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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...