September 30, 2023
Bank of Japan

Central Bank Finances and
Monetary Policy Conduct

Speech at the 2023 Autumn Annual Meeting of
the Japan Society of Monetary Economics

UEDA Kazuo
Governor of the Bank of Japan

(English translation based on the Japanese original)

Introduction
It is my pleasure to have this opportunity to speak at the Japan Society of Monetary

Economics.

Today I will speak on the theme of "Central Bank Finances and Monetary Policy Conduct."
This issue has been gaining heightened interest, with foreign central banks entering the exit
phase. On the other hand, in Japan, sustainable and stable achievement of the price stability
target of 2 percent has not yet come in sight, and there is still a distance to go before
reaching the "exit." Given the current distance, however, I believe now is the right time to
discuss this topic from an objective perspective. At the Japan Society of Monetary
Economics held 20 years ago, I gave a speech on "The Role of Capital for Central Banks."!
My speech today is a sequel to that one, but the fundamentals are essentially unchanged.
Nevertheless, taking into account the developments in monetary policy at home and abroad
during the subsequent two decades, I would like to provide somewhat of a review, reflecting

upon this important topic once again.

At the time of my previous speech, the Bank of Japan had already implemented its
quantitative easing policy and had started purchasing new financial assets, such as
asset-backed securities. Moreover, amid the global disinflationary trend, other central banks
were beginning to consider unconventional monetary policy measures. Under these

circumstances, interest in central banks' financial risks grew.

In the last 20 years, with the disinflationary trend continuing, major central banks conducted
monetary easing by cutting policy interest rates as well as implementing unconventional
monetary policy measures such as large-scale asset purchases in response to shocks such as
the Global Financial Crisis (GFC) and the COVID-19 pandemic. Since 2021, however,
inflationary pressures have been rising worldwide due to the resumption of economic
activities after the pandemic and the global surge in commodity prices. Against this
backdrop, foreign central banks have been tightening monetary policy by raising policy

interest rates rapidly and substantially and by reducing their asset holdings. Over the 20

' See Ueda, K., "The Role of Capital for Central Banks," speech at the Fall Meeting of the Japan
Society of Monetary Economics, October 25, 2003.

years, there have been significant changes in the situation surrounding monetary policy and
central bank finances. During this time, there have been many discussions on central bank

finances and monetary policy conduct."

Therefore, today I will talk about the relationship between central bank finances and
monetary policy conduct in light of recent developments. I would like to start by describing
the basic structure of a central bank's balance sheet and profits and reviewing changes over
the past 25 years in the finances of the Bank of Japan, the frontrunner in terms of
introducing unconventional monetary policies. Next, I will provide an overview of the
mechanisms through which the expansion and contraction of a central bank's balance sheet
affects such factors as its profits. Further, I will touch on the debate over central bank
finances within academia, for example, and describe recent developments at foreign central
banks that are in a phase of tightening monetary policy. Lastly, I will summarize these
issues and explain the Bank's basic thinking on central bank finances and monetary policy

conduct.

I. Central Banks' Balance Sheets and Profits

Let me start by describing the basic structure of a central bank's balance sheet (Chart 1).
Conventionally, the Bank of Japan and other major central banks had conducted monetary
policy by controlling short-term interest rates at their target level through adjusting the
amount of funds in the short-term money market. Means for such money market operations
include short-term operations, such as lending to financial institutions, and purchases of
government bonds, which are recorded on the asset side of the central bank's balance sheet.
On the other hand, current deposits of financial institutions held as required reserves,
government deposits, banknotes in circulation, and capital are recorded on the liability and

net asset side of the central bank's balance sheet.

Given these balance sheet items, let us look at the profit structure of a central bank. The
central bank receives interest income on assets, such as the government bonds it purchases.

On the other hand, on the liability side, banknotes and current deposits of financial

? Such discussions include Adler, G. et al. (2012), Bell, S. et al. (2023), and Reis, R. (2015). Other
examples are listed in the References.

institutions held as required reserves are costless, in the sense that the central bank pays no
interest on them. The profits earned from this difference are called "seigniorage," and the

central bank is usually able to generate such profits on a stable basis.

