Central bank losses. Money robbed from printing. Unlawful and unethical.

 

Article's Background

The central bank (CB) Governor at a special press meeting held on 7 May 2024 explained the technical background for central bank profit or loss. The relevant video clip circulated in the YouTube is attached here (Video play).

This article is intended to highlight the inaccuracy of explanations given by the Governor relating to CB's loss for the year 2023. Accordingly, it appears that he has no idea of financial reporting relevant to central bank monetary operations and policies.

This article proves that the CB loss stated above is a result of improper monetary policy operations and inappropriate accounting adopted for measurement and reporting of CB monetary operations.

Governor's explanations

• Central bank (CB) may make profit or loss when implementing its policies.

• CB reported a loss of Rs 19 bn in 2015, Rs. 374 bn in 2022 and Rs. 114 bn in 2023.

• He cited two factors attributable to the loss in 2023.
• The revaluation cost due to the increase in the exchange rate on foreign currency liabilities of the CB as the exchange rate rose from Rs. 203 to Rs. 370 in 2022 due to the instant float of the exchange rate.
• The one day loss of Rs. 700 bn incurred on restructuring of government debt about Rs. 2.5 trillion raised from the CB.
• This loss of Rs. 700 bn is the CB's contribution to the financial advantage of the government and tax payers to reduce the public debt.

• The CB also has so far given about Rs. 300 bn of profit to the government.

However, the review of the CB financial statements 2023 shows that above explanations are grossly incorrect and, therefore, mislead the government and general public. This articles establishes it under four areas.

• nature of central bank monetary/financial operations

• standard accounting used for central bank financial operations

• impropriety of monetary policy operations

• profit distribution to the government

Nature of central bank financial operations 

The central banking has been created to keep the national/sovereign currency system by providing reserves required by the economy. Such reserves which take form of currency and bank deposits held at the central bank are provided by printing of money for lending to banks and governments and purchase of foreign currency from banks and governments. 

Such lending and foreign currency are the assets that earn incomes for central banks. Conversely, reserves created by central banks are the liabilities without any financial cost such as interest payment. Therefore, the nature of central banking is necessarily a profitable operation. This profit is known as the seigniorage. The seigniorage is always the profit on money printing.

The monetary policy is primarily carried out through changes and composition of earning assets of central banks while resulting liabilities without a financial cost. Therefore, the standard monetary policy whether relaxed or tight cannot end up in losses. However, the monetary policy is not carried out for any target of profit as the objective of monetary policy is necessarily macroeconomic as provided for in central bank legislations. Otherwise, central banks can print money for acquisition of earning assets and change interest rates and exchange rates to achieve profit targets without any business plans.

Standard accounting for central banks

Given the nature of central banking operations stated above, central banks do not use evolving business accounting principles and standards to measure and report their financial operations on the monetary policy. 

The valuation of assets on their current market prices and accounting of unrealized profit/loss on such valuations are a major part of modern business accounting standards (fair value accounting) required for or used by large trading firms which are geared for profit targets. The principle underlying this market valuation-based unrealized profit/loss is to provide it through capital or reserves to shareholders so that share prices determined accordingly. If valuation losses are reported, shareholders will apply due care on the company as share prices will decline. Therefore, the market valuation of assets is a kind of market discipline on the performance of the company.

However, central banks conventionally do not adopt such accounting as their monetary operations are not profit-based trading businesses and there are no market price-based shareholdings. Instead, central banks are state-owned monetary authorities. Accordingly, how central banks account their asset trades known as open market operations (both domestic and foreign securities) are as follows. The best example for such accounting is the US central bank which is the world's largest and most influential central bank.

• Assets are valued at initial cost in the balance sheet. They are not valued at market prices to avoid unrealized book-keeping profit/loss in financial reporting. 

• Any profit or loss realized in open market operations of assets is taken into income statement as they are actual profit/loss.

• Assets and liabilities denominated in foreign currencies are valued at the current exchange rates of such currencies as central bank financial statements are prepared in the domestic currency. This is specifically applied for central banks in developing countries as the majority of their central bank assets is foreign currency assets.

• However, profit or loss arising from revaluation of net foreign currency assets due to changes in exchange rates is not taken into income statement because such profit/loss is just book-keeping values.

• Such exchange revaluation profit/loss is shown in a special item (e.g., international reserve revaluation account) in the balance sheet, i.e., profit as a liability and loss as an asset, which will adjust annually depending on changes in revaluations.

