Pondering the Bankruptcy of Central Banks

June 22, 2011

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In their own minds, they can’t, but this is a tail risk that needs to be considered. In a bloomberg interview yesterday, Westbanc’s James Shugg noted that Germany’s Bundesbank has lent $500 billion to other central banks, and was given European periphery debt as collateral. China’s PBOC is leveraged 1500-1, according to James Grant. The US Federal Reserve is leveraged at about 100-1 and recently changed accounting rules so it would never have to realize losses on subprime mortgages. Fannie Mae, Lehman, Bear Stearns, and Long Term Capital were levered about 50-1 leverage by comparison. If this were to happen, then the bank would likely print first, but there are political limits to that people will accept. Treasuries could recapitalize the central banks, although this wouldn’t help if the Treasury itself is insolvent or not able to access the markets. Lastly, it could seek to raise taxes indirectly.

While an academic, Citi’s Willem Hendrik Buiter wrote a paper “Can Central Banks Go Broke?”

No 6827, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Central banks can go broke and have done so, although mainly in developing countries. The conventional balance sheet of the central bank is uninformative about the financial resources it has at its disposal and about its ability to act as an effective lender of last resort and market marker of last resort. As long as central banks don’t have significant foreign exchange-denominated liabilities or index-linked liabilities, it will always be possible for the central bank to ensure its solvency though monetary issuance (seigniorage). However, the scale of the recourse to seigniorage required to safeguard central bank solvency may undermine price stability. In addition, there are limits to the amount of real resources the central bank can appropriate by increasing the issuance of nominal base money. For both these reasons, it may be desirable for the Treasury to recapitalize the central bank should the central bank suffer a major capital loss as a result of its lender of last resort and market maker of last resort activities. The fiscal authorities of the Euro Area should as a matter of urgency agree on a formula for dividing the fiscal burden of recapitalizing the European Central Bank/Eurosystem, should the need arise.

EconPapers

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