Transparency in financial reporting of central banks: Rationale and comparative practices

From a position that central banks should maintain, over time, a risk-based, non negative, level of capital, central banks need to construct their law to enable it to ensure this through the maintenance of sufficient reserves to protect against losses. Banks need to achieve this while addressing the government's legitimate rights to central bank profits and without impairing monetary policy efficacy. The evolution in the measurement and composition of central bank profit, and bank's move to adopt more transparent reporting frameworks means that previous formulaic allocations of profit to dividends and reserves are becoming problematic in ensuring the maintenance of central bank capital.
Central bank law should specify the central bank's accounting and framework, which will subsume the calculation of profit. Such an approach is more efficient than specifying the elements of profit calculation as it allows evolution of the measurement and reporting framework to reflect developments in accounting frameworks. The evolution of international standards, including the growth of fair value measurement, has resulted in greater volatility in measured profit, along with an increase in the unrealized elements in its composition. These developments significantly affect dividend policy. As a minimum, central banks should ensure that they base the pool for calculating dividends on realized profits, net of unrealized losses not covered by reserves, delaying distribution of unrealized gains until realization. Dividends will be a residual item after appropriate allocations to reserves. Banks will calculate such reserves on a model of risk-based capital adequacy enabling a dynamic adjustment of capital in a manner that does not conflict with monetary policy objectives. Mechanisms for determining the allocation to reserves will be consistent with the central bank's overall accountability and independence configuration. The law will also provide mechanisms for the allocation of net losses and bank recapitalization in the event of extreme crisis.
Credibility is important for the success of financial policy. The central bank must be financially strong. The practical implication of this premise is that financially strong central banks should ensure that their strength remains adequate to cope with their policy responsibilities and attendant risks. Their auditors should in turn utilize risk based models to ascertain whether in most circumstances the central bank can survive adverse events without the need to abandon its objectives. Clearly when the objective changes the appropriate degree of central bank financial strength should be reevaluated to the appropriate level.  A second implication of this approach is that central banks ought to earn profit on a regular basis. However it also implies that profit in excess of what would need to be maintained to keep the central bank financially strong ought to be delivered to the treasury. The accumulation of "excess" net worth is not justified; could require the government to borrow from private capital markets at excessively high interest rates; and create a temptation to plunder the central bank's reserves for reasons of political expediency.
Appropriateness of IFRS in the central banks: While significant progress has been made and the profile of the issue has been considerably raised during the last several years, certain controversial points remain and improvements in individual countries have been sporadic. IMF safeguard assessments have identified a number of problems that have been or are being addressed in the central banks assessed but these constitute only a subset of member countries. In particular, 88 percent of assessed central banks were identified as having had inadequate accounting standards.  Two particular broad issues are whether IFRS are fully applicable for central banks and the appropriate level of central bank capital. Many banks have not implemented International Accounting Standards, in particular the U.S. Federal Reserve and the European Central Bank. The essential issue is whether there is something special about central banks which invalidate certain elements of IFRS designed for commercial enterprises. The reasons given for why central banks are not done justice by IFRS include: they are not profit maximizing institutions and indeed the profit outcome comes quite late in the central bank's policy priorities; central bank shares are never exchanged for "market" value and they are immune from bankruptcy; as a matter of policy they may be subject to significant economic risks, e.g. open foreign exchange positions; they are part of the public sector and their accounts may represent only a part of the relevant balance sheet, e.g. central bank losses on its holdings of government securities are exactly offset by government gains and vice versa. Central banks have also argued, as have hedge funds, that they should not be subject to the disclosure requirements of publicly held companies. While there is some merit in these arguments, they generally do not stand up well to good financial reporting requirements.
Accounting conventions in government and central banks:  The conventional government deficit concept as presented here is based on a cash-accounting system. Cash accounting is both useful and practical for government. It is useful in that it will be consistent with the deficit financing in any given period. It is practical because government is often unaware of its accruing receipts (for example, tax receipts due) and expenditures. It should be noted, however, that conventional fiscal deficits are not based entirely on the cash concept. This arises, on the one hand, from non cash accounting in the central government where expenditures are typically recorded on a checks issued basis, which creates a problem of adjustment to the monetary figures-check float-and on the other, by the fact that public sector entities, including the central bank, presumably base their payments or receipts to government on the basis of their accounting surplus or deficit, which may not be on a cash basis.  Central bank accounting systems typically follow the normal business practice of being on an accrual basis. This practice allows an easier calculation of the net worth concept. The analyst must therefore be careful in comparing the two-deficit measures.
