Relations between the profit of the central bank and distribution thereof and monetary policy

The structure of a central bank's balance sheet, the profitability and profit distribution of the bank have been dealt with relatively extensively under the theory on the functioning of the monetary system, particularly in the context of the central bank's autonomy. Firstly, a central bank as a bank of issue is in a unique position owing to which it technically never faces direct liquidity problems. Secondly, public confidence in the central bank is not based on the mechanical external capital to the capital and reserves ratio but rather on whether the currency issue guarantees the stability of the currency and often also on how the liabilities are covered by foreign currency. Thirdly, the central bank is a part of the state authority and, under normal circumstances, in the eyes of creditors, besides its capital and reserves, it also has state guarantee.

However, the arguments above are purely theoretical. Firstly, the size of the bank's capital and reserves automatically sets an upper limit to the central bank's foreign currency cover of the liabilities. This reflects its potential weakness of using the external stability of the currency as an interim monetary policy objective, which directly undermines efficiency upon achieving the stability of the currency. Secondly, the state can provide the central bank with a full guarantee and cover the losses incurred from its activities, which is inevitable in some monetary policy situations, but the government may not be able (and is often not) to support the central bank with foreign currency. Thirdly, it is most unclear how is it possible to ensure the independence of the central bank upon maintaining the stability of the national currency when it has to rely on the good will and understanding of the government in some basic monetary policy issues. Particularly if we take into account that short-term objectives of the central bank and the government are often different in such situations and, therefore, in some cases the government can dictate inappropriate decisions to the central bank.

Consequently, in practice there are weighty arguments in favour of maintaining the strength of the central bank's balance sheet (both in terms of equity and foreign reserves) without the arbitrary interference of the government.

Threats to the central bank's capital or foreign reserves arise from both the implementation of the monetary policy as well as from operational risks. While issuing cash is basically a fairly profitable activity, the same cannot be said at all about broader monetary policy. Monetary policy interference by the central bank means in essence that the bank often has to offer instruments in the market at interest rates that are impossible to cover from its earnings. Therefore, the central bank's own monetary policy activities can lead to considerable losses.

The risk is even bigger when, in order to avoid a systemic crisis, the central bank has to interfere in the operations of the monetary system in a situation where it is impossible to provide a guarantee that is sufficient, reliable and with required liquidity.

Among operational risks, there are two that are the most important. Firstly, the central bank has to take into account potential sudden and extensive changes in the value of its assets. The bank is not fully protected against the credit risk or, in the short term, against market risks. This is inherent to every institution with liabilities whose term is unpredictable. Secondly, the central bank has to be secured, to a certain extent, against inevitable technical risks (e.g. in the clearing and settlement system) as well as against malicious attacks.

Although the main activities of the central bank can, under normal circumstances, be fairly profitable, emergency choices in monetary policy as well as technical implementation of monetary policy involve the risk that the bank's financial situation will deteriorate.

When comparing profit distribution mechanisms of the central banks of different countries the following significant observation can be made:

  the central banks of comparatively big and stable countries earn relatively higher income from issuing currency and are, owing to the position of the reserve currency, inherently more profitable and, therefore, transfer regularly relatively large sums from their profits into the state budget;
  detailed profit distribution mechanisms are extremely diverse. This is due to certain differences in accounting policies, but probably even more so due to the practices developed in the course of history. In case of completely new central banks (e.g. the European Central Bank) the formation of reserves is usually more clearly defined;
  as a rule, the determining or central decision-making authority when distributing the profit lies with the central bank itself. Even in cases when legislation seems to set clear limits to profit distribution, the central bank often maintains the right of making its own decision;
  even if the legislation defines quite clearly the profit distribution mechanism, the absolute size of reserves is not always the decisive factor. Transfers to the state budget are rather linked to some dynamic indicators, or the legislation provides for relatively frequent revision of the level of capital and reserves.

In conclusion, one can say that even though the alternatives of the central bank's profit distribution are technically very different, their objective, as a rule, is to secure the central bank with sufficient financial resources so as to carry out its principal tasks.