In-depth analysis on Credit Writedowns Pro.

Central banks can go broke

The failure to sort out the ambiguities concerning the distribution of the fiscal burden that may arise through bail-outs of banks operating in multiple Euro Area nation states puts a large question mark behind the effectiveness of the Euro Area financial stability arrangements. The Euro Area has proven itself to be capable of handling a banking sector liquidity crisis. The institutional arrangements, including the fiscal burden sharing key, for handling a banking sector insolvency crisis are opaque at best, non-existent at worst.

We must know who would recapitalise the ECB should it suffer a material capital loss, and through what mechanism this would occur.

-Willem Buiter, May 2008

This is the scenario the ECB now faces. Its liquidity provisions to the member states are no more free than the liquidity the Fed has provided is. Just like the ECB, the Fed can go bankrupt too – even if it is lending in domestic currency. Of course, the Fed or the ECB would never be declared insolvent. They would be bailed out. But this is something to consider in the event of defaults triggered by a recession and panic. In the US, it is clear who would bail the Fed out; it’s the US government. In Euroland the situation is not at all clear.

Remember, this is a solvency crisis too, not just a liquidity crisis.

I suggest you read Buiter’s whole piece.

Also see this from 2008: Main Bank of China Is in Need of Capital.

UPDATE 2050ET: These points from Buiter’s presentation linked in the article quoted above and embedded below bear highlighting:

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 recapitalise 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.

Also see Buiter’s most recent thinking on a potential need to recapitalise the ECB in this post: To repeat, the ECB is not conducting a stealth bailout

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

21 Comments

  1. marketseer says:

    Could you please describe further how the Fed could go bankrupt? Every central bank is unique in what it can and cannot do based on the laws of the specific country. For example, Zimbabwe central bank legally is set up much different than the Fed. I am not familiar enough with the ECB to speak intelligently on the ECB but the Fed is the legal entity in the United States which can print money. So on paper, the Fed could not go bankrupt, correct? The Fed can essentially generate equity. Its the same reason why quantitative easing is worthless. What the banks needs is equity (not to mention loan demand) to really start lending. Quantitative easing is liquidity. QE transaction.

    Journal entries for Citibank:
    Debit Dollars
    Credit Treasury

    It was simply an asset swap.

    Journal Entry for Fed
    Debit Treasury
    Credit Dollars

    But where did the dollars come from? They printed it out of thin air. How does the accounting work for that? Aren’t they essentially manufacturing equity?

    Debit Dollars
    Credit Equity

    They aren’t creating a liability to the treasury. They aren’t getting another asset for printing money so the only journal entry possible is equity. By law the Fed can print dollars. The treasury cannot. Treasury can manufacture coinage.

    If my logic is right, the Fed can never go bankrupt. It is the sole entity in the United States that can generate its own equity.

    Any corresponding insight would be appreciated.

    • The Fed doesn’t create its own equity because it’s not technically ‘printing’ money i.e. creating net financial assets. The treasury does when the government deficit spends.

      So if it held (MBS) assets that went into default and had to be written down – I’m not talking about mark to market – then it’s capital base would be impaired. That’s exactly the same problem that the ECB has with its buying peripheral sovereign paper.

      • but what would happen with those MBS and Fed when those toxic financial assets mature if the Fed stills hold them?

      • TC says:

        I think this is the main point:

        ” Of course, the Fed or the ECB would never be declared insolvent.”

        Who could force these entites to show up and restructure…well, what would they restructure?

        • I’m not so sanguine in the least. We saw what the debt ceiling debate looked like. Would this be any different. Here’s what Buiter says in 2008 about it:

          “There can be no doubt that in all large and medium-sized advanced countries where a single fiscal authority stands behind the central bank, the fiscal authorities are, from a technical, administrative and economic management point of view, capable of extracting and transferring to the central bank the resources required to ensure capital adequacy of the central bank should the central bank suffer a severe depletion of capital in the performance of its lender of last resort and market maker of last resort functions”.