Accrual accounting: The first significant accounting policy change affecting central banks was the move from cash to an accrual basis of accounting. Accrual accounting recognizes income and expenses at the time that the entity legally or technically incurs them, not at the time that there is an exchange of resources. The most obvious consequence of this is a better matching of income and related expenses to produce a more accurate measure of net income. In normal circumstances, this tends to produce a smoothing of earnings between periods but can produce some subsidiary issues. An example of such is the recognition of income on non performing assets, particularly government debt. In some situations, central banks accrued interest on government debt while never receiving any real resources to match the accrual. This enabled the central bank to report an accounting profit that it distributed to the government as dividends without, real assets to back them. The resulting increase in government liquidity had monetary consequences that conflicted with central bank policy objectives. Fortunately, accounting standards offer mechanisms to recognize such impaired performance and enables the bank to stop accruing income that is not received, though such a decision is not without political difficulties in the situation of government debt.
Central banks derive capital from three sources:  
First: authorized capital which is also known as statutory capital is specified in the central bank law. Second: retained earnings covering those profits that have not been distributed as dividends or assigned to revaluation reserves. Hence, they will include balances in the retained earnings account and all non revaluation reserves, such as general or special reserves.  Third: revaluation reserves. Conceptually, revaluation reserves consist of unrealized revaluations for assets and liabilities. These revaluations may be assigned directly to the reserves or else recognized in the income statement before being transferred to the reserves. In some central banks, system limitations, or policy decisions, result in these revaluation reserves accumulating realized as well as unrealized gains and losses. Generally, this is a sub optimal situation as it confuses the purpose of the revaluation reserve.
In this discussion, capital refers to the net capital position, which is the sum of these three. Authorized capital is usually prescribed in central bank legislation, perhaps with a statutory requirement for recapitalization in the event of reported capital dropping below zero or the level of authorized capital. Issues of transparency, independence and financial sustainability require that governments to execute such recapitalization using marketable bonds or other real assets, a requirement reinforced by developments in accounting standards that require the disclosure of the fair value of all assets. Conceptually, a timely and automatic recapitalization mechanism could enable a central bank to operate with zero capital, even in a high-risk environment, though the integrity of any such mechanism rests on a government's willingness to assume the fiscal burdens involved and thus it is a problematic assumption in many situations. This tends to make it difficult to meet requirements for risk-based changes in capital by adjusting authorized capital. Consequently, banks adjust capital to cover risks through retaining changes in the value of their assets or by retaining earnings from operations. This paper is concerned about the recognition, reporting and disposition of these latter two elements, as evolution in accounting standards have changed the composition of measured profit, creating some difficulties for central banks, particularly in those situations where the central bank law prescribes procedures for calculating profits and distributable dividends. The issue is to ensure central banks are able to measure profit in compliance with their accounting framework but avoid adverse effects through inappropriate distribution of dividends.
Profit transfers and Distribution:   Profit transfers and Distribution should be closely related in time to the activities that generate the profit. The appropriation of profit generated in previous accounting periods produces incorrect fiscal statistics, i.e., nontax revenue earned in one period is brought to another period and vitiates the essential link that ought to exist between central bank income and government revenue. Severing this link often makes the annual or more frequent profit distribution the subject of political discussion which is absolutely equivalent in macroeconomic terms to arguing over an annual credit tranche to government, a possibility that has been explicitly ruled out in dozens of "independent" central bank laws over the past two decades. Transfers of profit that have or will be realized in other accounting periods are equivalent to credit. For both macroeconomic analysis and statistics, it is essential to draw a distinction between distributed central bank profit (non-tax revenue) and credit to government as the latter creates additional claims on resources while the former reflects the payment to government of non repayable resources withdrawn from the economy.
Transparency in profit calculation and distribution is important for several reasons. As central bank profits transferred to the treasury are considered budget revenue, it is important that they be distinguished from transfers more properly classified as credit to government or changes in government equity in public corporations. It is also important to understand whether profit distribution follows the basic principle of accrual accounting, i.e., do profits transferred to government correspond roughly in time to the activity that earned the profit. A further key fact is that in the vast majority of countries, the treatment of profit and losses is asymmetric, namely that profits are transferred to government but losses are not covered, i.e., losses lead to a reduction in capital or reserves. This asymmetry makes problematic judging overall public sector finances. Progress in improving the transparency of central bank profit determination has come with a general improvement in accounting and in some cases with recapitalization of the central bank-which brought to an end a chronic problem with losses. The IMF, in its surveillance work has for certain countries long found it important to report the overall public sector deficit-including the cash losses of the central bank-in its assessment of the fiscal stance. The 2001Manual on Government Finance Statistics also covers these issues.