In the late 1990s, the Bank implemented conventional monetary policy by controlling
short-term interest rates. Therefore, its balance sheet and profits at the end of fiscal 1998

took the shape that I just described.

Subsequently, Japan's economy, in addition to the non-performing loan problem, faced a
variety of shocks, including the bursting of the IT bubble, the GFC, and natural disasters.
Moreover, the appreciation of the yen and the inflow of cheap imports from emerging
economies exerted direct downward pressure on prices. Under these circumstances,
overcoming deflation and achieving price stability became a longstanding challenge. With
Japan facing the zero lower bound on short-term interest rates at the end of the 1990s, the
Bank embarked on a variety of unconventional monetary policies to achieve price stability,
including Quantitative Easing, Comprehensive Monetary Easing, Quantitative and

Qualitative Monetary Easing (QQE), and the current QQE with Yield Curve Control.

These monetary policies gave rise to three major changes in the Bank's balance sheet (Chart
2). The first is that the large increase in purchases of long-term Japanese government bonds
(JGBs) to encourage a decline in longer-term interest rates led to a substantial increase of
such JGBs on the Bank's asset side. The second is that risk assets such as exchange traded
funds (ETFs), which the Bank began to purchase to encourage a reduction in risk premiums,
appeared on the Bank's balance sheet for the first time. The third is that, in line with the
developments on the asset side, there was a substantial rise in current deposits on the
liability side, in the form of an increase in financial institutions' excess reserves. In order to
control short-term interest rates at the target level in the presence of such large excess
reserves, it became necessary to apply interest rates on excess reserves. For this reason,
during the GFC, the Bank introduced the Complementary Deposit Facility in October 2008,

under which it started applying interest on excess reserves.

With such changes in the Bank's balance sheet taking place, its profits have shown the
following developments (Chart 3). First, the Bank's income has been on an increasing trend.
Interest income on the government bonds has been rising following the increase in the
purchases of long-term JGBs. In addition, the dividends received from its holdings of ETFs
and other assets have grown to a sizable amount over the past few years. On the other hand,
as the Bank began to apply interest on excess reserves, it started to record interest payments
as expenses. Nevertheless, the amount of interest payments brought about by applying
interest on excess reserves has been small compared to the rising income. Therefore, the
Bank's operating profits, which are the difference between its income and expenses, have

been on a rising trend with its balance sheet expanding.

Thus, the Bank's financial structure has changed substantially as a result of the

implementation of unconventional monetary policies.

Il. The Mechanism of Changes in Profits When the Balance Sheet Expands and
Contracts

Changes in Profits Associated with the Expansion/Contraction of the Balance Sheet

I would now like to provide an overview of the general mechanism through which the

expansion and contraction of the central bank's balance sheet is linked to changes in profits.

First, let us examine a situation where the balance sheet expands. When the central bank
expands its balance sheet by purchasing government bonds and other assets as part of its
monetary easing, both the holdings of long-term government bonds and other assets on the
asset side and the current deposits on the liability side increase. Moreover, since the average
residual maturity of asset holdings increases, the duration gap between assets and liabilities
widens. While such balance sheet expansion brings about interest expenses on excess
reserves, the interest rate on excess reserves is kept low, since short-term interest rates need
to be controlled at a low level during a phase of monetary easing. On the other hand, since
long-term interest rates are usually higher than short-term interest rates, the yield on
long-term government bonds purchased exceeds the interest rate on excess reserves, and the
rise in interest income through the increase in government holdings exceeds the rise in

interest expenses. If the central bank purchases risk assets in addition to government bonds,

the profits from such assets will increase in line with its holdings, although such profits will
be returns commensurate with the risk. It can be said that the Bank of Japan's finances are

currently in this phase.

Next, let me explain how central bank profits typically change during the exit phase, when
monetary policy moves toward tightening and the balance sheet shrinks. In this phase, there
will be a decline in government bonds and other assets on the asset side and a decline in
current deposits on the liability side. Moreover, the central bank will hike the interest rate
on current deposits in order to raise short-term interest rates. As a result, interest expenses
will increase, putting downward pressure on the central bank's profits. Central banks
including the U.S. Federal Reserve (FRB), the European Central Bank (ECB), and the Bank
of England (BOE), which are currently tightening monetary policy in response to inflation,
are in this phase and their profits are decreasing in practice. I will elaborate on this point

later.