• The reason for exclusion of book-keeping profit is to prevent creation of reserves through the distribution or utilization of such unrealized profit and manipulation of monetary operations to make such profit consciously.

• Provisions are available to defer extraordinary expenses through suspense accounts so that current year profit is safeguarded (or prevent current year losses) and such deferred expenses are recovered from the future profits before distributing profit to the government.  

• In addition, a minimum capital ratio is imposed on domestic assets to limit the remittance of profit to the government and creation of reserves through domestic assets.

In view of above accounting principles, following comments are made in response to Governor's clarifications.

• First, losses on revaluation of foreign currency liabilities and debt restructuring (Rs. 700 bn) cited by the Governor as two reasons for the loss of Rs. 114 bn in 2023 are due to inappropriate accounting of asset valuation and unrealizes losses. This is against the standard central bank accounting. Therefore, the calculation of a loss of Rs. 114 bn for 2023 is unacceptable.

• Second, the clarification on the exchange loss on foreign currency liabilities due to higher exchange rate is wrong. Revaluation is applicable to net assets (foreign currency assets less liabilities) and not on liabilities only. In fact, a foreign currency revaluation profit of Rs. 140 bn is reported for 2023 as against a loss of Rs. 610 bn for 2022.

• Third, the first day loss of Rs. 766.4 bn (Not Rs. 700 bn as cited by the Governor) on debt restructuring is a valuation of newly issued bonds at market prices prevailing on same day. This is a book-keeping loss on CB books equivalent to 28.2% discount over the face value which is repaid by the government with interest on due dates. Therefore, Governor's clarification for this amount as a financial benefit to the government and tax payers resulting a reduction in domestic debt by equivalent amount is grossly incorrect and misleads the government and public.

• Fourth, the estimation of one day loss on restructured debt and outstanding debt stock reported in the CB financial statements show serious reporting issues.
• First, the secondary market yield curve used to estimate the one day loss on new bonds is not disclosed.
• Second, as new bonds are not traded in the secondary market as those are placement bonds specially issued to the CB, the use of secondary market yield curve to value these new bonds is arbitrary and questionable.
• Third, unrealized gain/loss on market valuation of these new bonds as at the end of 2023 is not reported. Therefore, just reporting one day loss is meaningless.
• Fourth, the face value of newly restructured bonds in respect of CB credit to government was Rs. 2,713 bn as on 21 September 2023 (restructuring date). This is the face value or the principal due from the government (Read special article). As domestic debt is now restructured to be sustainable (domestic debt optimization) as the government/CB thinks, there is no credit risk on these bonds. However, this bond portfolio as at end of 2023 is reported as Rs. 2,012 bn. Therefore, a market valuation loss of the portfolio reported as Rs. 701 bn is unjustified and unwarranted. This is a 25.8% discount. However, what is taken into income statement is the one day loss of Rs. 766.4 bn and not this loss of Rs. 701 bn. If the CB values government bonds at such high discounts, the prudence of banks not following same principle/discount will be questioned. Further, the face value of government securities portfolio reported by the CB under open market operations as at end of 2023 was Rs. 2,704 bn. Therefore, these bond figures are questionable numbers.

The Governor does not reveal the impact of following outcomes of foreign currency operations on the loss of the CB.

• First, an income of Rs. 86 bn on foreign currency assets is reported in 2023 as against a loss of Rs. 136 bn in 2022. Of this, the market valuation profit in 2023 is Rs. 29 bn as against the loss of Rs. 127 bn in 2022.

• Second, the CB has incurred in a significantly high interest cost of Rs. 142 bn in 2023 to mobilize foreign currency liabilities such as currency swaps to boost the foreign currency reserve. This high cost exceeding the total income of Rs. 86 bn on foreign currency assets has led to a net loss on foreign currency operations.

Improper monetary policy operations

Modern monetary policy model of central banks is to target overnight inter-bank interest rates though controlling of reserves or liquidity of banks. The central bank overnight lending rate to bank is the primary instrument used to set a target for the inter-bank market. Therefore, the monetary policy is a simple operation that provides interest income through lending to banks. In addition, central banks hold government securities for the use of open market operations to regulate reserves in the economy and, therefore, earn a risk free source of interest income on such securities. 

However, various other kinds of monetary operations that are carried out on arbitrary estimates and targets of interest rates and market liquidity in the economy cause unnecessary costs to central banks although macroeconomic outcomes of such operations are not clear. In the case of the CB, following monetary operations have adversely affected the cost and income.

