Explainer - Why huge European Central Bank losses matter

FRANKFURT (Reuters) - The European Central Bank chalked up another large financial loss in 2023, burning through the last of its provisions, and said more losses are forthcoming as high rates push up interest payments to banks.

While the bank said it can operate effectively "regardless of any losses", the accounts have broader implications - from reputation and independence to state finances.

The following explainer looks at the risks and costs associated with losses at the ECB and the national central banks across the 20-nation euro zone.

WILL THAT AFFECT THE ECB'S REPUTATION?

The ECB printed trillions of euros over almost a decade, despite copious warnings from conservative economists. The losses could amplify critical voices, especially if central banks ask for additional capital from their governments, which some may portray as a public bailout.

The losses, which have already reduced state incomes and may lead to additional expenditure, could prompt governments to question how the central bank operates, a potential risk to legitimacy and ultimately independence.

While official bodies from the International Monetary Fund to the Organisation for Economic Co-operation and Development (OECD) argue that losses are not an indication of policy error, the broader public may struggle to understand the nuances, especially because central banks operate differently to any other firm.

Sustained losses could also damage central bank credibility because then investors would assume it would be printing currency over a longer period.

WILL THE LOSSES AFFECT GOVERNMENT BUDGETS?

Governments across the euro zone enjoyed a dividend payout from their central banks for decades, so losses also mean a loss of income to budgets. If provisions are exhausted and losses must be carried forward as is the case now, even future profits become inaccessible to shareholders since the bank must first make up for losses, then rebuild provisions, before any dividends can be paid.

WILL THE ECB NEED RECAPITALISATION?

Central banks do not operate like commercial banks and can even function with negative equity. Indeed, the Reserve Bank of Australia and the Czech National Bank, among others, have negative equity, as did Germany's Bundesbank for some of the 1970s.

However, some, including the central bank of the Netherlands, have warned a negative equity situation cannot be maintained for an "extended period" and a government recapitalisation may be required.

The central banks of the Netherlands, Belgium and Germany have all warned in the past that more large losses are likely.

Sweden's Riksbank - which is not part of the euro zone - has already said that according to its new statutes, it must apply to parliament for recapitalisation because its capital fell below the required threshold.

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WILL THAT AFFECT THE ECB'S FRAMEWORK REVIEW?

The ECB is currently reviewing its operational framework, including how it will provide liquidity to lenders in a new normal of central banking.

Over the past decade, it provided "abundant" funds and there is still 3.5 trillion euros ($3.8 trillion) of excess liquidity sloshing around in the financial system, years after ultra-easy monetary policy was abandoned.

One issue under consideration is how much the ECB pays lenders on their excess liquidity parked at the bank overnight. Some policymakers argue that the ECB should remunerate a smaller portion of bank deposits at the 4% deposit rate, thereby lowering its own interest rate expense at the cost of bank earnings.

However, there is little monetary policy justification for such a move and the ECB's only mandate is price stability, so a move to shore up its own finances might be legally contentious.