Thus, once entering the exit phase, central bank profits will be under downward pressure for
a while. However, eventually, interest expenses will decline as current deposits decrease.
On the other hand, proceeds from the redemption of maturing existing government bonds --
of which the central bank needs to hold a certain amount -- will need to be reinvested at
some point. In that case, amid interest rises, interest income will increase as such
government bond holdings are successively replaced by higher yielding ones. Therefore, in
theory, from a somewhat longer-run perspective, the central bank's profits will eventually
recover, although this will depend on economic activity, prices, and financial conditions at

each point in time, as well as the conduct of monetary policy based on these conditions.

Factors Affecting the Amplitude of Profits as the Balance Sheet Expands and Contracts

Thus, central bank profits fluctuate as the balance sheet expands and contracts. However,
the extent to which profits fluctuate depends substantially on a range of factors. In what
follows, focusing mainly on the contraction in balance sheets currently faced by major
foreign central banks, I would like to outline the four main factors affecting the amplitude

of central bank profits and the mechanisms through which they do so.

(1) Balance sheet size

The first factor is the size of the balance sheet (Chart 4). When central banks turn toward
monetary tightening, as major foreign central banks have done recently, they raise interest
rates by hiking the interest rate on current deposits. In this process, the interest rate on
government bond holdings may temporarily fall below the interest rate on current deposits,
and spreads may turn negative. In this case, the larger the size of the balance sheet, the

greater the downward pressure on profits, resulting in a greater amplitude of profit changes.

(2) Extent of reinvestment of proceeds from redemption of government bond holdings at
maturity
The second factor is the extent to which proceeds from the redemption of government bond
holdings at maturity are reinvested (Chart 5). If all of the redemption proceeds are
reinvested in new government bonds, the size of the balance sheet is unchanged. On the
other hand, if only part of the redemption proceeds are reinvested in new government bonds,
the balance sheet will shrink. Thus, the pace at which the balance sheet shrinks depends on
the amount reinvested. If no reinvestment is made at all, the balance sheet will shrink at a
rapid pace. Since long-term interest rates are expected to rise to a certain degree during the
monetary tightening phase, the larger the reinvestment, the greater its impact on improving
the yields on government bond holdings. Meanwhile, the pace of improvement in yields
through such reinvestment depends on the maturity structure of its government bond
holdings. As government bonds with low yields are redeemed at maturity while new ones
with high yields are added to the portfolio, the larger the share of bonds maturing early, the

faster the pace of improvement in yields.

Of course, the extent to which proceeds from the redemption of government bond holdings
are reinvested -- in other words, at what pace a central bank reduces the size of its balance
sheet -- will depend on the circumstances at any given time. For example, when the FRB
raised interest rates from the end of 2015, it maintained the size of its balance sheet for less
than two years from the start of its policy interest rate hikes by reinvesting all of the
redemption proceeds from its holdings of government bonds and other assets. This time,
however, due to the need to deal with historically high inflation, it began to reduce the size

of its balance sheet by reinvesting only part of its redemption proceeds from maturing

government bond holdings soon after raising the policy interest rate. Thus, reinvestment of
proceeds from maturing government bond holdings greatly depends on economic activity,
prices, and financial conditions as well as the conduct of monetary policy based on these

conditions.

(3) Developments in short-term and long-term interest rates

The third factor is developments in short-term and long-term interest rates or, in other
words, the shape of the yield curve and changes therein (Chart 6). As explained earlier,
during a balance sheet contraction, interest expenses increase as the interest rate on current
deposits is raised, while interest income also increases due to the reinvestment of proceeds
from maturing government bond holdings. Therefore, when the yield curve steepens -- that
is, long-term interest rates rise at a faster pace than short-term interest rates -- the increase
in interest expenses will remain relatively small, so that the downward pressure on profits
will be limited. On the other hand, when the yield curve remains flat -- that is, long-term
interest rates rise at a relatively moderate pace while short-term interest rates rise rapidly --

the downward pressure on profits will be greater.

