This article continues my sequence of articles on central banks as banks, which should constitute a chapter in my banking manuscript. This article is relatively light-hearted, but I wanted to isolate this issue from another planned article.
The question of what assets central banks should have on their balance sheets is controversial for some people, but between World War II and the 2008 financial crisis, developed countries without a monetary anchor were content to hold government bonds without raise questions from most economists. The financial crisis forced central banks to buy private sector assets, which reignited the debate. This article examines one type of private sector asset to hold: unsecured loans to the private sector.
I’m assuming here that the currency is not pegged, which requires holding the anchor instrument (usually gold or “hard currency”). Even if the currency is pegged, the central bank can hold assets that are not the anchor instrument, and it raises the question of what these other assets will be.
Non-credit assets?
As noted earlier, the central bank is in the same boat as other investors who engage in quid pro quo. Their liabilities consist almost entirely of short-term “deposits” and bank notes – which are bearer claims on central bank deposits that can be repaid at any time. Nonetheless, it seems unlikely that the private sector will attempt to repurchase the entire monetary base within a few months, so the central bank (like other banks) may assume that a certain amount of its liabilities are “sticky” and that it therefore needs 100 billion dollars. % of short-term assets. This allows nonsense like buying foreign currencies (which do not match local currency commitments), stocks and gold. Central banks have made such purchases, but they tend to represent only a small weighting of the balance sheet. What concerns me here is the rest of the balance sheet, which must correspond to the liabilities.
The question might arise: why can’t the central bank simply “print money” in the face of capital outflows? The reason for the decrease in central bank liabilities is that the private sector no longer wants to hold “government money”. He could try to impose “money” on the private sector by buying something to counter the attempted contraction, but this would break the “rules of the game” of the monetary system and would be rebuffed. If it buys more illiquid assets, it worsens the liability matching problem.
Private Credit
Private sector loans (regardless of format) will create a credit portfolio whose maturity structure can be tailored to potential capital outflows. In other words, if there is a good weighting of short-term maturities, the portfolio will self-liquidate – or at least be able to liquidate close to par – in response to a balance sheet contraction.
Historically, these loans to the private sector are generally granted in a guaranteed form: loans at the discount window or against guarantee as part of a repo operation. (I am only interested in the economic effects of loans, not the financial accounting or credit risk dimensions of different types of “loans.”) This significantly limits the need for credit risk analysis at the central bank. Their counterparties are banks that the central bank is supposed to regulate, and the collateral is supposed to be high quality and provide backup credit protection. If there is a default on the guarantee, it is the problem of the counterparty bank. The central bank only suffers a loss if it goes bankrupt and the collateral defaults. Even if such events can occur, it is likely a systemic explosion that the central bank was supposed to stop. I will talk about secured loans later.
Why not without guarantee?
Unsecured loans to banks
Although many populist critics of banks are unhappy that the central bank lends to private banks via collateralized loans, this is only a way of maintaining circular funding flows. Assuming the collateral is of good quality, it is not exactly ‘free money’ for banks: they need to have good quality free assets on their balance sheets to be able to access this funding. If they lack these good quality assets, they will soon be visited by regulators to put their business out of its misery.
Things are different if no guarantee (or dubious guarantee) is provided. In this case, it’s a gift to the banks, and it raises a lot of questions. The central bank could easily do a terrible job of regulating banks and then lend money to those banks to cover up their lack of vigilance. Although there is no real resource cost associated with this, cash flow is actually a revenue stream. This creates the worst possible economic system: crony capitalism in the banks underwritten by the central government. While proponents of central planning may not be bothered by this, sooner or later it will run into political problems evident at the ballot box in most developed countries.
Private sector bonds
The central bank could easily create a bond fund and even if it paid market salaries, the cost would not be that high compared to the cost of keeping hundreds of economics PhDs on the payroll. The problem with having a corporate bond portfolio is that it would end up being managed in exactly the same way as private sector bond funds (“best practices”).
This means that when the corporate bond market explodes, we would have well-paid bond managers. work for the central bank running through the halls demanding a bailout of their central bank colleagues. The role of the central bank in the event of a major bankruptcy will be a political question. For example, if one of Quebec’s “national champions” went bankrupt before an election, many politicians would call on the central bankers in Ottawa who did not bail out the company.
Direct Loan Programs
Finally, the central bank could lend to non-financial entities. The problem is that unless the program is limited to large companies, it would significantly increase the need for credit risk management and assessment personnel. In other words, the central bank would act even more like a private bank, instead of being a bank for a few selected clients (private banks, central government).
The reality is that a loan is actually a transfer of income until it is repaid. Spending government money is the prerogative of the legislative branch, and I’m in the camp that doesn’t believe that power should be vested in unelected bureaucrats. To the extent that central government deals with the lending business (and it usually does), rules and losses are the responsibility of the fiscal arm of government.
Not everyone agrees with this position; some people are attracted by the “financial engineering” of using the central bank. This might be necessary in the euro system horror show, but it is not necessary elsewhere. If a program cannot attract the support of elected officials, why finance it? Meanwhile, it would turn central bankers into punching bags when the program explodes.
Concluding Remarks
Unsecured central bank lending to the private sector is just a way of handing over control of public funds to unelected bureaucrats. Opinions on whether such a measure is appropriate are largely a matter of personal political position.