Academic journal article The Journal of Social, Political, and Economic Studies

Central Bank Insolvency: Causes, Effects and Remedies

Academic journal article The Journal of Social, Political, and Economic Studies

Central Bank Insolvency: Causes, Effects and Remedies

Article excerpt


Investors typically view central banks as essential institutions for the stable functioning of financial markets. Governments entrust them with the role of monetary policy and allow them discretion to fine-tune the economy to provide either price or economic stability.

They traditionally use two tools to achieve these goals. The first are monetary policy tools at the central bank's disposal through its function as the primary supplier of money in an economy. In this regard, there are three operations that allow the central bank to enact monetary policy: 1) banking system reserve requirements, 2) direct lending through the discount window, and 3) asset purchases or sales that alter the money supply.

The second area of policy tools involves measures the central bank can use to serve in its function as a lender of last resort. Institutions that are dangerously nearing insolvency and may cause contagion throughout the economy may be assisted directly by central bank funding. In this way, an institution's liabilities may be retired and a return to sustainability achieved.

Limitations on a central bank's ability to implement these functions are determined by the economy's financial structure. On the one hand, the degree to which private liabilities such as bonds have been denominated in foreign currencies will dictate how much funding the central bank can supply from its asset base, which includes both domestic (e.g., government bonds) and foreigndenominated assets (e.g., foreign-exchange reserves). On the other hand, in a fixed exchange-rate regime the degree to which an economy runs a positive trade balance or attracts foreign investment in turbulent times will determine the amount of foreign exchange reserves a central bank may obtain to fund the foreign liabilities of insolvent companies.1 Indeed, due to lags in price level adjustments, flexible exchange rate regimes also allow prolonged external balances to develop into either trade surpluses or deficits.

The insolvency of a central bank is highly improbable because a large part of the central bank's liabilities (i.e., the monetary base), are not liabilities in the usual sense; they do not imply redemption in assets other than those it can produce itself. From an accounting point of view the monetary base can be written down on the liability side, thus increasing the capital position. Losses on the asset side of a central bank also affect its capital position. However, the fact remains that a central bank may operate with a negative accounting capital position because the majority of its liabilities are not liabilities in the sense we normally attach to the word.2

The situation is different when there are foreign-denominated liabilities on its balance sheet (for example, IMF loans, swap lines or lines of credit from foreign central banks, or loans from foreign governments). In these cases, the insolvency of a central bank is possible. Alternatively, in light of the functions that the central bank exists to serve with regards to the private sector, a pseudo-insolvency may obtain if a lack of foreign-denominated assets exist to cover the private banking sector's foreign-denominated liabilities. Having only the ability to increase assets in the domestic currency, central banks may find themselves impotent if presented with banking sectors largely indebted in foreign currencies.

This paper will outline the conditions that endanger central bank solvency. We will see that sovereign insolvency and its current solution - namely help by international consortiums of central banks led by the IMF - have created a situation that promotes central bank insolvency. The implicit bailout guarantees generate the illusion that exchange rates may be artificially maintained which, in turn, encourages currency mismatching. The currency mismatching may then trigger an inability to sustain its banking system and lead to the eventual insolvency of a central bank if it secures foreign loans that are ultimately unable to be repaid. …

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