Central banks’ capital policy and balance sheet risk management: credibility and financial transfers

Central banks adopt several approaches to manage their capital, based on a variety of accounting practices, with the majority of those institutions maintaining positive capital ratios, although some operate with negative capital. This paper highlights how certain central banks navigate accounting rules to mitigate the effects of unrealized profits and losses on their capital levels. Unlike commercial banks, central banks cannot face bankruptcy, which shifts the focus of their capital policies toward both preserving monetary authority credibility and minimizing financial flows between the central bank and the treasury (due to volatile unrealized results). As a further step to improve systematization and control within the decision-making process regarding central banks’ capital policy goals, this study proposes a risk management framework that prioritizes the balance between transfer probabilities, economic conditions, balance sheet risk exposure, and accounting practices. By advocating for an incremental and probability-based approach, this paper underscores the central role of risk management in shaping optimal capital policies for central banks.