What if Swiss National Bank has negative equity…

I knew this was coming. After some huge intervention by SNB recently in forex markets, people were speculating on what would happen if SNB ends up incurring losses on its forex operations.

What is SNB doing currently? To defend its CHF/EUR peg at 1.2, it is buying foreign currency and selling CHF. This is leading to rise in its forex reserves. They have risen from some USD 280 bn in July to USD 316 bn in Aug. The forex reserves are more Euro-heavy. SNB has been shifting its forex assets from USD to EUR. EUR depreciated in 2010 leading to losses for SNB. And EUR is under pressure now. So, it can clearly happen again. In that case, SNB might have negative equity and need more.

SNB’s Vice-Chairman Thomas Jordan gives a superb speech on the topic:

The Swiss National Bank (SNB) had to report heavy losses for 2010 and the first half of 2011 due to the strength of the Swiss franc – or, more precisely, due to valuation changes on its foreign currency reserves. Consequently, it suffered a substantial reduction in its equity. Understandably in such a situation, concerns began to be voiced in public. Questions often posed in this context include: Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?

He says nothing of this sort is likely to happen:

The short answer to these questions is ‘No’, because the SNB cannot be compared with commercial banks or other private enterprises. For one thing, a central bank cannot become illiquid. This means that a central bank’s capacity to act is not constrained if its equity turns negative. Moreover, unlike other enterprises, it is not forced to implement recovery measures or go into administration. For another, central banks enjoy a funding advantage over private companies, owing to their banknote-issuing privilege. Moreover, they generate surplus income over the long term. Thus, over time, a central bank like the SNB can usually rebuild its equity level all on its own after a loss.

Nevertheless, even for a central bank, a long period of negative equity is not without its problems, as it can undermine the bank’s credibility and its independence in the longer term. For these reasons, it is important for the SNB to maintain a sufficient level of equity. To ensure that the SNB can carry out its monetary policy mandate without restriction, also in the long term, in the interests of the country as a whole it is essential that its capital base be adequately rebuilt. This means that the necessary profits must be earned, and retained. In the long run, the entire economy will benefit. 

The whole speech is worth a read. It tells you a lot about central banking operations and why it is a special entity. As it has the magic power to create money out of nothing (just increases bank reserves), it never is illiquid like other entities.  The central banks’ cost of creating money is very low and hence it only gains over a period of time.

He points to 1970s where similar operations led to negative equity for SNB:

let’s look back at the foreign currency losses of the 1970s. Following the collapse of the Bretton Woods monetary system, the SNB suffered huge valuation losses on its foreign currency positions. Over the next five years, the SNB’s financial situation redressed itself, as a result of valuation gains and current earnings. Then, in 1978, the SNB once again reported foreign currency losses. And, once again, the SNB’s balance sheet recovered, without a new injection of funds being needed.

In both cases, the SNB had a negative equity position, which was not reported as such: in 1971, because of a guarantee from the Confederation – entered in the SNB balance sheet as a federal government debt obligation, although the SNB never needed to invoke it – and in 1978, because the loss was covered from undisclosed reserves. In contrast to the 1970s, today the SNB would report a negative equity situation openly and transparently.

The bold italics is one of the main messages from the speech. It is also a very bold statement.

He says same things are happening now but nothing to really worry about:

The most significant change in the balance sheet is doubtless the massive expansion in foreign currency investments. In times of high global uncertainty, the Swiss franc tends to strengthen, which results in valuation losses on foreign currency investments. The SNB’s equity may decrease as a result, and in some circumstances can even turn negative. In particular, in such an environment, the interest income and dividends on foreign currency investments are nowhere near enough to offset the exchange rate losses.

Thus the SNB – as I mentioned at the start of my speech – had to report heavy losses for 2010 and the first half of 2011. As a side-effect of setting a minimum exchange rate against the euro, part of the foreign currency losses were reversed. Yet, even with the minimum exchange rate, our balance sheet remains vulnerable to valuation changes; unfortunately, the risks have not disappeared. Losses could still occur on other currencies, or on gold. The amounts involved can build up rapidly, owing to the size of our balance sheet.

In the medium to long term, however, the interest income and dividends will gradually offset the exchange-rate-related valuation losses on foreign currency investments suffered to date.11 Even if the exchange rate losses are substantial, the SNB’s long-term structural profit potential will hardly be affected.12 Consequently, despite the exceptional situation with a hugely inflated balance sheet, much more volatile positions and greater risks, the SNB can still achieve a structural surplus over the long term.

