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Central Banks Cannot Go Bust—But Can Cause Trouble

Monday, 29 Aug 2011 | 5:16 AM ET

With speculation growing that the Fed could pull the trigger on QE3next month and the ECB buying up bonds in the euro zone, analysts at ING in Amsterdam have been asking if it is possible for a central bank to go bust.

Financial Crisis
CNBC.com
Financial Crisis

“With governments increasingly unable or unwilling to further stimulate the economy, eyes are turning to the central banks once again,” said Teunis Brosens, a senior economist at ING in notes sent to CNBC before an interview on Monday.

“The Fed’s capital is only $51.8 billion, a mere 1.8 percent of its assets. Any commercial bank with such a tiny capital cushion would immediately be declared insolvent and shut down.

“The European Central Bank has reluctantly resumed its bond-buying programme to calm markets. The Euro system is now holding 110.5 billion euros of Greek, Irish, Portuguese, Spanish and Italian government bonds,” said Brosens, who notes that a Greek write-down remains a distinct possibility.

Central banks are not like commercial banks, though, so the question of whether one could go bust needs to be looked at in a very different way, according to Brosens.

“For normal banks, the rationale for a capital cushion is clear. The cushion, of which equity is the most prominent component, is the first absorber of any losses on the bank’s assets,” he said.

If loan losses mount up a commercial bank then depositors and creditors get nervous but as we have seen time and again in recent years, the bank's supervisor will not allow a run on a bank even if the shareholders end up losing everything.

“Back in the days of the gold standard, similar logic applied to the central bank. It was obliged to convert banknotes into gold for anyone who had come in and presented a note. As such, the bank had to have sufficient gold reserves. Should doubts arise over the quantity of gold and other reserves underpinning banknotes in circulation, a central bank run would follow,” said Brosens.

This is no longer the case, and central banks are not obliged to convert banknotes into gold or any other asset.

“If the central bank needs money, it just turns on the printing press to buy whatever it needs,” Brosens explained. “When the Fed wanted to buy assets as part of its QE programmes, it did not first have to borrow the funds to do so, as an ordinary individual or company would need to.”

So technically a central bank cannot go broke bit that does not mean the huge jump in the balance sheets at the Fedand ECB cannot cause trouble, according to Brosens who noted that inflationcould be the consequence.

“Losses may force the central bank to print more money than it would like, which – in the case of an inflation-targeting central bank, such as the Fed or the ECB – brings it into direct conflict with its prime policy objectives.”

This does not go down with inflation hawks - and the Germans in particular - but Brosens believes the central banks have an asset that is sometimes overlooked.

“This “asset” is called seigniorage. Banknotes in circulation bear no interest, but the assets that central banks buy with them do. The central bank’s monopoly on issuing currency thus provides the central bank with a steady stream of income, called seigniorage”.

“From a technical perspective, moderate central bank losses are irrelevant, and do not force the central bank to turn to the printing press and put the bank’s policy objectives into jeopardy. The central bank will not go broke when its capital is negative, even when losses could be hundreds of billions.

“Credibility is the reason why central banks fret about losses, not solvency. Finally, we should not kid ourselves into thinking that siphoning off losses to the central bank makes them disappear. One way or another, losses incurred by the central bank will end up on the taxpayer’s plate,” said Brosens.

Contact Europe: Economy

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