How long- and short-term interest rates change also depends on the prevailing conditions at
the time. In the United States, policy interest rates have been raised rapidly and
substantially during the current monetary tightening phase, and the yield curve has become
inverted with higher short-term than long-term rates. In terms of the impact on the central
bank's finances, this is a situation that will contribute to downward pressure on central bank

profits to an extremely considerable degree.

(4) Developments in banknotes in circulation

Lastly, developments in banknotes in circulation are also a determinant of central bank
profits (Chart 7). Banknotes are recorded on the liability side of a central bank's balance
sheet, but since they do not bear interest, they are a costless liability for the central bank. On
the other hand, excess reserves bear interest, so a large part of current deposits are
cost-bearing liabilities for the central bank. Therefore, central banks' profits are also

affected by the proportion of banknotes on the liability side, which incur no cost.

For example, if deposit interest rates at private financial institutions rise as the policy
interest rate is raised, people may have a greater incentive to deposit their banknotes in their
bank accounts in order to earn interest income. The banknotes accepted by private financial
institutions will return to the central bank in the form of deposits in current accounts held by
private financial institutions at the central bank. As a result, on the liability side of the
central bank's balance sheet, costless banknotes will decrease and their contribution to

liabilities will be reduced, thereby putting downward pressure on profits.

Changes in the demand for banknotes, in addition to such economic factors, are determined
by a range of background conditions, including social, cultural, and historical factors.
Therefore, the level of banknotes in circulation differs across countries, regions, and periods.
In Japan, banknotes in circulation as a percentage of nominal GDP hovered around 6 to 8
percent until the mid-1990s, after which they began to trend upward, recently reaching a
level exceeding 20 percent. The basic background to this trend likely includes the prolonged
low interest rate environment. On the other hand, the demand for banknotes is thought to
decrease if the trend toward a cashless economy grows. In fact, in Sweden, where the use of
cashless payment is very advanced, banknotes in circulation as a percentage of nominal
GDP have been on a declining trend in recent years. Thus, since the demand for banknotes
depends on a variety of factors, it is difficult to predict future developments in banknotes in

circulation.

Il. The Debate within Academia and International Organizations over Central Bank
Finances
So far, I have described the mechanisms through which central bank balance sheet
expansion and contraction lead to changes in profits and the factors that determine the
amplitude of such changes. As major foreign central banks have experienced, a central
bank's profits increase during a balance sheet expansion. They decrease temporarily when
monetary policy tightens and the balance sheet contracts. I hope this mechanism is now
clear. Next, I would like to look at the relationship between central bank finances and

monetary policy conduct from a theoretical perspective.

A major premise is that the finances of a central bank depend on the currency system
adopted. In the past, under the convertible money system, banknotes issued by the central
bank were convertible notes for which convertibility to gold or silver was guaranteed. In
other words, such central banks were required to hold gold or silver corresponding to the
amount of banknotes issued as specie reserves so as to meet requests from banknote holders
to exchange their banknotes for gold or silver at any time. Thus, under the convertible
banknote system, confidence in banknotes was directly based on the value of the underlying
assets, such as gold and silver, held by the central bank. However, subsequently, many
countries and regions switched from a convertible money system to a fiat money system,
under which the common understanding is that confidence in the currency is ensured
through the appropriate conduct of monetary policy with the aim of achieving price stability.
Therefore, under a fiat money system, the link between central bank finances and
confidence in the currency must be considered from the perspective of how decreases in a
central bank's profits and capital affect the conduct of monetary policy. Within academia
and international organizations such as the International Monetary Fund (IMF) and the
Bank for International Settlements (BIS), there have been various debates on this issue from
such perspective. Looking at the conclusions, our impression is that there is a range of
positions, with some saying that decreases in the central bank's profits and capital adversely
affect monetary policy conduct and others saying that they do not. However, taking a

bird's-eye view, I think that these arguments are not inherently contradictory.

