Those of you with time on your hands and a interest in spending some it it in a basement being beaten with a rubber hose, may want to take a look at my recent Centre for Economic Policy Research Policy Insight No. 24, “Can Central Banks Go Broke?”
In that paper, I ask whether it matters if a central bank suffers a large capital loss. Can the central bank become insolvent? How and by whom or by what institution should the central bank be recapitalised, if its capital were deemed insufficient? These are relevant questions not just in Zimbabwe and Tajikistan today, but wherever central banks have taken on or may be asked to take on large exposures to private credit risk. This includes the USA, the Euro Area, the UK, Iceland and many other advanced industrial countries.
Special problems arise where private financial institutions (or the central bank and the Treasury itself) have large liquid foreign exchange-denominated liabilities or index-linked debt. Examples of countries that have an internationally active banking system with very large foreign currency-denominated liabilities and assets (including a significant amount of short-term liabilities) include Iceland (whose currency does not have an international reserve currency role) and the UK, where sterling is a much-diminished global reserve currency, with 4.7% of the total global stock of reserves at the end of 2007, against 26.5% for the euro and 63.9% for the US dollar.
The central bank’s lender of last resort and market maker of last resort capacity is diminished if the liquidity needed by the banking system it is responsible for, is foreign exchange rather than domestic currency. The ability of the national sovereign (central bank, Treasury, sovereign wealth funds etc.) jointly to beg or borrow the foreign exchange resources required to provide credible lender-of-last-resort and market-marker-of-last-resort-support to their banking system and financial system, then becomes crucial for the financial viability of the banking sector, including the central bank.
Even if the exposure is domestic-currency denominated, the lender-of-last-resort and market-maker-of-last-resort-role may conflict with maintaining price stability. In that case it is essential that the central bank is backed fiscally by the Treasury, that is, by the tax payer.
Fiscal backing of the central bank by the Treasury/ministry of finance, creates special issues whenever there is significant cross-border banking activity. Lender-of-last-resort and market-maker-of-last-resort-responsibilities are informal and flexible. The range of eligible counterparties/beneficiaries at the discount window, in repos and other open market operations, and for special liquidity facilities that can be created at the drop of a hat, is discretionary and can be varied at will. The presumption that a foreign subsidiary, unlike a branch of a foreign bank, will be supported by let alone bailed out by the central bank of the host country (the country where the subsidiary is registered) is not a firm legal convention.
The potential problems concerning which central bank is responsible – as lender of last resort, market maker of last resort and bailer out of first resort – for which kind of bank (or even non-bank financial institution), is likely to become acute in the Euro Area, once there are banks incorporated as Societas Europaea (SE), which will not have any clear national identity. Perhaps the national central banks of the Euro Area (which one assumes to be backed by their national fiscal authorities) will continue to implement the lender-of-last-resort-role for banks incorporated as SE but domiciled/located in their traditional jurisdiction. Perhaps instead, the ECB assumes lender-of-last-resort and market-maker-of-last-resort-functions directly for SEs. In either case the fiscal backing of the ECB and even that of national central banks is a murky area. Will, say, the Banca d’Italia (backed by the Italian Treasury) bail out an Italian bank that was taken over by a Dutch bank which is now itself owned by a British, a Spanish and a Belgian bank?
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. The shareholders of the ECB are the 27 EU national central banks. Only 15 of these national central banks belong to the Eurosystem. Central banks in any case have only limited and qualified deep pockets. We must know how the Euro Area or EU tax payers are lined up to recapitalise the ECB, should the need arise. This is not an issue that should be sorted only when a banking sector solvency crisis hits the Euro Area.