• Payment of interest on excess reserves of banks held at reserve accounts with the CB. This interest rate known as the standing deposit facility rate is to set a floor for the variability of the overnight inter-bank interest rate. Therefore, this is an unnecessary monetary operation to pay interest on idle reserves parked at the CB. This interest cost was Rs. 15.6 bn in 2023 (Read special article).

• Restricting the CB's overnight standing lending facility in 2023 (maximum up to 90% of statutory reserves). This may have reduced relevant interest income in 2023 as the total standing lending volume reduced significantly to Rs. 26 trillion in 2023 from Rs. 163 trillion in 2022. The fact that the interest income on loans and advances to banks has declined in 2023 as compared to 2022 shows an unjustifiable reduction in interest income despite higher interest rates and higher volumes of supply of reserves through various other devices such as reverse repos, outright purchase of government securities and special liquidity facilities.  

• The arbitrary restriction on standing lending facility has resulted in the regular conduct of reverse repo auctions at a large scale to supply reserves to banks at lower interest rates. This has reduced the interest income to the CB. For example, the CB has conducted overnight reverse repo auctions regularly and provided reserves at rates lower than standing lending rate. The resulting loss of income compared with the standing lending rate is about Rs. 11 bn in 2023. The loss involved in term reverse repo auctions is difficult to estimate as benchmark interest rates are not found. Therefore, reverse repo interest income reported as Rs. 51.5 bn in 2023 as compared to Rs. 117.8 bn in 2022 is a significant disadvantage despite high interest rate policy. In fact, the CB heavily used reverse repo auctions to keep inter-bank interest rates suppressed closer to standing deposit facility rate without policy rate cuts (Read special article).

• Implementing a special liquidity support facility to commercial banks and National Savings Bank in 2023. The interest income on this facility is reported as Rs. 16.7 bn. It appears that this has been a last resort facility offered at significantly lower interest rates than standing lending facility. The year-end balance of the facility is reported as Rs. 32.5 bn. As the total turnover of facility and interest rates charged are not reported, it is difficult to understand the loss of interest income. As this seems to be an emergency lending facility beyond reverse repo auctions, interest rates should have been very low. Therefore, this liquidity operation also has reduced the income of the CB in 2023.

• Interest free intra-day liquidity facility to banks and primary dealers. This interest free lending against government securities without a limit significantly reduces the need of borrowing of reserves from the CB's standing lending facility or reverse repo auctions during the day. As a result, the CB looses a routine source of monetary policy income. The daily average use of this facility was about Rs. 657 bn in 2022.

Therefore, arbitrary monetary policy operations stated above have reduced the legitimate incomes of the CB. In fact, the CB has earned a significant increase in interest income on government securities portfolio due to effects of both increased portfolio and yields kept elevated through auctions by the CB as part of implementation of high interest rate policy. Therefore, interest income on government securities has risen to Rs. 525.5 bn in 2023 from Rs. 357.4 bn in 2022. Therefore, it is the government that has effectively bailed out the CB from the possible bankruptcy in 2023 by paying a high interest income at a cost to tax payers and debt. 

Profit distribution to the government as the owner of the CB

The standard central bank accounting is to distribute the final profit to the government from the income statement. If it is a loss, it is reported as differed assets so that it will be recovered before distributing future profit (The US central bank adopts this standard).

However, the CB follows an abused practice of calculating distributable profit outside the standard financial statement. Therefore, distributable profit statement is an unorthodox financial statement.

It is strange that the distributable profit for the year 2023 is negative Rs. 313.7 bn. Nobody knows how this figure would be accounted and dealt with. One critical issue is whether the CB would transfer a positive distributable profit to the government next year without recovering this year's loss.

The calculation of distributable profit is as follows.

• Take the profit figure in the income statement prepared on business accounting standards.

• Deduct reserves to be used for specific CB operations planned in the future. However, this is unnecessary as such operations can be financed by money printing. This is why the CB Governing Board approved a huge salary increase in January 2024 knowing very well the huge loss of the CB in 2023.

• Deduct book-keeping profit/loss (market valuation of securities and exchange revaluation gains/losses on net foreign currency assets) taken into income statement prepared in line with business accounting.

• The final amount is the profit distributable to the government.

The deduction of book-keeping profit/loss on foreign assets as stated above from business profit is nothing but the compliance with standard central bank accounting that excludes such profit as stated above. However, the manner in which such book-keeping profits are deducted here for calculation of distributable profit raises three issues.

