Central bank to increase reserve volume by 3.5 times

The Supervisory Board of Eesti Pank has decided to increase in longer term the central bank’s reserve volume as a ratio to risk assets to the same level as the euro area average, which is currently 3.5 times higher than the reserves of Eesti Pank.

The Supervisory Board decided at their regular meeting on Tuesday that the level of Eesti Pank’s equity capital needs to be the same size as is the central bank’s participation in the Eurosystem. The decision was based on the consideration that due to the euro area financial crisis, the volume of Eesti Pank’s risk assets has grown to a large extent.

The decision means that the bank’s equity capital must increase from the current 0.37 billion euros to 1.31 billion. Right now, the volume of Eesti Pank’s own capital is 0.07% compared to that of the Eurosystem, whereas our central bank’s participation in the Eurosystem is 0.26%.

“The Supervisory Board’s decision will ensure the credibility of Eesti Pank. The central bank’s risks have increased and reserves must comply with risks. People will trust the central bank if it is financially independent,” said Jaan Männik, Head of the Supervisory Board.

In addition, the Supervisory Board decided that until fulfilling the goal of larger reserves, no more than 25% of the central bank’s previous year’s profit will be allocated to the state budget.

Eesti Pank’s 2011 profit was 22.7 million euros. The Supervisory Board has decided to allocate three-quarters thereof to the central bank’s reserves and a quarter (5.7 million) to the state budget.

Eesti Pank’s 2011 profit from the Eurosystem’s joint action (monetary policy and cash issuance) was 20.2 million euros and from its own financial transactions 14.7 million euros. Other income was 6.2 million euros of which the sale of coin metal brought in 3.5 million euros and the sale of collector coins and numismatic products 2.1 million euros. Eesti Pank’s operating expenses were 19.4 million euros.

Background

Eesti Pank’s risks in implementing monetary policy
During the Currency Board System, Eesti Pank’s risks were related to the central bank’s investments and to the banking system. Joining the euro area means there are now also risks related to the Eurosystem as a whole and these are mostly monetary policy risks.

The Eurosystem consists of the central banks of the euro area and of the European Central Bank. The Eurosystem shares monetary policy related income and expenditure. This means, income on monetary policy loans to euro area banks is divided according to participation in the Eurosystem and the same applies to expenditure. Eesti Pank’s participation in the Eurosystem is 0.26%.

The Eurosystem’s monetary policy activities are currently divided into two: monetary policy loans to commercial banks and the Securities Markets Programme (SMP).At the beginning of March, their volumes were 1.14 trillion euros and 0.2 trillion euros, respectively.

Mitigation of monetary policy risks
In order to mitigate risks related to monetary policy loans, euro area central banks have claims on the banks that have borrowed from them. Basically, the borrowing bank’s equity capital is the collateral of the loan. Another thing to consider is that euro area central banks only lend against collateral, that is, if the bank is unable to pay back the money borrowed from the central bank, the latter has the right to liquidate the collateral. Credit risks to central banks are also alleviated by countries’ ability and will to recapitalise their insolvent banks.

In the case of the SMP, the collateral lies in the countries’ promise to fully repay their debts. This means that if countries fail to fully or partly meet their liabilities, central banks will bear losses.

Equity capital and its relevance
Here, equity capital is looked at in its broader sense – it is the share of reserves and capital that the central bank can use to cover losses.

The central bank’s capital level is important, because if the central bank has not enough equity capital, the general public will have two kinds of doubts. First of all, they may doubt the independence of the central bank that is forced to ask for more funds from the government. Second of all, it is possible to question the commitment of the central bank to adhere to its inflation goal and this may step up inflation expectations. As a result of the doubts, the credibility of the central bank is damaged and the general public may cease to believe that the central bank will keep inflation in check.

Eesti Pank’s profit sharing
Since 1992, Eesti Pank has transferred a total of 109 million euros of its profit to the state budget. There have been five years, when the central bank has not shared its profit:in four cases the year ended with a loss and in one case it could be seen that the next year would end with a loss.
 

Source: Bank of Estonia

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