“…they have had three core functions. They are the lenders of last resort to banks in trouble; they serve as banking regulators, and they act as their governments’ economic agents.”
When it comes to supporting the central banking system there are 2 important economists you should have heard of: Walter Bagehot and Hyman P. Minsky.
(They wrote two very interesting papers, definitely worth reading for a deeper understanding, but I will sum up the most important parts for you.)
Bagehot became famous because he stated that we need a central bank as lender of last resort. Which means that we need a central bank that lends money to banks that are running out of liquidity (money/currency).
Maybe you remember my example from the last blog post: The bank gives a loan to a client and this client receives money into his account and withdraws it immediately. Additionally, my friend and I want to throw an expensive party and withdraw all of our money as well. Our bank is solvent (which means that she has enough assets (loans from their clients) but she is not liquid because the payments from these loans are not available right now. Therefore the bank can not make any more payments because her money is bundled up in long-term assets. So even though the bank is solvent, she can be illiquid and liquidity kills you quickly.
That’s why the bank needs to go to another bank and ask for money to pay out my friend and me. The other bank might not have customers who want to throw expensive parties, so they profit from borrowing their surpluses to our bank because cash does not pay interest but loans do. Both banks are happy :)
5. What if we are in a crisis?
In a financial crisis, we don’t have enough money, because the economy is doing poorly. People are scared, do not consume as much, lend or borrow money for investments and loans are defaulting. So the balance sheets are shrinking and banks need to fight for their own survival.
The balance sheets are shrinking because loans are being paid back, fewer people take out new loans and therefore deposits are vanishing. Banks are too afraid to lend to each other because they are afraid that the other banks might get bankrupt and can not pay back its debt, so they keep the money to themselves. That’s where the downward spiral starts to spin.
The first bank will not be able to make payments because even though she is solvent, she is illiquid and can not pay her clients (e.g. my friend and me). The clients are going to panic and try to withdraw their money from this and probably other banks as well. That puts pressure on the entire banking system and it might collapse. That’s why we need a central bank to step in and lend money to banks. We need a bank that does not care for its own stakeholders but for the entire system. A bank which can not go bankrupt that is backed up by a government because we trust the government and the government is able to raise money by raising taxes or a bank that is able to print money.
In consequence, Bagehot and Minsky wrote that a central bank (in their case the bank of England) should lend freely at a high rate. That does not mean that the CB should just give away money because banks can not meet their payments, but it means that the CB should give a loan against good collateral (dt. Pfand). Collateral could be a mortgage, loan or other valuable assets.
Why should it lend at a high rate? Thusly it discourages banks to lend money if they do not really need it and it gives the incentive to pay back debt quickly, which protects the reserves of the CB. One can argue that this can lead to a moral hazard because banks are giving away too much money because they know, they will be rescued from the CBs anyway. That is why the CB should not give away money blindly but against good collateral so the bank can meet its payments during a hard time and is able to continue to give away loans so the economy can recover. Banks should only get help if they are illiquid for a short period not if they are mismanaged and insolvent.
Especially Minsky emphasizes how important money and investments are for the economy and that the CB should only control the conditions of refinancing not of the quantity of money supply. I guess it’s too late for that because as we know the CBs have been printing too much money.
Financial Times Quote: The banks should act as the lender of last resort, therefore give money to banks that are in trouble, provide stability through regulations and act as the government economic agent, which refers to my last paragraph, but I will give further explanation in the next blog post.
The first article: The hierarchy of money
The second article: Why do we need banks?
The third article: Why we need a central bank?
The fourth article: How can banks create money out of thin air?
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