• First, such book-keeping profit is transferred to reserves in capital/equity. Therefore, the CB accumulates capital through book-keeping/unrealized profit. As such, the most part of capital of the CB is such profit although central bank accounting standards prevent accumulation of such unrealized capital.

• Second, when distributable profit is greater than the annual profit in the income statement, funds are withdrawn from reserves accumulated by book-keeping profit. Therefore, the very purpose of retaining book-keeping profit without distribution is lost. This situation arises when book-keeping profit for the year is negative while the profit in the income statement is positive.

• Third, when the negative book-keeping profit for the year is very high, accumulated reserves will be insufficient to distribute profit without causing a negative equity position. There were instances in the recent past that such profit as calculated were distributed by just printing money without making any adjustments to reserves in order to prevent erosion of capital. This is an arbitrary accounting irregularity that should be punished.

• Fourth, the principle behind the deduction of book-keeping profit on foreign currency operations is to avoid distribution of book-keeping profit to the government. This is in turn to prevent creation of new reserves/money in the economy. However, the CB has not deducted the book-keeping loss of Rs. 766.4 bn on government securities when estimated the profit distributable to the government. Therefore, the CB has violated its own accounting principle. If this loss was deducted, the profit distributable to the government should not be a negative Rs. 313.7 bn but a profit of 452.7 bn.

Therefore, this calculation of distributable profit provides unthinkable results that are unacceptable in prudent financial management and reporting. That is why the distributable profit is negative for 2023. Therefore, the profit distribution accounting of the CB is unjustified and unethical. In this manner, the CB purposely hides profit distributable to the government. For example, the CB did not distribute a single cent for 2022 out of total distributable profit of Rs. 235 bn. whereas the estimate of the distributable profit as negative Rs. 314 bn for 2023 is unpractical.

I recalled that the Bank of England (BOE) Governor Mervyn King was summoned to the Parliament in 2012 over a complaint of not distributing the profit on quantitative easing reported in the income statement as the BOE also followed a practice of accounting similar to the CB. Accordingly, the BOE Governor explained the book-keeping profit and reserve creation story. The Parliament Committee responded that the accounting was a BOE's matter and profit so calculated belonged to the government. As a result, the BOE immediately transferred all retained profit around £ 37 bn to the Treasury. One of the reasons that the Governor of Reserve Bank of India had to step down in December 2018 was the attempt to retain profit for the augment of its capital.

The CB Governor's statement that the CB distributed nearly Rs. 300 bn to the government in the recent past appears to be the total profit distributed during the past two decades. However, no profit has been distributed in 2015, 2018 and 2023. The distributed amount has significantly varied between Rs. 6 bn and Rs. 35 bn. The distributed profit in some years came from reserves of book-keeping profit. In some years, profit has been distributed against the loss reported for the year. As such, the distribution of profit to the owner of the CB has been arbitrary and confusing.

Therefore, financial management and outcomes on money printing need an external investigation. If the CB handles Rs. 4 trillion of assets acquired on money printing with a negative profit of Rs. 313.7 bn payable to the government, which has been effectively borne by tax payers, they require a convincing answer as to why money printing business of the CB causes such huge losses to them. In fact, the government should receive a profit of Rs. 452.7 bn as per CB's published  accounts.

Concerned remarks

• The losses on money printing are not acceptable in public as it is beyond the common business sense to state that money printing business can make losses.

• Such losses are financial outcomes of improper monetary policy operations and inappropriate accounting of money printing.

• Governor's clarifications provided at the press meeting are grossly incorrect.

• If the CB reports losses frequently, it indicates structural problems confronting the monetary and banking system in a fractional reserve-based currency system although the CB talks about policy interest rates and prudent monetary policy for keeping the price stability whereas monetary system has a wider purview in the society.

• Annual profit transfer to the government is only a negligible amount of reserves as compared to the total volume of reserve operations daily handled by the CB through its monetary operations. Therefore, the use of various creative accounting methods to prevent the profit transfer is unacceptable.

• Unless the government/Finance Ministry investigates into this subject including the accounting principles and standards adopted by the CB, the government will have to provide hard cash very soon to the capital of the CB in order to prevent its bankruptcy as required in the new CB Act. This investigation is necessary as CB financial statements do not come under the purview of any external accounting regulator.

• Who ever experts are the policymakers, acting without attention to underlying true financial outcomes of policy actions is a serious governance issue as poor tax payers have to pay for them. The present bankruptcy of the nation is the classic instance.

• Overall, stakeholders of the CB have no use of financial statements published by the CB unless they are redesigned and reformatted to reprent true operations of central banking.

This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published.