I imagine you know that insolvency has a very different meaning for a central bank than it does for a commercial bank. Cash is nominally a liability of the cent

I imagine you know that insolvency has a very different meaning for a central bank than it does for a commercial bank. Cash is nominally a liability of the central bank, but it does not represent a real claim on the bank's assets, so a central bank's capital balance can go negative without consequence. It's true that the rules governing the Federal Reserve System and some other central banks date back to the days before fiat money, when cash represented a real claim on the central bank's gold or other assets. In that era, solvency of the central bank was a real concern. But today a central bank's capital balance has practically no meaning beyond the significance the central bank itself gives to it, and worrying about a central bank's solvency is rather silly. That said, the credit instruments a central bank issues against the commercial banks in its jurisdiction should not represent uncompensated liabilities of the central bank. Aside from the premia collected by the central bank when it sells the CDSs at auction, the CDSs should also transfer equity in the underlying commercial bank to the central bank in the event of a credit event; in other words, the central bank would eventually be compensated by the shareholders of the commercial bank that has defaulted if the central bank must pay out on its credit instruments on that bank. Again, the basic point is to formalize the informal mechanisms that already exist and are already begrudgingly employed ad hoc to bail out the financial system when a credit crisis occurs. The advantage of doing it through credit instruments issued by the central bank is that it dispels uncertainty about whether obligations will be paid, and about what will happen when they're not. The scheme eliminates uncertainty about who will be bailed out and who won't, and it creates markets that better reveal risks, while also managing to get the financial system to pay up front for at least some of its eventual bailing out. It should also be possible to set the terms of the credit instruments to minimize their long-term effect on the central bank's balance sheet. Instruments with equity clawbacks and other provisions that would eventually push the losses onto the shareholders of commercial banks, making it unlikely that the central bank would suffer substantial losses in the long run. A credit crisis feeds on uncertainty: by issuing these instruments and paying out on them immediately, the central bank would prevent the financial system from seizing up, and thereby prevent a crisis of credit and liquidity from worsening and spilling over into the real economy. Note also that the credit instruments I have in mind are intended to remove counterparty risk from the system. This means that they should give the holder a claim on the central bank in the event that a counterparty does not make a contractual payment; that is, they should be instruments on small credit events, not big ones like bankruptcy. Further, they should only compensate the holder for unpaid obligations to the holder. Thus the notional value of the instruments would not exceed the actual liabilities of commercial banks to their counterparties, and they would not be useful for speculation. Over the long term, the central bank would be on the hook only for actual unmet liabilities of the commercial banks it regulates, and if it's doing its job, those banks should be well enough capitalized that they are not in danger of becoming insolvent: the central bank would only suffer long-term losses if the commercial banks are truly insolvent, rather than if there is merely a temporal mismatch between their assets and liabilities.