Breaking the bank?

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Central banks across the world are making losses, and in some cases, this is already costing their government treasuries billions. This is the case in the UK. The Bank of England has cost the UK government nearly £80bn since 2022 and is expected to cost around £20bn a year until 2033. While the Bank did make a profit for the government before 2022, it is now expected to make a lifetime loss close to £150bn. Despite such large costs, the issue has received little mainstream political scrutiny. This is surprising when one puts these numbers into context. The Bank’s £20bn a year cost would make it the tenth most expensive government department, below the Department for Transport and above the Home Office. Despite being more expensive than the majority of the government’s 24 ministerial departments, the costs of the Bank of England received no scrutiny at the latest spending review.

The situation is even more surprising when one realises these costs represent a massive transfer to the banking sector. The reason central banks are making losses is largely because of their quantitative easing (QE) operations. When central banks first conducted QE, they purchased government bonds by issuing new central bank reserves – the money that commercial banks use to clear interbank payments. However, as central banks have raised interest rates to tackle inflation, the interest paid out on reserves has outstripped the interest income received from government bonds. Central bank costs are therefore greater than their income – a loss. Yet this loss has profited commercial banks, who are much better off from holding reserves than if bonds had stayed in their (or their customers) hands. In a context where the UK’s top four banks have posted record-breaking profits, is this really a good use of public money?

In the UK, the costs of QE are shared with the Treasury due to the indemnity which was introduced by George Osborne in 2012 when QE operations were profitable. At the time, such an agreement helped him meet his fiscal rules. As easily as it was done then, the UK government could change the indemnity so these £20bn a year costs are not putting so much pressure on the Chancellor in meeting her fiscal rules. In fact, such an approach is adopted in the USA and the eurozone, where the Federal Reserve and European Central Bank (ECB) absorb their own losses via ​‘deferred asset’ and ​‘losses carried forward’ accounting. This allows central banks to retain profits (which would otherwise be sent to the government) until their losses are paid off.

Whether indemnified by the government treasury or using deferred asset accounting, both these positions implicitly seek to return the central bank to a position of positive equity. That is, a central bank has its losses covered through a cash injection from government borrowing or taxing (like the indemnity) or by retaining its own profits (like the deferred asset). Yet, there are also multiple examples throughout history of central banks that have persisted with negative equity, ie central banks that have made losses that have ultimately gone ​‘unfunded’ by borrowing, taxing, or even retaining profits.

This report explores the reasons why central banks may want to avoid losses. It looks at the economic and political constraints on central banks and explains why they may prefer to have agreements that share losses with governments. Yet, current central bank losses demonstrate that there are certain levels of losses they can make; the theoretical limits on losses that central banks can afford are also much larger. Given this, the report argues that there should be better democratic scrutiny over how these losses are made and recognition that making additional losses is a credible option. While it may not be conscionable to make a £150bn loss that mainly goes to the banking sector, it may be more palatable (and economically justifiable) if this £150bn were spent enabling the green transition or helping bring down the cost of living. The fact that this sort of debate is considered taboo is a weakness of our economic and political systems; this must change.

Without change, we are stuck in a situation that can properly be described as monetary dominance. Central bank decisions are constraining fiscal policy. Such a system has attracted criticism, with calls for a more radical overhaul from parties like Reform UK. Yet, the response to this challenge can’t simply be to reaffirm monetary dominance, as some argue, because the unchecked power of the central bank is the cause of these populist challenges in the first place. Nor should the response be to adopt a form of fiscal dominance — where fiscal authorities take control of monetary policy operations in a way that harms their ability to meet inflation or financial stability objectives. Instead, the solution is to adopt better monetary-fiscal coordination that will allow governments to democratically engage with the central bank while making sure both are working towards the same goals.

This report makes the following recommendations:

1. The Bank of England should begin absorbing its own losses by abolishing the indemnity to save the Treasury up to £20bn a year.
2. Central banks should regularly publish their non-inflationary loss absorbing capacity, with appropriate sensitivities, to ensure the public have a better understanding of a central bank’s ability to make losses without calling on the government.
3. Central banks should make losses if this can help them meet their mandates and support government policy. For example, central banks could strengthen their collateral frameworks and targeted refinancing operations by offering negative haircuts and discounted interest rates, respectively. Both would entail the central bank taking on greater (risk of) losses (in the former case). Yet, both would also make those policy tools more effective, heightening the preference for certain types of collateral and the incentive to lend in targeted areas, which can be aligned with government objectives.
4. If losses are not necessary to meet mandates and act against government policy, these should be reduced. For example, a tiered reserves system where commercial banks are required to hold reserves at the central bank that pay no interest could be implemented. This would reduce losses at the central bank with little impact, if any, on their ability to set interest rates – such a system is used by the ECB and the Swiss National Bank. Furthermore, the amount of unrenumerated reserves commercial banks are required to hold could be set in line with government objectives ie tighter conditions for areas that are not government priorities and looser conditions for ones that are. This would reduce losses while also better aligning the central bank with government policy, helping guide credit to priority areas.
5. To make sure such decisions to make or reduce losses are taken with democratic scrutiny, NEF recommends more explicit monetary-fiscal coordination. NEF has previously proposed the institution of an Economic Coordination Council (ECC). This would be an advisory board of fiscal and monetary policy experts (among others) identifying and recommending areas where the central bank and relevant fiscal authority could better coordinate. Importantly, to improve transparency and accountability, the central bank and the fiscal authority would have to justify why they didn’t implement ECC recommendations.

These recommendations could encourage the use of central bank tools in an aligned whole-of-government strategy. Equally, they could relieve pressure on central banks to respond to supply-side inflation by encouraging governments to take on more responsibility. Doing so could potentially relieve short term fiscal pressures on governments, enabling them to respond to inflation in lower interest rate environments and stay focused on wider government objectives. The current approach to inflation has failed. A more coordinated approach is needed, not just to make monetary (and fiscal) policy more effective, but to make central banks more democratically accountable.

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