A recapitalization purely for transparency purposes would involve the provision of government debt to the central bank sufficient for it to generate a profit. The conventional fiscal balance would fall by an amount equivalent to the higher interest cost (net of central bank. profit), which would be financed by interest-free central bank credit. Effectively, this (continued …….)  The government has a choice between transferring the required securities in a lump sum fashion at the beginning of the reform or transferring only the minimal amount of securities required each time period of the budgetary year. To introduce the notion of credibility, it is assumed that the public does not know the true objective of the government and therefore must form expectations of future government policies on the basis of incomplete information. For simplicity, it is assumed that the public knows the main objective function of the central bank and that there are only two possible types of governments, one that has the same objective function as the central bank, the other which is the weaker in the sense that under certain circumstances it would choose to accept higher inflation than the other government or relax the fiscal constraint which in the model can be thought of similarly. That is, the choice variable is the rate of inflation but the instrument is the quantity of government bonds to issue to the central bank each period which has a government debt service cost as well as a monetary implication attached to it. This motivation is but one of many for including surprise inflation in the reduced form for the government's objective function.
Avoiding policy conflicts in dividend distributions: For central banks, the issue of realized and unrealized profits has important monetary policy implications. Realization of central bank profits represents a transfer of real resources from the economy to the central bank resulting in a contraction in the money base. Unrealized profits are still awaiting this transfer of resources so their distribution as dividends provides the government with an expansion of resources for which no corresponding contraction has occurred. This produces an expansionary outcome, which may conflict with the central banks monetary policy objectives. Economically, realized profits represent the transfer of real resources and are a legitimate component of fiscal revenues. The distribution of unrealized profits is equivalent to unsterilized lending to government, something often prohibited in central bank legislation. Extending this argument to other elements of capital, it is possible to view any central bank negative capital as unsterilized lending to government thereby reinforcing the argument of the desirability for central banks to maintain non negative equity.
Potential conflict exists when dividend policy is pro cyclical rather than counter cyclical. In a strict simple rules based policy, a formula prescribes dividends. Using such an approach to ensure sufficient reserves to cover losses, in times of economic crisis the central bank will increase allocations of profits to reserves to cover the expected increase in losses. Given that the bank will apply this approach to a profit already reduced by increased loan loss recognition, the result is reduced dividends to government at a time when the bank is probably loosening monetary policy. The reduction in government liquidity potentially adds to the economic contraction that monetary policy is seeking to avoid. The converse is true in boom conditions. Hence, while it is appropriate to have a risk based capital adequacy framework, there is some merit in allowing central banks a contingent role and some discretion to accumulate reserves on a counter cyclical basis, providing minimum risks are covered. Given that no one has perfect foresight, it is necessary to include an accountability mechanism in any discretionary dividend scheme.
Dividend policies for central banks:  While accounting standards have much to say about the calculation of net profit, they specifically disassociate themselves from issues of dividend calculation. An International Accounting Standards Committee discussion paper on Accounting for Financial Assets and Liabilities noted: "that it is fundamental that an enterprise's income distribution/dividend policy….should be distinguished from income measurement. It is not appropriate, for example,.. to delay income recognition until cash is received, in order to reduce income to an amount that directors believe may be prudently distributed to owners." As dividends are a residual element, after ensuring that appropriate capital and reserves exist to cover a bank's risks, any discussion on dividend determination needs to accept, as a minimum, a non negative capital position, over time, for central banks. A failure to accept this negates many concerns on dividend policy as it becomes perfectly acceptable for banks to accumulate negative equity through unrestricted dividend distribution or unremunerated operating losses. Hence, dividend policy should focus on ensuring the central bank maintains sufficient capital to maintain its non negative capital position. While the divergence between profits and distributable dividends is a feature common to commercial entities, the unique nature of central bank functions means that this divergence between recognized and realized profits may be more material. Much of the unrealized profit may not be backed by the liquid assets required to enable its distribution without eroding the bank's liquidity and solvency, or generating adverse monetary policy benefits.  To maintain central bank capital adequacy, it is important for dividend policies to protect central bank capital by ensuring dividends are backed by liquid assets. Simultaneously, it is important for central banks to ensure that their dividend policies do not conflict with monetary policy objectives or exacerbate the business cycle. Complications arise for those central banks obliged to pay income tax on their earnings, a practice not recommended by the IMF, and by the need to pay dividends by installment, in anticipation of final earnings. A range of exogenous factors determines the effects on central bank capital of these practices and while it is not possible to say categorically that they are bad, neither represents preferred practice, especially for transition and emerging economies.
