W A Wijewardena: Auditing the key policy functions of a central bank -
views from the top
Keynote address by Mr W A Wijewardena, Deputy Governor of the Central Bank of Sri
Lanka, at the Seminar on "Effective Internal Audit for Central Banks", Windsor, UK,
30 April 2009.
The views expressed in this paper are those of the author and should not be construed as those representing the
Central Bank of Sri Lanka.
* * *
The primary objective of a central bank is to stabilise the value of its currency and continue to
maintain that stability to facilitate long term economic growth. There could be other ancillary
objectives assigned to a central bank, such as providing liquidity to the government to bridge
its revenue and expenditure flows or refinancing banks' loans to priority sectors. But the
primary objective of a central bank takes precedence over any such ancillary objective and, if
there is a conflict between the two, a central bank should always give priority to its primary
objective1. This is because the success or failure of a central bank is gauged by its
attainment of the primary objective and not the ancillary objectives. Even if a central bank
has done well in realising its ancillary objectives, but failed in the primary objective, then, that
central bank is deemed to have failed in its operations. Hence, the key policy functions of a
central bank should perforce be geared towards the attainment of its primary objective and
all systems, within and outside, should be aligned to ensure it.
It is, therefore, necessary to review and monitor the working of the key policy functions of a
central bank continuously in order to diagnose the impending risks and take appropriate
prescriptive measures. This function requires a special type of auditing of the key policy
functions of a central bank.
The irresponsible use of a central bank's discretionary powers
Central banks are privileged institutions in the sense that they can acquire assets by creating
liabilities at their own discretion. No other organisation enjoys that kind of a discretionary
power. If others are desirous of acquiring assets by assuming liabilities (in other words, by
borrowing from others), they have to go along a tedious path. They have to do so by
establishing their creditworthiness before prospective lenders and after complying with
tedious legal and market-established procedures. The lenders too would lend them not
because of being subject to any compulsion, but upon their free will, having assessed the
risk and the profitability of the transaction involved. But, central banks could acquire assets
just by making book entries. They could issue currency and get others to part with their
assets in exchange for that currency. All that happens in a central bank's balance sheet is
the creation of a liability item in the form of "currency liability" and an asset item
representing the asset the bank has acquired. This would make both assets and liabilities to
rise simultaneously. This extraordinary power is being enjoyed by a central bank due its
functioning as the monetary authority of a country. However, the community has given such
a power to a central bank with a non-violable obligation attached to that power: the
responsible use of the discretionary power vested with it.
There are two reasons why a central bank should use its discretionary power of issuing
currency responsibly.
First, the issue of currency over and above the needs of the society will expand the nominal
aggregate demand creating an excess demand for goods and services. Since the aggregate
supply is inflexible to meet this demand in the short run, the excess demand will put pressure
for prices to rise. If this continues year after year, it generates inflation, reducing the wealth of
people in real terms and creating a series of adverse consequences that hinder the long term
growth.
Second, in an open economy which most countries have today, the rise in the aggregate
demand could partly be met out of imports. Unless the country makes a surplus in its current
account, the payment for imports has to be made either through capital inflows (both debt
capital and non-debt capital) or running down the existing foreign reserves. Both generate
long term balance of payments problems and exert pressure on the exchange rate to
depreciate.
Thus, the irresponsible use of the discretionary power of a central bank to acquire assets by
creating a currency liability will lead to a depreciation of both the domestic value of its
currency (domestic inflation) and the external value of its currency (continuous depreciation
of the exchange rate). However, the fall in the external value of the currency is linked to, and
preceded by, a fall in the domestic value. In other words, depreciating exchange rates are an
effect and not the cause of domestic inflation. Hence, the continuous domestic inflation is a
sign of a central bank's failing to fulfil its primary obligation to the community.
The new role of auditors of a central bank
The central bank auditors, both internal and external, have for long confined themselves to
the financial type of auditing of the operations of a central bank. The objective of this auditing
is to identify whether a central bank has complied with the set-financial rules and procedures,
whether there are irregularities or malpractices in payments or recording transactions or
whether frauds have taken place in the operations of a central bank. Internal auditors report
on these aspects to the top management of a central bank, while the external auditors do so
to alert both the management and the legislators. Such compliance auditing is necessary and
useful, but not sufficient to gauge the risks faced by a central bank and, accordingly, to take
early prescriptive measures.
A central bank may operate quite perfectly with regard to its internal procedures and
systems. The accounts of a central bank may have been prepared having compliance to the
best accounting standards. The external auditors may have given an unqualified certification
to a central bank's financial statements. In the eyes of the public, a central bank may have
been projected as a model institution to be emulated by others. Yet, all these salutary
features which pertain to a central bank's past or current actions may hide the major risks it
may be facing with regard to its future operations. It is the duty of the auditors to dig out
these risk aspects and alert the management and, if necessary, the legislators, before it
becomes too late to take any prescriptive measures.
