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How do the national central banks of the euro area and the European Central Bank arrive at their profits and losses?


The European Central Bank is not like other banks. It draws up annual accounts and reports profits and losses like a normal bank but with one big difference: at the ECB our job is not to make profits. Instead, our job is to keep prices stable. And any profits or losses are side effects.

The same is true for the national central banks of the euro area countries (known collectively, together with the ECB, as the Eurosystem). That’s not to say that profits and losses don’t matter to Eurosystem central banks. In fact, whether we make a profit or a loss is still very important. Below we explain why, and where profits and losses can come from.

Profits and losses are numbers that show whether income and expenses are in balance. By looking at what comes in and what goes out over the course of a year, we can draw up an annual account. It’s the same thing you might do for your own household budget, or that a company might do to understand its finances. If the income is greater than the expenses, then we make a profit. If the expenses exceed the income, then we make a loss.

It is important to remember that the operations of a central bank are very different from, say, a bakery that gets income from selling bread to people and has expenses to pay for flour or energy. Central banks mainly operate through the banking system. 

What is a central bank?

Where does the Eurosystem get its income from?

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The euro banknotes in your wallet are worth a lot more than it costs to physically produce the notes themselves. Commercial banks provide these euro notes to you via their branches and ATMs. To do so, they have to “buy” them from the Eurosystem by handing over financial assets. Those assets are a source of income – experts call this 'seigniorage'.

What is seigniorage?

Another form of central bank income is the interest that commercial banks pay when they borrow money from us.

The ECB and the national central banks have also purchased lots of financial assets, for example government bonds. We bought these to support the economy when interest rates were very low or even zero. Our aim was to prevent inflation from staying too low for too long. The assets we purchased can be a source of income.

Finally, central banks hold reserves in foreign currencies and have other investments, all of which also generate income.

What are the Eurosystem’s expenses?

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When commercial banks keep deposits with the Eurosystem, we need to pay them interest. So, for us, this is an expense. These costs can increase, for instance, if we raise interest rates as part of our monetary policy.

To tame high inflation, we raised our interest rates a lot in a very short time. This has led to interest rates going up in financial markets, which makes getting credit more expensive across the economy. Higher interest rates make borrowing money less attractive and saving more appealing. This dampens spending, cools the economy and brings down inflation – which is what we ultimately want to achieve. 

What is monetary policy?

As a side effect, the amount of interest that Eurosystem central banks pay to banks for their deposits has also increased significantly and fast. At the same time, the income they earn on the assets that they hold has not gone up in the same way.

This is because many of these assets – especially government bonds – do not pay much interest, since we bought them at a time when interest rates were low. They often also have a long maturity. For instance, if Eurosystem central banks hold a government bond with a 10-year maturity, this means that it will take ten years for the full amount of the bond to be paid back.

When we bought those bonds, it was the right thing to do to return inflation to our 2% target. This is because inflation was too low at the time. Buying those assets for the prices we paid at the time helped to lower interest rates in financial markets. 

How does the ECB’s asset purchase programme work?

But doing so also shifted the risks related to future interest rate changes from the financial markets to the central bank.

Right now, this risk is starting to materialise, as central banks across the world are increasing rates to fight inflation. The result for the Eurosystem is that its expenses go up faster than its income. This means profits go down, and can even turn into a loss.

What happens if the Eurosystem makes a loss? 

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If we record a loss, we can try to cover this by first dipping into the profits we made in previous years. The ECB and other euro area central banks have made sizeable profits for several years – approximately €300 billion between 2012 and 2021.

These profits came largely from the monetary policy pursued during these years. We had purchased lots of assets and interest rates were negative, meaning banks actually paid a fee for keeping deposits with us.

As prudent central banks, we have used part of these profits to build up financial buffers, such as general provisions and reserves. In addition, some financial buffers are generated when we regularly revalue some of our assets. These buffers can now be used.

At the ECB, if our general risk provisions were not enough of a cushion, the national central banks of the euro area countries could cover the remaining loss with their own income earned on monetary policy operations. Alternatively, the loss could be recorded on the ECB’s annual account to be offset against any income received in the future.

You can find out more about profit and loss sharing procedures in this Occasional Paper.

Does it matter if the ECB makes a loss?

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European Parliament

It is important to remember that central banks are not like ordinary companies. They can lose money and still operate effectively. Still, the principle of financial independence implies that national central banks should be sufficiently capitalised.

We expect that, over time, losses will decline because the income earned by the Eurosystem central banks on their bonds and other assets, and from the loans they give to commercial banks, will also rise.

Ultimately, with interest rates back in positive territory the Eurosystem should be making a profit again in the medium term.

Sources


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