Protecting unrealized elements of profit: Concerns for monetary policy neutrality and capital adequacy creates an approach which excludes all unrealized elements from the calculation of dividends. The concerns have two causes. The bank is concerned that it will have insufficient liquid assets to cover the unrealized distributions, which will result in a monetization of the dividends. Also, there is a concern that the unrealized profits will reverse with an interest rate or exchange rate correction, nullifying distributed gains and adversely impacting capital. To exclude unrealized elements the bank would start with the Net cash flows from operations in the Statement of Cash flows as the closest proxy to realized earnings and proceed to determination of dividend distribution from there. This would exclude all unrealized elements regardless of source, including accruals, price and exchange rate movements.
Losses and net worth of central banks:  Following Vaez-Zadeh (1991), Teijeiro (1989) and Leone (1993), we argue that a central bank carrying out traditional monetary policy functions in a stable macroeconomic environment will make profits, for example, from seigniorage on currency issues. However, the macroeconomic environment in transition economies is usually unstable and the central bank is often forced to increase revenues, fiscal activities reduce central bank profits or even produce losses. Thus, central bank losses occur when the bank takes on functions outside its normal role, e.g. subsidized lending to priority sectors or rescue operations. Fry (1993) indicates that serious central bank losses may arise when timing of domestic currency receipts has been divorced from the timing of foreign currency payments. The lack of financial discipline, sterilization operations or bad management may also lead to losses, but permanent losses usually represent hidden fiscal deficits and reflect QFO.  Accumulated losses are reflected in negative net worth of the balance sheet. It is commonly argued that a central bank can have a persistently negative. Stella (1997), central bank may operate well without capital, but large negative net worth may compromise bank's independence and interfere with its monetary policy goals.  From a macroeconomic point of view, central bank losses are a problem if they endanger attainment of monetary targets. Moreover, as noted in previous section, losses caused by QFO can have distortionary effects. Losses can be financed through creation of additional losses or through inflation. As losses represent an injection of liquidity, the central bank may have to sterilize its impact in order to achieve its money growth objectives [Vaez-Zadeh, 1991]. This vicious circle of rising losses and rising remunerated liabilities is accompanied by increases in interest rates in each round. Hence, losses of the central bank can erode the ability to conduct monetary management efficiently and lead to inconsistent use of monetary policy instruments. Vaez-Zadeh stresses that the higher the ratio of non-earning assets, the stronger the incentive for the central bank to generate a surprise burst of inflation to finance its losses.
Central bank exchange rate guarantees:  Unlike most other central bank activities, guarantees have no immediate effect on either the profit-and-loss account or the balance sheet. Nevertheless, in many cases, notably in Latin America, they have eventually resulted in very large losses.  A foreign exchange rate guarantee is a form of insurance contract.  For a specified premium, the insured obtains a guarantee of foreign exchange at a certain price on a given date. If a premium is charged that is above the actuarial value of the contract, then the insurer stands to make a profit in return for reducing the insured's risk. Of course, if a lower premium is charged, and many guarantees were offered for free, an ex ante subsidy is provided.  In many cases in Latin America, exchange rate guarantees were offered as a way to facilitate foreign borrowing by domestic residents. These guarantees fixed the debt service in domestic currency terms, thereby reducing the risk to the creditor that the debtor would default solely on account of a real exchange rate depreciation. Had the central bank acquired the foreign currency counterpart of such borrowings, it could have diversified its own risk by holding external foreign assets. Because much of the borrowing was tied to imports, and also for other reasons, central banks did not keep foreign exchange backing for their guarantees. (Inasmuch as these might be considered contingent liabilities, one would not expect that full backing is necessary.)
Realized and unrealized gains: Should the unrealized gains become realized, a different situation would exist. Compared with the situation that would have obtained with no revaluation gain, purchasing power in the private economy is reduced by the amount of the valuation gain, and thus expenditure "financed" by realized gains is similar to expenditure financed from revenue. If the central bank's accountants took note of the capital gain, it would be hypothecated to reserves: thus, other transfers from income to reserves would be correspondingly reduced, and transfers to the government would increase, reducing the, fiscal deficit.  In some cases, the central bank does not keep track of capital gains and losses that are due to the sale of previously purchased foreign exchange. Rather than shifting the accounting entry from revaluation account to profit account, no change is made. In practice, this means the gain is never effectively realized. Nevertheless, it is a true gain, as the liabilities of the consolidated central bank or government are lower after the gain than otherwise would be the case.  One ad hoc way around this accounting problem would be to attribute valuation gains or losses to central bank income over a period of several years.
