Can Central Bank Go Broke

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POLICY INSIGHT No. 24

MAY 2008

Can Central Banks Go Broke?

Willem Buiter

European Institute, LSE, Universiteit van Amsterdam and CEPR

CEPR POLICY INSIGHT No. 24

Introduction

The Federal Reserve System has recently accepted exposure to a considerable amount of private sector credit

risk, partly on its balance sheet, through the riskier collateral it now accepts at its discount window and in

open market operations, and partly off-balance sheet,

through its $29 billion exposure to the special purpose

vehicle (SPV) created to warehouse $30bn of Bear

Stearns most toxic assets. It is possible that the new

reality, prompted by the financial crisis, of larger-scale

open market and discount window operations, less

demanding collateral requirements and a wider set of

counterparties will cause the Fed to take on exposure to

considerably more private sector default risk in the

future.

The Bank of England also took on additional credit

risk when it created the Liquidity Support Facility for

Northern Rock in September 2007 and accepted mortgages and mortgage-backed securities as collateral for

its loans. The widening of the eligible collateral in some

of its liquidity-oriented open market operations at one

and three month maturities has further increased the

Bank’s exposure to private sector credit risk, as has the

creation of the £50 billion Special Liquidity Scheme in

April 2008, through which the Bank of England lends

Treasury bills to banks, secured against illiquid mortgage-backed securities, covered bonds and asset-backed

securities backed by credit card receivables. There could

be a significant further exposure if the Bank were to

engage in outright purchases of illiquid and possibly

impaired private securities, as has been proposed by

some.

There is little doubt that the Eurosystem – the

European Central Bank (ECB) and the 15 national central banks (NCBs) of the euro area – have also relaxed

the creditworthiness...