That is, those arguing that decreases in the central bank's profits and capital have no adverse
effect on monetary policy conduct mainly focus on the fact that a central bank can supply its
own means of payment and settlement and that damage to its finances normally can be
repaired eventually through seigniorage, and they highlight that decreases in the central
bank's profits and capital do not immediately impair its ability to conduct policy in an
operational sense. This describes the major difference between a central bank and private
financial institutions or business corporations, and is the basic idea when considering the
relationship between the central bank's finances and its ability to conduct policy. In other
words, it is inappropriate to capture central bank finances through analogies with private
financial institutions or business corporations. On the other hand, those arguing that there

are adverse effects on monetary policy conduct focus on the possibility that decreases in the

central bank's profits and capital can lead to a decline in confidence in that central bank.
Specifically, a theoretical argument is that speculation will grow that, for example, there
will be political intervention or the central bank will prioritize improving its finances in its

policy conduct, leading to a substantial rise in inflation expectations.

Taken together, I think we can reach the following conclusion on the relationship between
central bank finances and monetary policy conduct. In general, decreases in the central
bank's profits and capital do not immediately impair its ability to conduct policy in an
operational sense; however, in order to avoid a decline in its credibility triggered by
decreases in the central bank's profits and capital, it is also important to pay attention to the

central bank's financial soundness.

IV. Recent Developments in the Finances of Foreign Central Banks

So far, I have talked about the relationship between central bank finances and monetary
policy conduct from a theoretical perspective. I would now like to turn to recent
developments at foreign central banks as practical examples (Chart 8). Major foreign central
banks adopted unconventional monetary easing policies after the outbreak of the GFC.
Subsequently, the sizes of their balance sheets expanded significantly and profits increased
as they responded to the European debt crisis and the COVID-19 pandemic, for example.
Since 2022, however, major foreign central banks have been tightening monetary policy in
response to inflation, leading to a decline in profits. In the following, I would like to review
recent developments in central bank finances, focusing on various aspects, using the central

banks of the United States, Europe, and Australia as examples.

Decrease in Profits

The first aspect I would like to focus on is developments in profits. The foreign central
banks' profits increased substantially in the past phase of balance sheet expansion. Foreign
central banks, however, are currently experiencing in practice the mechanism in which their
profits are decreasing as they are contracting their balance sheets (Chart 9). The FRB began
raising its policy interest rate in March 2022, and the rate hikes have been more rapid and
more substantial than in the past, reaching around 5 percentage points in a little over a year.

Since the interest rate on current deposits has been raised as well, the cost of liabilities has

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increased substantially at a rapid pace. As mentioned earlier, the FRB's policy during this
phase of monetary tightening is to limit reinvestment of proceeds from redemption of
government bonds at maturity and contract its balance sheet at more or less the same time
that it is raising interest rates, due to the need to firmly rein in inflation. Under these
circumstances, partly because of the difficulty in improving yields on its asset holdings, the

FRB has been reporting weekly losses since September 2022.

Similar developments can be observed in Europe. In the United Kingdom, the BOE has
conducted large-scale asset purchases through its subsidiary, the Asset Purchase Facility
Fund Limited (APF). The APF borrows from the BOE at the policy interest rate to finance
the purchases, while any profits and losses on the assets purchased accrue to the
government. Against this backdrop, the BOE has raised its policy interest rate rapidly and
substantially, resulting in negative spreads for the APF. Since October 2022, the interest
income from the APF's asset holdings has been insufficient to cover its interest payments on
borrowings from the BOE, and thus the government has been making transfers to the APF

to cover its losses.

Also, in the euro area, the ECB has been raising the deposit facility rate, which is the
interest rate on current deposits. As a result, not only the Bundesbank, which has purchased
large amounts of German government bonds with relatively low yields, but also the Bank of
Italy, which has purchased large amounts of Italian government bonds with relatively high
yields, have seen the interest rate on current deposits at a level exceeding the average yield

of their government bond holdings and other assets, resulting in a squeeze on their profits.

Increased Unrealized Losses on Bond Holdings

The second aspect is unrealized gains/losses on bond holdings (Chart 10). Major foreign
central banks have seen the market prices of their government bond holdings fall in tandem
with rising interest rates, resulting in widening unrealized losses. However, central banks
choose their valuation method based mainly on the developments in their bond holdings,
and the impact on their financial statements varies from one central bank to another. For
example, the FRB, like the Bank of Japan, uses the amortized cost method and discloses

unrealized gains/losses as reference information. As of March 31, 2023, the FRB held

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substantial unrealized losses on its bond holdings, amounting to 0.9 trillion dollars.
However, this does not directly affect its actual profits/losses, as in the case of the Bank of
Japan. Other central banks that use the amortized cost method to value their government
bond holdings include the ECB. On the other hand, the Reserve Bank of Australia (RBA)
uses fair value accounting for its government bond holdings. For this reason, the large
unrealized losses on government bonds held by the RBA exerted substantial downward
pressure on its actual profits, so that the RBA's equity turned negative in the June 2022

financial statements.