Activities affecting the profit and loss account:  Central bank activities that affect solely the profit-and-loss account of the central bank include the banking services side of monetary activities and certain quasi-fiscal activities, for instance, subsidized credit refinancing for exporters, which is unwound over a short period. If the central bank makes a profit and provided that the amount the central bank transfers to its reserves is not excessive (reserves policy is discussed further below), the net operating surplus of the bank will accrue to the government and reduce the deficit. Therefore, the net result of these activities is effectively already included in a conventionally measured deficit. This analysis implicitly assumes that central banks remit 100 percent of marginal profit (when the bank is making a profit) and zero percent of the marginal loss (when it is making a loss). It may be, however, in a particular country, that the marginal rate of transfer of central bank profits is less than 100 percent. In such cases, even were the central bank making profits, the transfer of a quasi-fiscal activity between the government and central bank would not be completely neutral. This potential qualification is ignored in what follows.
It would thus seem that, for measuring the fiscal deficit, no distortion will arise if the central bank performs banking services, or if it undertakes quasi-fiscal activities of a kind such that the entire impact is felt on the central bank's, profit-and-loss account in the year in question. Two points should be made, however. First, leaving such activities in the central bank accounts will understate the gross level of government expenditures and revenues, frequently taken as a proxy for the level of government intermediation in the economy. Second, as noted above, the cost of quasi-fiscal activities undertaken by the central bank is rarely transparent. There are analogous problems with certain central government activities, for example, measuring the net value of public asset sales-that is, the gross sales proceeds minus the value of the asset sold.
Activities affecting the central bank's balance sheet:  This subsection is concerned with activities whose costs do not immediately (or fully) fall on the profit-and-loss account, but are instead reflected in a change in the composition of the central bank's assets and liabilities. Examples are central bank loans to commercial banks or industries that are financed by changes in high-powered money or by central bank borrowing.  Some theoretical considerations are needed at this point. The economic cost of an activity can be considered as the amount that would have to be paid to the private sector to undertake the activity in
question. Thus, for example, the cost of net lending to the private sector is the sum that would have to be paid to a private commercial bank to undertake the lending itself" and would, in theory, be equal to the expected discounted future loss arising from the loan, adjusted for risk. Thus, to maintain its financial integrity, when undertaking a quaSi-fiscal activity, the central bank would ideally increase its reserves sufficiently to cover that cost, effectively reducing its profit transfer to government and increasing the fiscal deficit by the same amount. If it did this, the fiscal deficit would fully reflect the cost of the quasi-fiscal activities undertaken by the central bank in the sense of their impact on net worth.
Overall balance sheet of the central bank: The overall balance sheet shows the composition of the bank's assets and liabilities. The liabilities of the central bank typically include the note issue, deposits by the government (in the central bank's role as fiscal agent), deposits by the private sector (usually owing to legal regulation or the central bank's role as the banks' banker), and loans raised by the central bank (which can be in foreign currency). On the asset side, the central bank may hold a variety of assets. Resulting from its monetary activities-intervention or rediscounting-it may hold government or private sector bonds and foreign exchange. It may extend credit to the government, to finance the government deficit. And finally, it may undertake quasi-fiscal activities, including the extension of credit to the private sector.  To make the accounts balance, the difference between the bank's assets and liabilities is shown on the liability side of the balance sheet. This item which is broadly equivalent to "other items net" in the central bank monetary accounts-has three important components. First, it includes the revaluation account that reflects valuation changes in the net foreign assets of the central bank. Second, it includes the net worth of the central bank, the accumulation of its profits, plus interest, over time. And third, it includes the central bank's original capital, physical assets (such as buildings), and reserves.
Profit and loss account (revenue):  Almost all central banks have a monopoly in issuing currency and creating reserves-this right almost defines a central bank.s As the cost of production of notes and coin is much less than their exchange value, the central bank captures the difference, seigniorage, during the money creation process. The same is true of the creation of reserves, a virtually costless procedure. To quote Meyers (1985, p. 27):  Like monarchs of old, the Federal Reserve makes money by making money. It does this first by purchasing Federal Reserve Notes at the cost of production (less than 3 cents per note) and by issuing the notes at par. These non-interest-bearing IOUs (Federal Reserve Notes) are then exchanged for interest-bearing assets (government securities).  The interest on these securities in most cases provides a substantial part of a central bank's income. In countries where central banks are allowed to lend directly to the private or public sector, or both, interest on these loans is often an important component of income.