          The key part of this is “the fiscal authorities are, from a technical, administrative and economic management point of view, capable of extracting and transferring to the central bank the resources required”

          And the key word is “capable”. It is the difference between ability and willingness, exactly the same issues we saw in the debt ceiling debate. Do not dismiss this lightly.

          • TC says:

            I’m with you on the “capable”. I need to think about this a bit more.

            But off the cuff, I’d say:

            1. CB’s don’t have any economic reason to be broke.
            2. FX Intervention is a fiscal policy done by the CB
            3. FX intervention is usually the place where large “losses” for CBs happen
            4. Debt driven losses are only possible if they buy external assets OR if they don’t act as lender of last resort.
            5. This is one of the fulcrum points where it becomes obvious that politics is a huge part of economics and we’ve ignored this to our detriment.

      • marketseer says:

        I appreciate the response. Very few people can talk intelligently about how the system fundamentally works and there are very few information sources. I am making these statements to challenge my own understanding.

        I am not sure I agree that the Treasury create net financial assets when it deficit spends. Again, you have to follow the debits and credits from an accounting perspective. When the Treasury deficit spends there is no creation of an asset in of itself and hence no creation of equity. There is a creation of a liability. It becomes debt of the United States government.

        Deficit Spending

        US Treasury Debits Cash
        US Treasury Credits Bond

        This is much different than the Wiemar Republic or China today. Here the central government does have the right to print the currency without an offsetting debt transaction.

        Debit Cash
        Credit Equity

        Here new assets are being formed without any contractual form of payback. It is why I believe hyperinflation is impossible in the United States until 1) Congress takes back to the power to print money through the Treasury instead of the Fed or 2) Trust in the currency itself collapses (not as a result of printing) causing the currency to be rejected as a medium of exchange.

        Correct me if I am wrong but the Federal Reserve Act in 1913 transferred the power to print from the Treasury to the Fed. As a result the power to create equity now rests with the Fed and any deficit spending by the Treasury increases the overall debt burden in the system. Pre 1913 we had the same system as today’s China or the Wiemar Republic in which deficit spending created new assets and equity devaluing the previous assets and equity. Currently in the United States such deficit spending creates a short term boost while longer term increases the debt burden in the system.

        • Leverage says:

          Operationally, first the US ‘deficit spends’ (by crediting bank accounts), then issues debt as required by law.

          Both things mean creating new net financial assets (treasury paper and deposits). They introduce new financial assets in the economy. This is independent of if spending necessarily means issuing new federal debt securities (and these securities, because of their qualities, are also new financial assets).

        • Leverage is right about the mechanics here. The Treasury “prints money’ by deficit spending and ‘unprints money’ by taxation. This should make intuitive sense if you think about it because money is created by government. If you ignore the bond aspect and think of government crediting accounts, it becomes clearer that it creates net financial assets in the currency of account it has created simply by spending and it destroys them by taxing and taking away those assets.

  2. Leverage says:

    Yes but in reality is no more than an accounting gimmick. They could fall into negative equity but… so what? They can still buy assets “printing dollars”. The balance sheet would look ugly but that’s about it.

    Furthermore they can buy treasuries to hedge which would hold good value and increase their price in the event of a balance sheet deterioration because of recession.

    I’m not sure this has any practical meaning in the market, eventually people would say “they will just print” and be done with it (even if it’s not operationally correct).

    The ECB could be trouble because of political constraints, but I’m uncertain about how things would play.

    Short version: at some point people will realize what is and what isn’t an accounting gimmick. Then we could see rules change (that’s what usually happens in depressions).

    • I disagree vehemently. Buying assets by printing dollars doesn’t repair the negative equity. That printed money is a Fed liability and the purchase is merely an asset swap. You act as if currency sovereignty is some magic elixir that makes the US alright. It is not.