Institutional Responses to Financial Risks

The third aspect concerns central banks' institutional responses to financial risks (Chart 11).
Since before adopting unconventional monetary policies, central banks have been holding
capital to prepare for financial risks. There is large variation in the level of capital held by
central banks, reflecting the nature of their asset holdings, institutional differences,
historical background, and other factors. All central banks, however, recognize the

importance of ensuring their financial soundness by holding capital.

With this in mind, as for other institutional responses, the FRB, for example, changed its
accounting rules in 2011 and started to record accumulated negative net income as a
deferred asset in the event of actual loss. Also, transfers to the Treasury are suspended until

the accumulated negative net income is eliminated.

Next, in the United Kingdom, the BOE and the government clarified the division of roles in
advance when starting asset purchases. Specifically, as mentioned earlier, the BOE provides
funds to the APF by lending at the policy interest rate, and any profits or losses made by the

APF accrue to the government.

Moreover, in Germany, the Bundesbank had been actively accumulating provisions to
prepare for financial risks in advance during the past balance sheet expansion. It avoided
losses by drawing down these provisions in the financial statement for 2022. The Bank of
Japan has a similar mechanism in place. In 2015, to prepare for a downturn in profits during

a future exit from monetary easing, the Bank expanded measures pertaining to provisions

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for possible losses on bond transactions. This measure allows the Bank to set aside a portion
of its profits during periods of higher profits, and if profits were to decline, it can draw
down those provisions. This helps to ensure the Bank's financial soundness by reducing the

amplitude of profit changes.

Thus, looking at these examples of major central banks, we can see that all have taken
various institutional measures to prepare for financial risks. In particular, central banks that
have implemented unconventional monetary policies have put in place a range of measures
apart from holding capital. These measures are evidence that central banks are acting on the

recognition that paying attention to their financial soundness is also important.

External Communication

The final aspect I would like to talk about is central banks' external communication; that is,
how they are explaining financial risks. First, all central banks have emphasized that there
will be no impediments to their ability to conduct monetary policy, even if they temporarily
make losses or have negative equity. In addition, some have mentioned that, although their
profits are currently decreasing, it is also true that they increased during the past balance
sheet expansion. On this basis, central banks have highlighted that assessments of their
large-scale monetary easing should focus on the positive effects on the economy overall and
not on central bank finances. At the same time, central banks have also continued to clearly
communicate their policy of giving due consideration to their financial soundness by
maintaining their stance of working to restore their capital over time, in recognition of the

importance of central bank capital.

There are various media for disseminating information, including explanations to legislators,
speeches, the publication of the central banks! staff papers, and Q&As on central banks'
websites. Because central bank finances are in some way different from those of private
financial institutions or business corporations, this may be difficult for non-experts to
understand. On the other hand, they are an extremely important topic with regard to
confidence in a currency and central bank credibility. Therefore, all central banks take every

opportunity to provide detailed explanations regarding their finances.

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V. Basic Thinking on Central Bank Finances and Monetary Policy Conduct

Lastly, based on what I have said so far, I would like to outline the Bank of Japan's basic
thinking on central bank finances and monetary policy conduct. Although there are some
points that overlap with what I have spoken about, I would like to explain the Bank's

thinking in the form of answers to frequently asked questions.

(1) If the Bank's profits and capital decrease, will there be a loss of confidence in the

currency?
Perhaps the most fundamental question is: "If the Bank of Japan's profits and capital
decrease, will there be a loss of confidence in the currency?" Under the current fiat money
system, which is adopted by many countries and regions, including Japan, the central bank
controls the level of interest rates and the amount of currency from the perspective of
achieving price stability. Therefore, confidence in the currency is not directly ensured by the
assets held by the central bank or its financial soundness, but by the appropriate conduct of
monetary policy with the aim of achieving price stability. As mentioned earlier, foreign
central banks have m