In many cases, the central bank requires commercial banks to hold reserves equal to prescribed fractions of their deposits at the central bank (often at a below-market interest rate). These can then be reinvested in government bonds, or used to finance other central bank activities, such as rediscounting, providing a further source of income. Many of the sources of revenue mentioned above fall under the rubric, "inflation tax." Although central banks are rarely charged with the maximization of revenue from this tax, in many developing countries the ease of collecting this type of tax has led it to become a major source of government finance. While it is well understood that the revenue obtained from the tax depends on the elasticity of the tax base, for example, see Auernheimer (1974), it is often the case that central banks appear to have exceeded the revenue-maximizing rate of inflation. (For an interesting discussion of why this might happen, see Khan and Knight (1982). Another method by which the central bank may generate substantial income is through the administration of a multiple exchange rate system, where the central bank profits from the monopoly purchase and sale of foreign exchange. This is analogous to an export-import tax scheme in a country with a unified exchange rate or a tax on the sale and purchase of foreign exchange. Depending on the accounting conventions in the country, the revenue obtained from such operations may be transferred to the treasury directly or be added to central bank revenue. If it is transferred, gross government tax revenue would not be understated whereas, in the latter, tax revenue would be understated and, if the profits come to the treasury as central bank profits, non tax revenue would be overstated.  Aside from these sources of income, central banks receive income from other activities, including fees for acting as fiscal agents to the government/ charges for check clearing, and miscellaneous receipts, such as rents. A further potential source of revenue (or loss) is the effect of exchange rate changes on the value of the foreign assets held by the central bank.s Such valuation changes, however, are usually excluded from the computation of profits and losses of the central bank; instead, changes on the asset side of the central bank's balance sheet are matched by changes in a revaluation account on the liabilities side. This is discussed further below.
Expenditures:  Central bank expenditures can be divided into three categories. First are the general administrative expenditures on wages and salaries, benefits, equipment, and premises. Second are interest payments on deposits of commercial banks at the central bank and any other central bank borrowings. Third, and most difficult to analyze, are quasi-fiscal expenditures-expenditures on activities that are additional to the central bank's monetary and exchange system responsibilities. These can take many forms: common examples are the provision of subsidized credit (either directly or indirectly through a rediscount scheme) to priority sectors, notably exporters and agriculture; contributions to development funds; expenses arising in connection with bailouts of ailing banks or industries; and exchange rate subsidies on particular types of transactions, such as debt-service payments or essential imports. The dividing line between quasi-fiscal and monetary operations, however, is often not easy to draw. For example, central bank rediscounting of bonds is generally considered a monetary activity (see also the discussion below, under "Economic Impact of Central Bank Activities"); however, it often takes place at subsidized interest rates, giving it a quasi-fiscal dimension.
As noted in the case of central bank revenue, the way in which quasi fiscal expenditures are captured in the accounts is often unclear. In most cases any subsidy will remain implicit; for example, the cost of granting loans at below-market interest rates is typically not calculated. Losses incurred in bailing out ailing industries may be reflected in an overvaluation of the central bank's assets rather than a reduction in operational surplus. (Although it should be noted that, in some cases, central banks are required to exclude bad or doubtful debts from the computation of net profits. In addition, if reserves are increased by an appropriate amount, the surplus for distribution would be reduced.) Other items may remain off-balance sheet, for example, exchange rate or loan guarantees. The provision of foreign exchange at an overvalued exchange rate can also be considered an implicit subsidy. Under a unified exchange rate, this will only generate a loss if the balance of payments is in deficit. If the balance of payments is in surplus, the central bank will make a profit.
Country Practice of Distribution of Profits or Losses: In almost all countries, the governing central bank law regulates the distribution of net profits among three beneficiaries: central bank reserves, the government, and-if the central bank is only partially owned by the government-dividends to shareholders. For example, in Belgium, profits can also be distributed to the bank's personnel; in Switzerland, profits are distributed to the cantons as well as to the federal government.  Among the three, in recognition of the financial autonomy of the central bank, priority is usually given to central bank reserves. Thus, for instance, in some cases the law prescribes that all net profits will go to the government once the reserve fund reaches a certain level; in others, that a varying percentage of net profits go to each, depending on the ratio of net profits to the bank's capital. In some cases the moneys transferred to the government must be used in a particular way, usually to service or retire the national debt.  Although a proportion of net profits transferred to the government is often substantial, a potential asymmetry exists in that a net loss  would not in general result in a transfer from the government (as might be the case, for example, in a public enterprise) but would instead be met by a reduction in reserves. A further point is that, unlike commercial banks, there is no reason why a central bank cannot continually make losses and have a persistently negative net worth. Therefore, unlike other public sector entities, central bank losses need not be "funded."
