a consensus on this issue. Some would argue that poorly capitalized central banks suffer from limited options in their policy choices; others would just simply loosen monetary policy rather than risk large losses due to political economic reasons. Central bank reputation could also hurt the credibility of central banks and impair their effectiveness. But nobody can argue against a central bank that succeeds in keeping inflation stable and promoting growth even at the expense of its financials. The question is whether social and economic goals could only be achieved at the expense of the central bank’s balance sheet.

Theoretically, some would also argue that as the exclusive issuer of domestic currency, the central bank will always succeed in meeting its liabilities in the same currency. They cite some central banks operating with negative capital. The assumption for this position to be viable is that central bank liabilities would remain a liquid and trusted instrument for settling transactions over the long run.

But as Garreth Rule said in a Bank of England publication in 2015 extracted from the literature, there is also some correlation between central bank losses and poor policy outcomes, including high inflation. The constraint is actually on the ability of central banks to expand their liabilities as they might lose their liquidity and public trust. This loss could be reached, according to former Bank of England monetary policy member Willem Buiter in 2008, around the point where accumulated losses exceed the potential future earnings of the central bank.

This must have been the judgment when the old Central Bank of the Philippines was abolished in 1993 in favor of the BSP.

The other equally important point is that central banks should be more conscious of their ability to deliver on their mandates when structuring their balance sheets to meet some desired policy objectives.

In this connection, Caruana raised four key points to his audience, but two are most relevant.

On the risk of inflation from increased balance sheets, he would rather say “not yet.” If some would argue “not necessarily,” Caruana was quick to say that much will depend on whether governments in the advanced economies would be more decisive in curbing fiscal deficits. Fiscal dominance cannot be ignored.

On the impact of large central bank balance sheets on sovereign debt, he mentioned the increasing trajectory of both public debt and bigger central bank balance sheets. They risk affecting money market conditions and monetary policy transmission. It is possible debt managers and central banks might pursue their tasks at cross purposes both during the crisis and the exit phase, as when government securities are to be sold by central banks and debt managers wish to issue new issuances.

In only one thing do we find Caruana more definite in his views. More is known to be unknown when it comes to central bank balance sheets, and this fact should not make us complacent “about possible medium-term risks arising from such a significant shift in the size and composition of central bank balance sheets.”


Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.