Business Model: ECB vs. SNB

The balance sheet of the Swiss National Bank (SNB) has increased by 89 billion to CHF 439 billion since the beginning of the year.

Foreign currency investments alone have advanced by CHF 108 billion. A large part of this increase is due to foreign currency purchases to enforce the minimum exchange rate against the euro.

The SNB is the only institution which has infinite capacity to buy foreign currency against CHF. Thus the SNB is able to stabilize the exchange rate.

The ECB however bought government bonds in the market on the framework of its Securities Markets Programme (SMP) by announcing that the program would be limited in size and time. It was a fatal failure so that the strategy did not work.

“The only strategy that can work is one that uses the ECB’s unlimited resources as its core. Thus, the ECB should announce a cap on the spreads of the Spanish and Italian government bonds, say of 300 basis points”, suggests Paul De Grauwe in an article (“The ECB can save the Euro – But it has to change its business model”) in INET Blog. Such an announcement is fully credible if the ECB is committed to using all its firepower, which is infinite, to achieve this target, adds De Grauwe, economics professor at the University Leuven in Belgium.

That is that a cap on spreads would be good to stabilize the markets such as the minimum exchange rate of Swiss franc per Euro set by the SNB.

But the ECB is unwilling to stabilize financial markets this way. Why? Cause the ECB is reluctance to be a lender of last resort in government bond markets. Why? It has to do with its business model. “This is a model that says the ECB’s main concern is the defense of the quality of its balance sheet, i.e., it should avoid losses and to show positive equity, even if that leads to financial instability”, explains De Grauwe.

The ECB’s insistence on having positive equity is therefore in conflict with its responsibility to maintain financial stability. According to De Grauwe this insistence has become in the meantime a source of financial instability.

De Grauwe: “The business model the ECB should have is one that it pursues financial stability as its primary objective (together with price stability), even if that leads to losses. There is no limit to the losses a central bank can bear, except as imposed by its commitment to maintain price stability”. In the present situation the ECB is far from this limit, as Willem Buiter retains in an article (“Can Central Banks Go Broke?”).

Last year, as the SNB faced huge losses (resp. write downs) and equity losses as a result of the strong Swiss franc and the valuation changes on its foreign exchange holdings, some fears emerged in the media and among main-stream economists that the SNB must have soon negative equity.

Given this, SNB-President Thomas Jordan responded in a speech to the question, whether the SNB can lose its ability to act through a negative equity?

The short answer is “no”. “A central bank cannot be compared to a company from the private sector. First, a central bank cannot run into liquidity problems. Second, in the long term, it will always return to a profit-making position, which it can build up an adequate equity base after a period of losses”, explains Jordan.

A central bank cannot experience liquidity shortages, because it can itself create the necessary liquidity. “The SNB is legally entitled to settle outstanding claims by creating Swiss francs “out of thin air”. “Thanks to this autonomy the banknote-issuing privilege” the SNB never suffers from a liquidity shortage”, emphasizes Jordan.

While Mario Draghi only raises expectations by saying the ECB would do whatever it takes to preserve the euro, the SNB does act long ago.