      Negative equity at the Fed would create currency revulsion. Moreover, it would also politicize the Fed even more because the US government would be forced to ‘bail out’ the central bank for recklessly buying up dodgy assets at inflated prices. There would be a steep political and currency price.

      In any event, the ECB is where the concern should be here because the prospect of sovereign default makes their potential negative equity more real.

      • Leverage says:

        Edward I don’t mean this: “You act as if currency sovereignty is some magic elixir that makes the US alright. It is not.”

        This obviously wouldn’t fix anything, in the same way QE2 didn’t fix anything, and wouldn’t make the economy run better.

        But I don’t see this situation where the CB ‘goes broke’ because of negative equity and this means they can’t buy more assets on the open market (off course I could be extremely wrong). The limit would be if the environment is inflationary or not, if it is then it would be troubling (as the CB would be tied short and would have hands cut), but if assets are degrading probably is because the environment would be recessionary and there wouldn’t be inflation.

        Yes, politically there could be some problems, but I don’t think this would mean anything ultimately, just like the debt ceiling was a charade. In Europe though, there could be trouble, because there is conflict of interests between nations.

        What does this means in practice? I guess you post this because the CB would be constrained about saving banks, buying any sort of synthetic securities, commercial paper or corporate debt. So they would be pretty much limited to buy sovereign debt (not even muni or state debt).

        However the banks are constantly cheating on their balance sheets because fake valuation of their assets (mortgages and real estate), so i don’t see what would impede the CB’s doing the same thing; in any case the capacity to leverage of the CB’s is much larger (indeed they have the largest leverage of the world). What are the precedents with the Bank of Japan?

        An other important thing is that CB’s control the yield curve of government debt, so they can actually set the market value of a big part of their portfolio.

        • I’m just thinking of Rick Perry’s comments about Bernanke committing ‘treason’. Clearly there is an element out there that would not want to recapitalize the CB just as some were willing to default on Treasuries. The US is now a banana republic and totally dysfunctional. This has got to constrain the Fed’s activity.

          • Leverage says:

            Touché!

            But I’m curious about precedents, probably Japanese didn’t want to hang on their central bankers but they faced this issue at some point?

            In any case, this could trigger the blow up of the financial and monetary systems at some point then, politically speaking. I still think that depending on the situation (deflation or inflation) the discussion would lean towards a policy or other. More TARP-like stuff it’s politicaly not feasible, probably even in Europe at this point.

            It’s gonna get interesting as we enter in recession in Europe in the coming months.

      • Gordon T says:

        The key phrase is: “present discounted value of current and future seigniorage income” for more information just read Buiter´s posts on this matter(maybe starting with this one: http://blogs.ft.com/maverecon/2009/05/does-the-ecbeurosystem-have-enough-capital/ ) before making alarmist claims which have been debunked a long time ago!

        • Gordon T, I’m sorry, you’re wrong about Buiter here because he was talking about JUST this issue in June in the same terms. The key is potential sovereign default which would most definitely impair capital at the ECB.

          http://www.creditwritedowns.com/2011/06/no-stealth-ecb-bailout.html

          “The stock of net Target2 claims of the Bundesbank does not reflect its exposure to risk and financial losses of other euro area central banks – the right measure would be the total exposure of the Eurosystem multiplied by the adjusted ECB capital share of the Bundesbank.”

          I should also point out that Buiter warns in the very same paper embedded above that seinorage could be inflationary:

          “While the Fed can always recapitalise itself through the issuance of base money if its liabilities are denominated in domestic currency and not index-linked, doing so may not be optimal or even acceptable, even though it is feasiblee: self-recpitalisation through seigniorage may generate undesirably high rates of inflation”

          Bottom line: there is reason to be concerned, more so in Europe than in the US – except for political reasons in the US.

  3. Max says:

    From an operational point of view negative equity doesn’t matter. The ECB never needs to be recapitalized unless the authorities admit that it is broke. Which they will never do. It will be a family secret.