This poses a daunting challenge to the auditors of a central bank. A central bank, with its
unrestrained resources, may have staffed itself with the best technical talents in the main
field of its operations. Auditors are now required to assess their work and make judgments
about the adequacy and the consequences of such work. In doing so, they should exert
utmost care not to make wrong or spurious judgements and give false alarms about an
impending catastrophe in a central bank. To do their job effectively, auditors should be more
knowledgeable of the technical side of the operations of a central bank than its internal
technical staff. Moreover, they should arm themselves with knowledge of how other central
banks are operating, how some central banks had got into difficulties due to irresponsible
behaviour and the emerging global best practices of central banking. Hence, it is a continuing
learning and knowledge enhancement process for auditors of a central bank. By any
measure, this is not a simple challenge.
It is only with this superior knowledge base that auditors acquire the capability of making a
proper risk assessment of a central bank and play their new role as a "risk-alerter" to the
management and legislators. This requirement equally applies to both internal and external
auditors of a central bank.
The major risks faced by a central bank
The policy failure risk, (that is, the inability to maintain the stability of the value of the
currency on a continuous basis) and the associated reputation risk (that is, the public no
longer trusts the central bank and its action) of a central bank are well known. But, a lesser
known risk of a central bank is the "insolvency risk" which could loom over a central bank
with or without the presence of the policy failure risk. In other words, a central bank can run
the risk of being insolvent, even when it has been successful in maintaining the stability in
the value of its currency.
The insolvency risk of a central bank is less obvious, because of the very nature of a central
bank. A central bank, even if its capital is negative and its currency liability is not matched by
an equivalent value of foreign assets or valuable domestic assets, could still continue to be in
business unlike a private organisation. In the case of a private organisation, if the net-worth
is negative, it has to be re-capitalised as an urgent need. If it does not happen, it cannot
operate as a going concern and has to be liquidated on the ground of insolvency. However, a
central bank can still operate with a negative net-worth, by continuing to issue currency as
long as the members of the public are willing to accept such currency in exchange for the
assets held by them. It could, in these circumstances, defer and hide the need for
recapitalising itself and continue to be in operation.
The fact that the insolvency of a central bank is not known to the outside world does not
mean that a central bank is without problems. A central bank's operations are smooth and
faultless, if its expenses are funded out of net interest income it earns on its foreign reserves
or its domestic asset portfolio. But, if it has to meet its day to day expenses only by issuing
currency, that is, by exchanging reserve money, its capital base gets further eroded reducing
its ability to back the currency it has issued. Its continuous reliance on inflationary financing
in this manner for running its affairs will ultimately render it a victim of its own irresponsible
behaviour.
When a central bank has to be re-capitalised by the government by using tax payers' money,
the bank would run a further risk. That risk is the loss of its independence. The legislators
who now get an opportunity to scrutinise the bank's affairs may be tempted to tighten their
control over the bank, because, in their opinion, the bank has failed due to the laxity of
controls. The corollary would be for the central bank to lose the budget independence and,
as a consequence of that loss, the policy independence as well. One cannot blame
legislators or tax payers for demanding for greater control over the affairs of a central bank,
because it is their scarce resources which are now used to re-capitalise a central bank. Since
such scarce resources have better alternative uses, the temptation on the part of legislators
to punish an errant central bank by tightening controls is unavoidable. But, for a central bank
to conduct its policy actions properly, the budget independence is a must and if it does not
have the budget independence, it cannot exercise the policy independence as well.
What are the early signs of insolvency of a central bank?
A central bank becomes insolvent when its capital is eroded to the extent that its net-worth
turns negative. A central bank reaches such a catastrophic situation when it makes mounting
losses year after year due to its engagement in imprudent financial transactions.
A central bank can always finance itself (and also the government) by inflating the economy.
However, it also spawns the danger of a central bank getting trapped in an ever expanding
spiral of inflationary financing, if it does not pursue an inflation-fighting policy consistently.
Economists have found that central banks, acting at the instance of their governments, have
incentives to reverse the tight monetary policy after they have made some gains in
controlling inflation. This is known as the "time-inconsistency problem"2 or the "prisoner's
dilemma"3 faced by a central bank.