Balancing central bank and government needs for profits:  Having defined the pool of distributable income as realized profits net of unrealized losses for which no offsetting reserves exist, the task is to determine the split between creating reserves and distributing dividends. As a residual element, dividends are what remain after meeting appropriate allocations to reserves. A draft Fund paper has summarized the methods for determining profit distribution into nine categories of: No target, Fixed nominal target, Fixed real target-capital indexed,  Residual profit fund,  Proportion of total assets target,  Proportion of selected assets target,  Proportion of liabilities target,  Proportion of external indicators "Value-at-risk" indicators. A further dividend distribution arrangement, not found in central bank laws, is the distribution as a preordained amount stipulated in the fiscal budget overriding both the provisions of the central bank law or the likely actual earnings of the bank. While nominally described as dividends, such distributions have the substantive characteristics of interest free credit to government or capital repatriation, especially in the situation where they exceed realized profits. Most of the distribution mechanisms specified in central bank law recognize the need for the banks to maintain a capital buffer to cover future shocks.
Appropriate level of strength:  The approach to this problem taken by central banks is generally made operational by discussing a target or target band for central bank capital.  Targets generally fall within one of 4 types, although some banks take a hybrid approach. The first is an absolute nominal level of capital. The second is a target ratio of capital to another central bank balance sheet item. The third category sets a ratio of capital to a macroeconomic variable (excluding central bank balance sheet items). The last bases the level of capital on the perceived risks to the "solvency" of the bank (which often is the underlying basis for the actual target chosen in the other 3 categories). Here "solvency" is sometimes interpreted as positive capital, sometimes as the more general concept of maintaining the ability of the central bank to undertake its policy goals. In practice, the Bank of Canada is an example of a bank in the first category. The Bank has a nominal level of capital and pays all of its accrued profits to the government.  The situation with financially weak central banks is not so facile. In this case; government/society has three options. One is to relieve the central bank of some of its policy goals, e.g., price stability or maintaining a fixed exchange rate. The second option is to achieve the goals through direct instruments and financial repression. The attractiveness of such a solution has been demonstrated to be low almost universally. The third solution is to strengthen the balance sheet, either now or at some time in the future.
Recapitalization involves the transfer of real resources to the central bank such that it attains profitability and its balance sheet becomes capable of recovering from adverse shocks without resort to the treasury. In determining how much capital a central bank should have, a number of factors are important. The correct amount will differ, depending on the economic environment in which the central bank operates, the historical legacy reflected in the balance sheet at a particular point in time, and the status of institutional relations with government.  If the central bank is subject to large profit and loss shocks, it may need quite a substantial amount of capital. Here the diversity of foreign exchange reserve policies provides a good example. In Canada, the central bank does not hold the country's foreign reserves on its balance sheet and thus is subject to very little foreign exchange risk. In the United States, the Federal Reserve System does hold part of the country's foreign reserves, but in comparison with other items on the balance sheet they are quite small. In Norway, Sweden, and Iceland-on the other hand-the central bank holds a large portion of its assets in foreign reserves and is thus very exposed to foreign exchange risk. In consequence, they hold relatively large capital reserves and tend to relate this to the size of their open foreign exchange position.  In other cases, central banks may be exposed to losses from quasi-fiscal operations, or from extensive credits to unsound banks. While the first-best solution would be to eliminate quasi-fiscal operations, a second-best solution would be to provide sufficient capital so that the operations do not generate losses that interfere with monetary policy and indirectly force the budget to bear the burden through lower profit transfers.  Greater independence should go hand in hand with greater accountability. A central bank with good management, strong internal audit, and close external oversight could be trusted with a large capital base.  The government has a legitimate interest in not allowing the central bank excessive latitude to finance operational losses.
Central banks often have a source of "hidden" capital. Fixed assets are sometimes held off balance sheet, gold is often valued at a historical rate, securities may be valued at  "Excess" central bank capital, if properly monitored, has a neutral fiscal impact provided that all of the central bank profit is transferred to the treasury. In cases where the treasury receives only a fraction of central bank profit, the situation is more complex, less transparent and hence ill-advised.  Hidden liabilities--particularly large negative net foreign asset positions resulting from devaluations and credit exposure to weak commercial banks--are also common. As demands for transparency and accountability mount, central banks will need to move toward applying an internationally recognized accounting framework such as IAS where the only prima facie reason for divergence would be where the profit distribution mechanism is not proper. Once the accounting is transparent, the transfer to government should then be derived from a clear set of rules designed to ensure central bank solvency. Institutional arrangements for careful auditing of the preparation of central bank accounts as well as of budgetary expenditures are an important complement to central bank financial independence. Determining the financial strength of a central bank requires careful analysis, not only of the balance sheet and economic environment but also of the accounting rules, profit transfer rules, and the bank's institutional status within government appropriate accounting rules and profit transfer rules. This will serve to safeguard the soundness of the central bank, differentiate genuine central bank profit from disguised credit to government, correctly reflect any central bank losses in the government accounts, and prudently provide for the future flow implications of changes in the current value of items on the central bank balance sheet. The appropriate level of central bank net worth is sufficient to ensure that in the normal course of operations the bank will be able to meet its policy goals and preserve its financial independence from the treasury.
