“This is why the banking system is prone to panic even when people think banks are solvent: solvency is contingent on the environment and impossible to determine in real time. Only government backstops, including a lender of last resort and deposit insurance ultimately guaranteed by the monetary authority, can overcome the risk embedded in banks’ funding model.”
Let’s go back to the old days, where we had a lot of agriculture. At the beginning of the season, the farmers needed money to buy seeds and machinery for their farming, therefore they needed credit. The small country banks were not able to lend that much money to their local farmers because everybody wanted to have money at the same time. The country banks went to the big banks in the cities, borrowed money and gave it to the farmers and paid back their loans when the farmer paid their loans at the end of the season. So the first reason why a Central bank would be helpful is because the small banks could go to the central bank and borrow at a fair price instead of going to the big banks. The money would be distributed better.
The second reason would be to create stability and to prevent bank runs
Imagine we are still back in the days, where no one could twitter about a bank getting bankrupt or a part of the country being in a recession. A part of a country wasn’t doing too well, chances were good that not the entire country knew about it. Scared people would stop trusting banks. and withdraw their money, only to check if it’s still there. That would cause much trouble because the banks don’t have enough reserves to pay out all their clients due to the fact that they gave away big portions of their clients’ money to provide loans for other clients. Suddenly more and more people would withdraw money and banks would get too scared to lend to each other.
In conclusion, the first bank would get a liquidity problem and this would spread like a wildfire and we would have even more and more bank runs. More people would run to their banks and withdraw all their money and the entire system would collapse eventually. To prevent this from happening the bank, which is not doing too well, could borrow money from the Central Bank (CB) to secure its customer that their money is safe, as well as continue lending money to local businesses to fire up the economy again. So the CB protects the system as a whole. The downward spiral including the bank runs wouldn't happen in the first place.
The first central bank of the world
Walter Bagehot was the first one writing about how the Bank of England should become the Central Bank of England. He argued that a central bank would protect the banks and the economies against a crisis, as well as act as the lender of last resort and they are supposed to lend freely at a high rate. What does that mean?
The first bank had enough assets (loans, cash) but probably not enough cash, because many assets like loans will be paid back in one or ten years. So the money is not gone forever but it’s not available right now. Especially in a crisis, the bank has a hard time to liquidate the asset, which means selling the assets for cash. So when all the people want to withdraw their cash, they will not have enough cash. Additionally, people do not want not a 100$ loan from someone else, hey want 100$ in cash. The central banks should always give money to a bank that has good securities, for example, government bonds or loans.
The high rate will be an incentive to pay back the loan quickly and it also makes sure that only banks that really need money, are borrowing from the central bank, so the central bank can protect its reserves. What is good about this mechanism? Banks can use their assets like treasury bills as collateral (dt.=Pfand). Instead of needing to sell them very cheaply (firesale), they are able to borrow money from the CB against their collateral and prevent bank runs and the following financial crisis. (I talk more about the financial crisis and central banks later and I promise you especially after the next article this topic becomes more clear.)
This system provides elasticity because banks know they can give away credit due to the fact that they could always get funding (money) from the central bank in exchange for good collateral.
To fully understand how central banks evolved you could read more from Hyman Minsky, Walter Bagehot or Allyn Young.
Financial Times Quote: As the Financial Times states, the banks are lending out loans over a long period (e.g. mortgages) and finance it with deposits that are short term. Therefore they need to be sure to always be able to borrow money from the central bank otherwise the entire system wouldn’t work because in a panic, where people withdraw money, banks would get into big troubles. Banks need to be able to lend long and borrow short."
The first article: The hierarchy of money
The second article: Why do we need banks?
The fourth article: How can banks create money out of thin air?
The fifth article: Why do we need central banks especially in a crisis?
The sixth article: What are clearing houses?
The seventh article: What are Fed Funds?
The eighth article: What are dealers, brokers and repos?
The ninth article: Quantitative easing and open market operation
The tenth article: Eurodollars
The eleventh article: Discounts, Discounts, Discounts
The twelfth article: Why dealers provide liquidity
The thirteenth article: Rates and the Treynor Model
The fourteenth article: Brexit
Written by: Philine Paschen