In the time-inconsistency problem, there is an unceasing battle between a central bank and
the public for fooling each other. A central bank, in response to public's outcry against the
high inflation, may pursue a tight monetary policy to lower the inflation rate. However, once
the inflation rate falls and the public's outcry subsides, it no longer has the incentive to follow
the same tight policy. Accordingly, in order to raise its expenditure levels (or alternatively, to
provide more funding to the government), it may go back on its tight monetary policy and
reflate the economy so as to extract real resources from the public. It, therefore, tries to fool
the people by generating inflation without their knowledge. However, the public are also
smart and aware that the central bank would reverse the course of its policy by inflating the
economy after it has made small gains. This mistrust of the public about the policy actions of
a central bank is well revealed by the exceedingly high inflation expectations they normally
form about the future trends in inflation. Consequently, they also try to fool the central bank
by asking for higher wages, if they are employees, or higher future contract prices, if they are
producers, than the normal wage or contract price levels permissible under the now low
inflation rate. This battle between the central bank and the people will trap the economy in a
high inflation-high wage spiral making it a self-defeating enterprise for both the central
bank and the public.
The high inflation in the economy now exerts pressure on the exchange rate to depreciate.
Both the central bank and the government may harbour a false view in them that allowing the
exchange rate to depreciate is equivalent to publicly accepting the failure of their actions, it
would further raise the cost of living and it would worsen the budgetary outcome by raising
the interest cost on the government's external debt. This false view may force the
government to defend the exchange rate at the expense of the loss of foreign reserves of the
central bank. At this stage, the auditors should notice a change in the composition of the
assets of a central bank: a decline in the foreign assets and an increase in the domestic
assets mainly in the form of lending to the government.
The change in the asset structure of a central bank leads to a series of unfavourable
outcomes that raises the risk of insolvency of a central bank.
First, there will be a change in the composition of the income of a central bank. The foreign
income will fall and the domestic interest income will rise.
Second, the decline in the foreign assets will force a central bank to borrow abroad on a
short term basis, raising its foreign liabilities and interest out-payments.
Third, if the government is still bent on keeping the fixed exchange rate, even the borrowed
funds would be used to defend the exchange rate, converting the net foreign assets of a
central bank to a net foreign liability position.
Fourth, the defence of the exchange rate will create a liquidity shortage in the domestic
money markets. The central bank may recoup the liquidity by expanding its domestic assets
by lending to commercial banks and also to the government which is now unable to raise
funds from the market due to the liquidity shortage.
Fifth, to pay interest on foreign loans and repay the principal, a central bank may be forced to
make further foreign borrowings. This will enlarge the net foreign liability position and cause
the interest payments to surpass the interest earnings. The losses so made will continue to
mount, gradually eroding a central bank's capital base.
The end result will be the conversion of a central bank's net-worth from positive to negative.
At that stage, a central bank will become technically insolvent. It actually becomes insolvent
when it is unable to make further foreign borrowing and the domestic high inflation makes it
impossible for it to fund itself by further issuing currency.
It is the duty of the auditors to be vigilant on the emergence of these signs and alert the
management and legislators in time.
The actual insolvency of a central bank: the case of the Central Bank of the
Philippines4
The Central Bank of the Philippines (CBP) became insolvent in late 1980s and had to be
liquidated in 1993. The events that led to its insolvency are an exact replay of the story
outlined above5.
According to the data published by the CBP6, it incurred losses from 1983 to 1990 year after
year, making the total cumulative losses for the period equal to 144 billion Pesos. There were
three sources of losses: losses arising from the foreign exchange swap arrangements which
CBP entered with domestic banks; losses which CBP had to bear on account of providing
forward cover for exchange risk involved in international borrowings of domestic corporations
and interest rate losses arising from higher out-payments on foreign loans and central bank's
own securities than domestic interest earnings.
The swap arrangement was a mechanism used by the CBP to boost its dwindling foreign
reserves. When CBP lost its ability borrow abroad due to the continuously experienced
balance of payments deficits and CBP's refusal to allow the currency to depreciate, it got the
state banks and private corporations to borrow abroad under a guarantee by the government
and swapped Pesos for the foreign currency loan proceeds. In the process, CBP assumed
the exchange rate risk at the time the swap was reversed. Though this provided a temporary
relief to CBP in the form of an augmentation of gross foreign reserves and a higher import
cover adequacy, it forced CBP to take a huge loss amounting to 31 billion Pesos during
1983-90 on account of exchange rate risks. At the same time, the use of the foreign
exchange balances so acquired for defending the currency led to an undue reserve risk by
converting the foreign assets to a net negative position and forcing CBP to borrow abroad to
settle its liabilities.
The was provided by CBP to local corporations, especially the oil corporation,
forward cover
by guaranteeing the exchange rate when they borrowed abroad in the wake of the balance of
payments crisis. When CBP had to relax its grip on the exchange rate from time to time due
to the non-availability of reserves, the forward covers given by CBP resulted in massive
losses. The total of such losses for the period 1983-90 amounted to 20 billion Pesos.