Superb stuff. Must read speech…

5 Responses to “What if Swiss National Bank has negative equity…”

  1. John Says:

    I want to thank you for drawing my attention to this SNB speech. But we differ in our assessment of Jordan’s approach.

    Some thoughts:

    1. It is unfair to compare today’s situation with the 70s.

    The SNB had exchanged their dollars for gold before Bretton Woods collapsed. Today’s SNB under Jean-Pierre Roth and Hildebrand have done the opposite – so the SNB is not in a position of strength as it was in 1971.

    2. The SNB’s balance sheet doesn’t look nice at all… I’m not sure if they can hold the peg for the whole of 2012.

    Fundamentally the SNB’s money is the people’s money. What the SNB has been doing is almost equivalent to giving away Swiss assets for crappy assets. Inflation is one thing, but this is redistribution of wealth on a large scale – and giving it away to foreigners at that.

    3. The SNB has many tools at its disposal – but with negative equity, they would have greater difficulty draining away the created liquidity.

    The stock of accumulated Swiss wealth is being diminished – and while the SNB can attempt to engineer the domestic economy (in terms of inflation and unemployment rates), nothing can change the fact that Switzerland has been made poorer by the SNB’s actions.

    4. I wonder if the SNB would find itself one day in the position of having to prevent the CHF from depreciating – under those circumstance having negative equity is fatal.

    I think it’s a real possibility, with the SNB’s currency debasing actions as well as UBS and Credit Suisse’s difficulties in the background.

    5. Including forex losses, as well as losses in selling off more than half their gold reserves in the early 2000s (which does not appear in the balance sheet), the SNB has lost tens of billions.

    Otherwise, the Swiss could have had several decades of of high living without having to work. Who cares about unemployment and economic output – when everyone could have afforded to be unemployed!

    But the SNB has chosen to give away that wealth – to foreigners, to currency speculators,,, so that Swiss citizens can remain employed while their savings and government provisions diminish.

    In contrast, the rich would have had more opportunities to diversity into hard assets – their wealth is preserved, and they get to enjoy high living. So the rich-poor income gap i.m.o. can be largely attributed to the mismanagement of the existing monetary system.

    Part of the problem is that the SNB – and most governments – focus on ‘flows’ (e.g. GDP), but the thing which truly matters are ‘stocks’ (stock of capital and wealth). They are sacrificing the latter just to have nice flows. That’s why Krugman can say space invasions and wars are good for the economy – the flows look good, but it destroys the stock of wealth.

  2. John Says:

    Do SNB’s losses matter?

    SNB’s money is the people’s money. There’s a reason why the CHF used to have a legal 40% gold backing (this requirement has since been removed by referendum, which in my view was not wise). The idea is that the central bank purchases good assets – and gold used to be such in the past (perhaps today too, but the gold markets are now heavily rigged). The SNB could alternatively purchase mines, islands, additional land in Asia… so long as they qualify as a good asset. Currencies and foreign bonds are assets which might not fall into this category as they deteriorate in value (and perhaps of no value). What the SNB has been doing is almost equivalent to giving away CHF (i.e. Swiss assets) for crappy assets.

    Both UBS and Credit Suisse are not faring well, and are heavily exposed to future financial shocks – this could eventually weigh heavily on the CHF. Their American operations would be better to be spun off (as a friend point out, they are really American banks). From this perspective, the strength of the CHF is illusory (there is a lot of CHF-denominated debt held in other countries too). As the current monetary order is collapsing and the situation seems to have little prospect of improving – SNB’s decision to sell its gold hoard has not only impoverished the country, but it has limited the SNB’s ability to act which could eventually prove fatal not only for the CHF but for Switzerland. We’ll see.

  3. John Says:

    Some nice articles:

    Freedom is lost in small steps – a prescient essay written in 2002 by a Swiss banker (former Rothschild executive)

    Click to access FreedomIsLost.pdf.pdf

    Interview with Swiss Banker

    Click to access Thebattleagainstsoundmoney.pdf.pdf

    Gold Wars: The Battle Against Sound Money As Seen From A Swiss Perspective

    • Amol Agrawal Says:

      Thanks John for the links and clarity on the SNB debate. It seems they are biting more than they can chew. We are living in such interesting times that there is so much to learn and unlearn…

  4. Central Bank Balance Sheet Negative Equity | Timeloves Says:

    […] What if Swiss National Bank has negative equity… | Mostly … – Sep 30, 2011  · What if Swiss National Bank has negative … even for a central bank, a long period of negative equity … And, once again, the SNB’s balance sheet … […]

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