This article continues my sequence of articles on central banks as banks, which is projected to be a chapter in my banking manuscript. This article is relatively lightweight, but I wanted to break this issue out of another planned article.
What assets central banks should have on their balance sheet is controversial for some people, but for the post-World War II to 2008 Financial Crisis period, developed countries without currency pegs just held government bonds without raising questions from the bulk of economists. The Financial Crisis forced central banks to buy private sector assets, which re-opened this debate. This article looks at one type of private sector assets to be held — uncollateralised loans to the private sector.
I am assuming here that the currency is not pegged, which necessitates holding the peg instrument (typically gold or a “hard currency”). Even if the currency is pegged, the central bank may hold assets that are not the peg instrument, and they face the questions of what those other assets will be.
As noted earlier, the central bank is in the same boat as other liability-matching investors. Their liabilities are almost entirely short-dated “deposits” and currency notes — which are bearer claims on central bank deposits that can be redeemed at any time. Nevertheless, it seems unlikely that the private sector would attempt to redeem the entire monetary base within a few months, so the central bank (like other banks) can assume that a certain amount of its liabilities are “sticky” and so it does need 100% of assets to be short duration. This allows for silliness like buying foreign currencies (which do not match local currency liabilities), equities, and gold. Central banks have done such purchases, but they tend to be a small weighting of the balance sheet. My concern here is the rest of the balance sheet, which needs to match liabilities.
The question might arise: why cannot the central bank just “print money” when facing outflows? The entire point of the central bank’s liabilities shrinking is that the private sector no longer wants to hold “government money.” It could attempt to force “money” onto the private sector by buying something to counter the attempted shrinkage, but that is going to break the “rules of the game” for the monetary system, and is going to get push back. If it buys more illiquid assets, this compounds the liability-matching problem.
Lending to the private sector (in whatever format) will create a credit portfolio that has a maturity structure that can be matched against potential outflows. That is, if there is a good weighting of short-dated maturities, the portfolio will self-liquidate — or at least be able to be liquidated near par — in response to a balance sheet shrinkage.
Historically, this lending to the private sector is generally done in a collateralised form: lending at the discount window, or against collateral in a repurchase transaction. (I am only concerned with the economic effects of lending, and not the financial accounting or credit risk dimensions of different “lending” types.) This greatly limits the need for credit risk analysis at the central bank. Their counter-parties are banks that the central bank is allegedly regulating, and the collateral is supposed to be high quality and provides backup credit protection. If there is a default on the collateral, that is the counter-party bank’s problem. The central bank only takes a loss if the bank goes bust and the collateral defaults. Although events like that can happen, it is probably a systemic blow up that the central bank was supposed to be stopping. I will discuss collateralised lending later.
Why not unsecured?
Unsecured Lending to Banks
Although many populist bank critics are unhappy with the central bank lending to private banks via collateralised lending, doing so is just a way to keep financing flows circular. Under the assumption that the collateral is good quality, then it is not exactly “free money” for the banks — they need to have unencumbered good quality assets on their balance sheets in order to access this funding. If they run out of those good quality assets, they are going to be getting a visit from regulators in short order to put their enterprise out of its misery.
Things are different if no collateral (or dodgy collateral) is posted. In which case, it is a gift to the banks, and it raises a lot of questions. The central bank could easily do a terrible job regulating banks, and then lend money to said banks to cover up their lack of care. Although there is no real resource cost associated with this, the cash flows are effectively an income flow. Doing so creates the worst possible economic system: crony capitalism at the banks underwritten by the central government. Although fans of central planning might not be bothered by this situation, it is going to run into obvious political problems at the ballot box in most developed countries sooner or later.
Private Sector Bonds
The central bank could easily set up a bond fund and even if it is paying market wages, the cost would not be that large when compared to the cost of keeping hundreds of economics doctorates 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 blows itself up, we would have highly paid bond managers working for the central bank running down the halls demanding a bailout from their central bank coworkers. The role of the central bank around any large bankruptcy is going to be a political issue. For example, if one of Quebec’s “national champions” goes belly up ahead of an election, there would be a lot of politicians screaming for the heads of the central bankers in Ottawa that did not bail the firm out.
Direct Lending Programmes
Finally, the central bank could lend to non-financial entities. The problem is that unless the programme is restricted to large firms, this would greatly increase the need for credit risk management and assessment personnel. That is, the central bank would be acting even more like a private bank, instead of be a bank for a few selected clients (private banks, the central government).
The reality is that a loan is effectively an income transfer until the loan is paid back. Spending government money is the prerogative of the legislature, and I am in the camp that does not believe that this power should be handed over to unelected bureaucrats. To the extent that the central government is in the lending business (and they generally are), the rules and losses are the responsibility of the fiscal arm of the government.
Not everyone agrees with that stance, some people are attracted to the “financial engineering” of using the central bank. This might be necessary in the horror show of the Euro system, but it is unnecessary elsewhere. If a programme cannot attract the support of elected politicians, why fund it? Meanwhile, this would just turn central bankers into punching bags when the programme blows up.
Unsecured lending by the central bank to the private sector is just a means of handing control of the public purse to unelected bureaucrats. Views on the advisability of this are largely a personal political stance.