Central bank capital adequacy:  Various economic literature portray a  large number of papers dealing with the issue of central bank independence and surprisingly contrasts  the limited attention that has been paid to analyses and determinants of central banks' financial autonomy. Only over the last few years has the issue of central banks' financial autonomy attracted the interest of some scholars. There are many explanations for this new interest. First, there is a direct connection with the more general concept of central bank independence from the spheres of politics and industry, given that financial autonomy or central bank capital adequacy (CBCA) can be seen as an important precondition for pursuing and gaining institutional and instrument independence. Second, the low inflation levels and low interest rates of recent years have brought with them a significant decline in central banks' revenues and profitability and consequently in the level of central banks' capital. Third, over the last few years some central banks have incurred large losses, depleting their capital and in some cases bringing it into negative territories. Fourth, there is a potential risk that financial innovations, through the increasing use of e-money and other cashless payments, might cause a reduction in the demand for banknotes, hence reducing the seigniorage of central banks. Finally, the issue of insufficient resources of central banks and financial regulators might also be associated with recent financial scandals; in fact inadequate financial resources of regulators and supervisors might have brought forward insufficient financial monitoring and supervision jeopardizing financial stability and investor protection.
Structure of the bank's balance sheet by currency of denomination should also affect the desirable level of CB capital:  By affecting the probability of sizable losses, the structure of the bank's balance sheet by currency of denomination should also affect the desirable level of CB capital. Since they issue currency and hold the reserves of the banking system, the bulk of CB liabilities generally lie in domestic currency. However, there are substantial differences between central banks in the fraction of their assets that is denominated in foreign exchange. At one extreme of the spectrum is the USA in which the bulk of CB assets lie in domestic currency. At the other extreme are small open economies with fixed pegs, like Hong Kong, in which the bulk of CB assets are denominated in foreign exchange. Sims (2004), who refers to those two extreme types as F (for Fed) and E (central banks) respectively, notes that F is perfectly hedged in currency risk, while E assumes large currency risks. The larger the currency mismatches between the currency composition of assets and liabilities, the larger the level of CB capital needed to cushion against CB losses due to changes in the exchange rate. Consequently, central banks with larger fractions of foreign exchange-denominated assets should have higher capital. A comparison of the past levels of CB capital in the US, and Hong Kong, as representatives of extreme types of central banks, is consistent with the view that CBs actually follow this principle. Prior to the recent crisis, the Fed's capital was less than one quarter of one per cent of GDP, while the ratio of the capital of Hong Kong's monetary authority to its GDP was more than one hundred times greater than this.
Central Bank of Bangladesh: Introduced Credit Rating of Commercial Banks as institutions and borrower Credit Rating. Stringent regulatory system on the commercial banks, improved corporate governance in state owned and private sector commercial banks, emphasis on off site and onsite supervision. ICT application in central bank and commercial banks has significantly improved. Banking reform is taken as continuous and ongoing process. Changes in loan classification system, emphasis on SME loans, significant achievement in banking the unbanked, Interest rate changes, BASEL-II implementation, Enhancing minimum Capital Adequacy, Enhancing supervisory and regulatory functions. Separation of Conventional and Merchant Banking taken place. Rules and procedures developed for operation Merchant Bank sudsidiary companies to deal with conflict of interest among the stakeholders. Demutualization of Stock Exchanges has taken place to address the conflicting situation of existing Stock Echanges run under mutual system. Green Banking has been popularized among the banking. Financial Reporting Act drawn in line with Sarbanes-Oxley Act of USA customized to the Bangladesh is in implementation process which would ensure improved and reliable financial reporting which is essential for Public Interest Entities of Bangladesh. Bangladesh is the first country where financial report of the Central Bank is prepared in compliance with the requirements of International Financial Reporting System. Moreover, one of the big four international accounting firms is appointed to certify the financial statements. The Bangladesh Bank has paid dividend to the government ranging from BDT25 billion to BDT35 billion in the recent years although the paid up capital of the Bank is less than BDT 50 million.  
Jamaluddin Ahmed PhD FCA is Director, Emerging Credit Rating Limited and vice-president of Bangladesh Economic Association. He can be reached at [email protected]