Can a Central Bank Go Bust?

There is a simple answer to this question which is usually correct – “No”.

If you regarded Central Banks as normal businesses, or even as normal banks, you would be mighty alarmed by their balance sheets today. Several of the leading western Central Banks are doing what they condemned commercial banks for doing in the run up the Credit bubble. They are gearing their balance sheets massively. The Bank of England has a £245 billion balance sheet, with equity and reserves of just £4.4 billion. In other words, its total liabilities are 55 times its capital.

The Governor and Directors of the Bank do however retain some sensible caution. The Bank of England’s balance sheet is massively distorted by the £200 billion of Quantitative easing the Bank has carried out so far. Here the acquired assets, UK government bonds, are matched by a Treasury loan. The Treasury gives a guarantee against loss. The UK state is expected to stand behind the Bank if it started losing significant sums on these assets at market prices, and it could hold them to redemption at par anyway. If you take this off the Bank’s balance sheet, it looks altogether more prudent.

Over at the European system of Central banks, before we factor in the mega loans to EU banks announced this week, a balance sheet of Euro 2.4 trillion is supported on Euro 81 billion of capital. That means they are 30 times geared.

These same central banks now think that maybe 10 times geared is about as risky as a commercial bank ought to go. So what makes them different?

There are two characteristics of a Central Bank that enable it to gear much more than other businesses in certain conditions. The first is single country Central Banks have the country standing behind them. Like the Bank of England they are usually owned by the state on behalf of taxpayers. The full taxable capacity of the country stands behind them to pay any losses. If need arose the state could put in more capital.

The second is a Central Bank usually has the power to create more of its own currency, with or without the control of the government. So a Central Bank should always be able to meet its payment schedules, at least in the currency of the day, as it can create some more. If it does this on too big a scale it will of course damage the foreign exchange value and the purchasing power of the money it presides over, but should always be able to meet its legal nominal obligations.

We need, however, to ask if these two very special characteristics of single country state controlled Central Banks fully apply to the European central Bank. We have to ask which country or countries stands behind it? If the ECB lost large sums on its assets, would all the shareholder members of the ECB put in new capital in the amounts required? Do the countries standing behind it have enough taxable capacity to carry the risks their Bank is running?

We also need to ask how much new Euro money the ECB is empowered to create? Given the understandable German fears of excess money creation, and the rules against state financing by the ECB, can we rely on the Bank always being able to print its way out of pressing obligations, if tax revenue from member states is not forthcoming?

The European central Bank is building a portfolio of assets in the form of loans to weak banks, and a bond portfolio with the emphasis on weaker sovereigns. Armed with such assets, and given the high gearing of the Bank. we do need to know what if these assets cause substantial losses? Who stands behind the Bank? Is it now full Central Bank, with all the powers it needs to finance its large portfolio?

I assume the answer to our central question is for the ECB as for the others, that a Central Bank cannot go bust. It would be good to have official confirmation on how any possible future losses could be covered and how much conventional Central Bank power the ECB now has.