The Eurosystem’s Red Ink Is Really Beige

Central banks are back in the headlines, and for once, it has nothing to do with when they might cut rates. Instead, attention centers on the ECB’s announcement, last Thursday, that it posted its first annual loss ever last year—which means member states’ central banks are also now in the red (e.g., the Dutch Central Bank) or burning through reserves to fund expenses in excess of income (Germany’s Bundesbank). Sensational headlines claim this all means the bloc is going bust, with grave consequences in store. Yet the truth is rather more boring: Since central banks aren’t normal banks, these “losses” are just accounting entries with little real-world significance. To us, this is yet another brick in this bull market’s wall of worry.

We can understand why the concept of loss-making central banks is scary. It is right there in the fact that they are called central banks! When a bank racks up losses, there is a real risk of implosion and insolvency as customers flee out of fear they won’t get money back if they wait. So instant recapitalization becomes paramount, lest a failing bank risk sparking a contagion. And if that can happen to a normal bank, how much more disaster would there be for a bankrupt central bank, the heart of a financial system?

But central banks aren’t like other banks. They literally can’t be insolvent, and operating losses don’t prevent them from conducting monetary policy. They are merely accounting entries, and the remedy is more accounting entries. It is actually really boring, which is why we suspect that once the initial hubbub dies down, these fears will fade into a banal, beige void as disaster doesn’t ensue.

Here is how it works. The ECB and eurozone national central banks are known collectively as the “Eurosystem.” Their primary expense is the interest paid on commercial banks’ deposits with the Eurosystem. On the income side, the Eurosystem’s chief source is the interest earned on all the bonds bought through its quantitative easing program. It also earns money from banks who borrow directly from it, from the assets that land on its balance sheet as part of its normal operations (known as “seigniorage”) and from its own portfolio of foreign currency reserves and investments. When the ECB’s policy rate was negative, interest expenses were negligible. But after several rounds of rate hikes, its expenses exceed income, leading to 2023’s loss of €1.266 billion.

Per the ECB’s announcement last week, this loss “will be carried forward on the ECB’s balance sheet to be offset against future profits.”^[i] It is not a call for recapitalization, and national central banks and governments aren’t ponying up. Instead, 2024’s financial statement will show a line item called something like, Prior Annual Loss. If the ECB makes an operating profit this year, instead of distributing it to the rest of the Eurosystem or putting it in reserve, it will go to chipping away at the 2023 loss accounting entry. If 2024 profits don’t fully cover 2023, then the prior loss will carry over to 2025, with that year’s income defraying it further. Lather, rinse, repeat until the loss is fully canceled and the ECB can resume business as usual: setting aside new reserves and distributing the remaining profits to national central banks.

See? Beige! Like all balance sheets! There is no bankruptcy, no bailout, no emergency cash infusion. Just balance sheet line items. Line items that don’t prevent the ECB from continuing to conduct monetary policy as normal, funding those efforts with more accounting entries as and when needed. It is a hard thing to reconcile for those of us with household and business balance sheets whose red and black ink matter in the real world, but central banks aren’t the real world. They aren’t businesses.

Some of the handwringing acknowledges this and turns instead to the potential impact on national governments—implying the lack of remuneration from the ECB (which would eventually trickle from national central banks to state coffers) will be a drain on budgets. But this is all a bit circular, because the money remunerated to these governments when the ECB made a profit was—wait for it—interest on these very same governments’ bonds. This isn’t a huge fiscal hole. Rather, it is a tiny shift in the debt service cost calculus and, in a way, a slight return to normal, to the days before the ECB gobbled up an ever-larger share of outstanding government bonds. In our view, that is no bad thing. The eurozone had to move on from perpetual crisis assistance sometime, and governments had to move to more traditional funding models. No time like the present, right?

We see some positive potential here. Over a decade after former ECB head Mario Draghi swore to do “whatever it takes” to preserve the euro, there remains a deep-seated societal fear that ECB support is the only thing standing between the currency bloc and disaster. If it goes a few years without ECB profits finding their way to government coffers, and everything goes fine, then reality can chip away at this fear and the world can move on, removing a long-running sentiment overhang in the process. It may not be some massively bullish cyclical driver, but a modest improvement to the structural sentiment backdrop would be welcome all the same.