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.