As mentioned above, the net foreign assets of CBP became negative from 1981 onwards
due to the depletion of reserves and the increase in foreign borrowings. They were negative
by 4 billion Pesos in 1981. But, the negative position progressively increased thereafter rising
to a peak of 141 billion Pesos in 1990 and recording at an annual average level of 101 billion
Pesos during 1982-90. The result was the payment of interest surpassing significantly the
interest receipts. The total such losses amounted to 91 billion Pesos for the period 1983-90.
The net outcome of all these adverse developments was the decline in the net-worth of CBP
to a dismal level of 2.6 billion by June, 1993 as against a total outside liability level of 605
billion Pesos and a domestic asset creation of 440 billion Pesos. The capital funds as a
percent of domestic assets fell to an insignificant level of just 0.5% indicating that the entirety
of the currency issue (monetary liability) had been backed by worthless domestic assets. By
end 1993, the foreign exchange liabilities of CBP amounted to US$ 11.4 billion or 35% of the
Philippine's GDP7.
Thus, CBP became insolvent and had to be liquidated in July, 1993. A new central bank by
the name of or was set up under the patronage of the
Bangko Sentral ng Pilipinas BSP
World Bank and the Export-Import Bank of Japan8. Arrangements were made to repay the
liabilities of the old central bank in 25 years9.
The issue at hand is how the oncoming signs of insolvency of CBP were not noticed by its
auditors. The growing distress of CBP due to the wrong policy of defending the exchange
rate at the expense of losing foreign reserves, accumulation of losses in CBP, rising foreign
borrowings through unsustainable swaps and the depletion of net-worth of CBP were
obvious to the auditors as early as 1985. It was simply the sad story of one mistake leading
to another mistake and that mistake leading to a further mistake and so on. Once a policy
making body gets entangled in an "enmeshed policy paradox" of this nature, it is
impossible to escape the paradox without outside support. Had the first mistake, that is,
defending the exchange rate at the cost of losing the reserves, were not committed, CBP
would not have driven itself to insolvency. But, the auditors who were confined only to a
compliance audit did not read the signs of impending risk build-up in CBP. Had the central
bank management and the legislators been alerted at that time, CBP could have been saved
from liquidation. But, the auditors failed to make that alert, because at that time, the audit
programmes were confined to a simple financial compliance audit only.
What the auditors should look for
Since a central bank is a systemically important institution in an economy, the auditors of
central banks should take extra care when the accounts of central banks are audited. The old
maxim relating to the role of auditors is relevant here:
"an auditor is a watchdog and not a
blood hound". Accordingly, auditors are required to keep vigil on central banking activities
and alert the relevant parties when there are signs of risks emerging. The central bank
management and the legislators should take serious note of such alerts and take appropriate
corrective and protective measures.
What are the signs of distress that auditors should look for?
First of all, a sign immediately visible would be the change in the structure of the assets of a
central bank from foreign assets to domestic assets. The depletion of foreign reserves drives
a central bank to a future risky situation. It will have to borrow abroad from foreign sources in
order to fund the immediate foreign exchange requirements raising both the income risks and
foreign reserve risks.
The next sign will be the depletion of the capital base. In the current paper money systems
with no backing of gold or foreign currency holdings, capital funds in a central bank serves to
back the domestic asset creation. If the capital funds which are non-monetary liabilities are
equal to the domestic assets (a hundred percent cover), then all monetary liabilities are
backed by gross foreign assets similar to a currency board. Therefore, the auditors should
look for the ratio of capital funds to domestic assets and if the ratio is above 100%, they
could be complacent. However, the risk factor emerges if the ratio falls. The auditors should
alert the central bank management and come to arrangement with it, to prevent its further
depletion. If the ratio falls closer to 15%, the level prescribed in many central bank
legislations as the minimum requirement, the auditors should issue a red alert to central
bank managements. When the ratio falls below 15%, then, it is a matter of national
emergency and urgent measures need be introduced to re-capitalise a central bank.
The third sign is the actual losses made by central banks due to larger out-payments.
The fourth sign is the necessity for issuing currency to finance a central bank's affairs, since
it amounts to inflating the economy to meet a central bank's expenses.
Conclusion
The auditors of a modern central bank should play a different role today. That role requires
them to be vigilant over the emerging risks in a central bank and alert all the concerned
parties, management of a central bank and the legislators, so that early corrective measures
could be taken to mitigate the risks. Since auditors are governed by the "principle of public
trust", they would be liable for criminal negligence if a central bank becomes insolvent and
auditors have not given early warning about it. To play this role effectively, auditors should
endeavour to acquire the knowledge necessary for them to assess the work of a central bank
and make judgments about the adequacy of that work. They should place themselves on a
continuous learning programme so as to acquire not only the technical skills, but also the
current global best practices relating to central banking. The central bank management on
their part should heed to the warnings issued by auditors and make the necessary internal
adjustments promptly.