Central Bank Capital and Shareholder Relationship

In pursuing its mandate, a central bank assumes financial risks through its mon- etary policy operations. Central bank capital is a critical tool in mitigating these risks. We investigate the concept of central bank capital as a mechanism for risk- sharing with its shareholder. Adopting an option pricing framework, we explore the setting where the central bank commits to distributing dividends when its cap- ital is robust, while the shareholder may be called upon to recapitalize the bank during adverse economic conditions, with negative capital. Our analysis dissects the trade-offs inherent in these options, seeking a mutually beneficial agreement that disincentivizes deviation for either party. This equilibrium is essential for safe- guarding the independence and credibility of the central bank in executing monetary policy effectively.

Keywords: Capital; Central Bank; Contingent Claim Analysis, Risk Management; Shareholder; Stackelberg Games
JEL codes G13; G32; E58

Working paper no. 809