The ECB’s five-year adjustment of its capital key and the ongoing Brexit negotiations are reviving an old debate over the nature of central bank capital. While the ECB has several options at hand, Sebastian Diessner argues that the most radical solution would – paradoxically – be to do nothing at all, thus departing from an old obsession with the importance of a central bank’s equity base.
The cottage industry of ‘ECB watching’ has seen a steady rise in activity over the years, with every aspect of the central bank’s policy-making and deliberation now under increased scrutiny from a range of different audiences. One of the more ‘obscure‘ technical details to watch out for these days is that of the ECB’s capital key.
In simple terms – and for those less enthused by central bank day-to-day practicalities –, the national central banks of all EU member states effectively act as the shareholders of the ECB, and the size of their shares is determined by the capital key, which in turn is derived from the respective sizes of EU national economies and populations (amounting to a total of just under €11 billion in subscribed capital for the central bank). While euro-area central banks have to pay up their shares in full, non-euro area ones (such as the Bank of England) are required to deposit only a fraction of their subscriptions.
Technical questions, political considerations
Every five years, the ECB reviews and adjusts the capital key in order to reflect economic developments in member states over the previous five-year period. The latest review is due to take place before the end of this year. In the past, few would ever have noticed this process – or, as one slightly less enthusiastic ECB watcher puts it, ‘these are technical issues that usually nobody would care about‘. But this time is different.
With the recent adjustment of the capital key, the monetary authorities may well have had two incidental political developments in mind throughout the supposedly technical calculation: the upcoming Brexit as well as the, at the time, still-looming conflict between the EU and Italy’s populist government.
As far as Italy is concerned, it should be remembered that the capital key has become significantly more important over the past few years as a result of the ECB’s quantitative easing program: at least in principle, government bond purchases under the programme are determined by the key, as about 80% of these are conducted by the national central banks and only about 20% by the ECB itself. In addition, the ECB itself has committed to orienting its purchasing volumes by the key.
When the central bank announced this past summer that new purchases would be discontinued at the end of the year, it equally emphasized that it would nevertheless continue to reinvest the principal from bonds it will already have bought until then. Avid ECB watchers have labeled this maneuver the ‘dovish taper‘. Ever since, however, they have been left guessing about the exact criteria according to which these reinvestments would be made. The natural candidate is – you guessed it – the capital key.
However, the readjustment of the key at the end of last year came at a very particular time, namely one in which the EU increasingly found itself in a stand-off with an Italian government that had already formulated direct accusations of being disadvantaged by the ECB’s asset purchase policy. If the capital key were now re-weighted so as to reflect the relatively solid growth developments in Germany over the last five years, and decidedly more sluggish growth in Italy, for example, this would signal that more German bonds will eventually be purchased vis-a-vis Italian ones, thereby possibly affecting already jittery financial markets. No matter how small this readjustment would actually turn out to be, it may well provide further ammunition for a recalcitrant government that seems firmly set on a collision course with the rest of the EU.
The consequences of Brexit
Arguably of equal importance to the ECB, yet relatively rarely discussed, is the advent of Brexit. In essence, the UK’s departure from the EU raises the question of what ought to happen with the Bank of England’s share in the ECB’s capital. That question is somewhat analogous to the conundrum of the EU budget, namely of who will step up and fill the Brexit-sized hole in the EU’s next Multi-annual Financial Framework once the UK bows out.
Will the gap have to be filled by the remaining EU member states’ central banks collectively (which all contribute to the ECB’s capital base), or only by the eurozone members (who are the ones subject to ECB monetary policy), or only by non-eurozone ones (given that it is a non-eurozone member that is leaving the EU)?
In each of these scenarios, this would be a small amount compared to the EU budget: since 1 January 2019, the Bank of England’s paid-up share only amounts to a mere €58 million, which is just over 0.5% of the ECB’s total subscribed capital (while its overall share in that subscribed capital would theoretically amount to around 14.3% or €1.55 billion, on the basis of the size of the UK economy and population).
Does a central bank need equity at all?
In both cases – Brexit and the end of QE – the actual magnitude of the problem thus appears relatively small. So why bother? The short answer is: apart from its actual size, there also is a more symbolic quarrel over the ECB’s subscribed capital. On the one hand, some argue that the mere suggestion that a central bank would need any subscribed ‘capital’ is nothing short of bizarre: after all, central banks are endowed with the legal monopoly to create money, and therefore should not have to depend on anybody else’s money in the first place.
On the other hand, the argument goes, central banks should care about their capital in order to safeguard their independence. In case the bank was to make losses from some of its operations, it is the capital base and other reserves that can provide additional buffers against political interference: if, for instance, the government had to step in and rebuild the central bank’s capital, it may do so only under strict conditions that could undermine the bank’s autonomy.
For those latter reasons, the ECB might have kept a very close eye on the recent experience of another supranational financial institution: the European Investment Bank (EIB). When the EIB proposed that the capital shortfall that it is going to incur due to Brexit be compensated by its remaining shareholders (i.e., EU governments), no less than seven member states were quick to respond by demanding a profound reform of the bank as a precondition for any fresh capital to be provided.
The options for the ECB
In light of all this, what could be the way forward for the ECB? Among the menu of more or less palatable choices, one option would be to adjust the capital key only very gradually over the next couple of years, so as to make a quantitatively small issue look even smaller. Yet another option would be to postpone the decision until the UK officially leaves the EU, or even to push the question into the transition period.
A more comprehensive solution would be to reach an explicit, inter-institutional agreement between the ECB and eurozone governments in the Eurogroup so as to obtain some form of political guarantee for the central bank’s capital (as recently exemplified by the Bank of England’s Memorandum of Understanding with HM Treasury). This could also allow the ECB’s seigniorage profits to be redirected towards the EU budget instead of its current shareholders (an idea recently floated by the European Commission), or even towards a eurozone fiscal capacity within that budget (as finally agreed upon by the German and French governments).
In a way, however, the most radical step for the ECB would be – paradoxically – to do nothing at all. That is, to not replenish its subscribed capital once the UK has left the bloc, and thus to slowly begin to stop caring about (the size of) its capital base altogether. While the current context indeed creates a unique opening for such rethinking, it is far from certain whether ECB decision-makers can agree to undo the symbol of central bank capital just yet.
Instead, the last meeting of the Governing Council of the ECB in December made it clear that the central bank is initially opting for option 1: the adjustment to the new capital key should take place only gradually, with respect to financial stability. The associated technical statement was, however, so cryptic that even long-time ECB connoisseurs frowned. Likewise, the Brexit question also remains unanswered to date. A further adjustment of the capital key should, therefore, remain on the radar of the zealous community of ECB watchers in 2019.