"Who is the Recapitaliser of Last Resort for the ECB?"

Richard Baldwin says if the ECB is going to purchase risky assets when financial markets are unstable, then there needs to be a plan to recapitalize the bank in case it goes broke:

Buiter’s warning: Who is the recapitaliser of last resort for the ECB?, by Richard Baldwin, Vox EU: The Fed, Bank of England and ECB have recently loaned money to banks against collateral that is riskier than usual – including mortgage-backed securities that are at the heart of the current crisis. Since some of these loans could go bad, questions arise: Can the central bank go broke? Who would recapitalise it if it did?

For example, it is not hard to envisage a situation where the Fed would suffer a capital loss on its private assets larger than $40bn. The $29 billion non-recourse loan it extended to JP Morgan to help fund the Bear Stearns transaction is surely at risk. Any loss greater than $40bn would wipe out the Fed’s capital as measured by conventional measures (see detailed discussion in Willem Buiter’s Policy Insight No. 24) and could indeed give it negative capital or equity. Similar calculations apply to other central banks. Would and should this be a cause for concern?

The good news is that the conventional balance sheet of the Fed or of any other central bank is a completely unreliable guide to its financial strength. A central bank can always bail out any entity – including itself – through the issuance of base money (as long as the liabilities are domestic-currency-denominated), so there is really no limit. The Fed could double its $900bn balance sheet almost immediately. But this would lead to inflation.

An alternative would be for a recapitalisation of the central bank by the national treasury. This option, however, would be quite different in the cases of a national central bank and the ECB. In the usual national setting, a single national treasury or national fiscal authority stands behind its central bank. Unique complications arise in the euro area.

Who is the recapitaliser of last resort for the ECB? Under current Eurozone rules, each national fiscal authority stands behind its own central bank, but no fiscal authority stands directly behind the ECB. The lender of last resort function is assigned to the ECB’s members – an arrangement that should work well when the failing private bank has a clear nationality. But who stands behind the ECB as its recapitaliser of last resort?

Not the European Community. It has a tiny budget and no discretionary taxation or borrowing powers. Presumably the burden would fall on the Eurozone national treasuries, but in what proportions would they participate in the recapitalising the ECB, should the need arise?

Conclusions Central banks can go broke and have done so historically, albeit mainly in developing countries (e.g. Zimbabwe and Tajikistan). As central banks assume risky assets in their support of private banks that are “too large to fail”, it is not impossible to think that the issue could arise in Europe. Recapitalising a central bank involves either a large inflation tax or a recapitalisation by the national treasury. If we are to avoid the former, we need a plan for the latter. But who would do this for the ECB?

The ECB euro area has a single central bank but fifteen national fiscal authorities. As long as the nationality of a failing bank is clear, the appropriate national central and treasury can be expected to handle the necessary lender of last resort and recapitalisation responsibilities. The growing complexity of cross-border banking activities in the euro area, however, is creating ambiguities and doubt as to who are the lender of last resort and recapitaliser of last resort for specific banks. To avoid decision-making in crisis settings, the euro area fiscal authorities should – right away – agree on a formula for dividing the fiscal burden of recapitalising the European Central Bank, should the need ever arise.

Comments

[hari]

This is not a theoretical issue for ECB. It's an internal EU policy machinery which develops over time before fundamental adjustments are made to policy framework. Once demand for such policy adjustments are identified by national govs, central policy makers get focused and develop the framework in which the final policy is fformulated and then approved by (EU) Council.

So the story of who will recapitalize ECB is essentially a non-issue. FT is creating a journalistic feature of ECBs problems without recognizing the policy machinery which drives EU-15 (Euro zone).

[tadhgin]

It is the European *System* of Central Banks - I would imagine that the national central banks could be made responsible for recapitalisation, and they would, in turn, secure funding from national governments.

It would be some food fight getting the money!

[jck]

It's a non-issue, the ECB itself doesn't purchase any assets, that job is done by the member banks of the Eurosystem, the NCBs. The ECB has a small capital base and hold mostly [small] foreign exchange reserves.
In case of losses of capital by the ECB, the process is crystal clear, the ECB has a general reserve fund and if it is exhausted [and that has happened in the past in 2004] then it has a call on the pooled monetary income [seignorage] of all NCBs in the Eurosystem. That amounts potentially to multiple times the ECB'own capital.

[Detlef]

jck is right.

Not to mention that as far as I know the national Central Banks transferred only a certain percentage of their reserves when the ECB was founded. 10% or so?

There´s certainly multiple times the ECB´s capital available in an emergency.
Is that one of those "Europe/Eurozone is doomed" articles? :)

[Cristina]

According to its Statute (Article 33.2), ECB's potetntial loss can be offset: 1) against its general reserve fund; or 2) following decision of Governing Coucil against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the NCBs.

The initial capital of the ECB was subscribed by the ESCB NCBs in proportion to their shares in the capital of the ECB - initially EUR5,000 million but with each new entrant, ECB's subscribed capital has increased.