On what happens to a Central Bank’s balance sheet when a client bank goes bursts

Dear Hobbes,

The other day I was discussing the current financial turmoil with a friend and we got to a dead end we couldn’t find an answer to. I have been trying to research the issue but I haven’t been able to get a clear response.

Central Banks around the world are pumping liquidity (creating money backed by… apparently nothing) into the banking system and financial markets.

In theory, they lend the money to banks in need of funds, but they are still reluctant to lend to the average person, or even other banks.Fear, distrust, “who’s going to be next” syndrome. But all in all, and without taking into account the potential effects on inflation of billions of dollars, pounds, yens and the like being injected into the financial markets, the question that raised was: What happens if a bank doesn’t pay back its dues to a central bank?

To dust off my understanding of a regular bank’s balance sheet, I found this interesting piece from The Motley Fool (myself an avid listener to their UK Money Talk podcast):

A bank’s balance sheet is different from that of a typical company. You won’t find inventory, accounts receivable, or accounts payable. Instead, under assets, you’ll see mostly loans and investments, and on the liabilities side, you’ll see deposits and borrowings.

OK, but what happens with that of a central bank? Are loans to commercial banks their assets? And how does the deposit side grows? By printing more money? After all, the central bank (where independent) of a nation has the key to the printing machines.

And so, what happens if Bank A goes belly up and files for bankruptcy owing the Central Bank money? I haven’t been able to find an answer, so Hobbes, if you know anything about it, please, let me know!

When I hear that Euribor, Libor and other interbank lending rates increasing even though central banks are printing money after hours, I usually think about the impact all this money would have on inflation were these banks to restart lending to the main street. I guess inflation would sky rocket.

Keeping that guess in mind, if Bank A fails, including the money that was desperately borrowed from the central bank, who and how does the central bank covers the hole on its balance sheet? After all, they “created” the loan out of nothing, with no hard asset like old or silver backing the new money, so if they just delete the loan from its account, what would be the effect on the central bank and the national (or supranational) economy?

Going back to Bank A, after being scavenged by other banks off its good assets, shareholders unhappy with their investment decisions, and bank customers saved by deposit protection schemes, the money lent by the central bank would ultimately be burnt, with no inflationary effect for the economy, wouldn’t it be the case? The central bank scores a black hole, but, didn’t it “created” the money in the first place? If it makes it disappear, all the better, isn’t it?

I hope I am not getting this right, and I am missing half the story, otherwise, talk about moral hazard, huh?


06/10/08 NOTE: I was just listening to a podcast from The Economist, they were discussing the financial tsunami with Willem Buiter, from LSE (London School of Economics, not London Stock Exchange…) and it seems that the answer is that where monetary policy leaves it off, fiscal policy catches the up the baton. So the anonimous citizen gets screw up either by inflation or a raise in taxes to pay up the hole left by the difunct bank.


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