that he was worried that international regulators were fixated on preventing another collapse like Lehman Brothers and not looking at the risks created by the expansion of central bank balance sheets.Please re-read the highlighted text because Mr. Sands has identified the largest systemic risk in the financial system.
Just like structured finance securities and bank balance sheets are 'black boxes', so too is a central bank's balance sheet.
While a central bank can always fund its balance sheet by printing more money, there is a risk from the expansion in the central bank balance sheets that the public loses confidence.
As Morgan Stanley said (hat tip Zero Hedge):
What happens when the public loses confidence in central bank liabilities?
A: A run on the fiat money systemIn response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy.Actually, the private sector is no longer willing to buy opaque products including structured finance securities and bank liabilities that are not guaranteed.
The central banks are using their balance sheet to fill this hole.
Should the central banks want to stop using their balance sheets, they should require the end of opacity in the financial system.
They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks’ own liabilities.
This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities – i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else.
A central bank will, of course, never default on its liabilities – they can, after all, create unlimited amounts of it.
But the ‘safety’ property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value – its value in terms of goods and services.
So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public’s confidence in the real value of such liabilities – and government liabilities more generally. The more such liabilities are created, the more we approach this point.
How would such a loss of confidence unfold?
If the supply of central bank liabilities – call it ‘liquidity’ – exceeds the public’s liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation – inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value.
We are probably very far from such an outcome – far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.