Considerations for times of disturbance

5.4.2.1. Central banking in financial crisis

During a financial crisis, the way in which a central bank makes monetary policy may change and a central bank’s role in the provision of stable financial markets may become more important. As inflation drops toward zero or even becomes negative, possible declines in the policy rate may be limited. With sufficient counterparty risk, banks may be unwilling to lend, even when interest rates tend toward zero and the banks are flooded with liquidity. In this section, we consider alternative policy tools for central banks and the role of the central bank in restoring the market for interbank lending.

5.4.2.1.1. Quantitative Easing

A problem with a nominal interest rate as an intermediate target is that it may be difficult to have a nominal interest rate that is below zero. Thus, in periods when inflation is near zero or is negative, central banks may employ a tool referred to as quantitative easing.

Quantitative easing refers to an expansion of the banks balance sheet brought about by an increase in base money: the central bank eases monetary policy by printing money and using the money to purchase financial assets. This tool was used by the Bank of Japan in the early 2000s in an unsuccessful attempt at tackling deflation and is currently being aggressively employed by the Federal Reserve.

When banks were the main providers of credit, financial crises manifested themselves as bank runs or liquidity squeezes, where troubled banks were unable to borrow. Central banks were expected to assist in promoting financial stability by acting as lenders of last resort: lending at a penalty rate to solvent, but illiquid, financial institutions. Now, however, that external financing is increasingly provided through the issuance of tradable financial instruments, a credit crunch can appear as dysfunctional financial markets, with little or no trade taking place in certain types of financial assets. To the extent that this reflects the market’s inability or unwillingness (because of its affect on their balance sheets) to price these financial instruments, central banks may have a role to play as market makers of last resort: either by outright purchases of these assets or by accepting them as collateral (with an appropriate haircut) in repos and in loans at the discount window.

Thus, in addition to expanding the size of its balance sheet, a central bank can ease monetary policy by lowering the quality of either its assets or the collateral that it accepts in repos or for discount window borrowing. The Bank of Japan pursued such a policy in the early 2000s and it is being currently pursued by the Federal Reserve, Bank of England and the ECB. Quantitative easing is designed to expand the money supply and hence encourage people to buy assets and spend because they do not want to hold so much money in the face of mounting potential inflation. If the banks merely hold the extra reserves and do little with them as in the case of Japan this achieves little. Quantitative easing also not the same as trying to encourage bank lending, that is done by a different route in recapitalising banks and also in trying to make the future look more secure so risks can be managed by lenders.

5.4.2.1.2. Financial Stability and Central Banks

In a severe enough financial crisis, flooding financial institutions with liquidity may not restore the market for interbank lending; in the current crisis, financial institutions borrow from the ECB and deposit the proceeds at the ECB’s deposit facility, even though they make a loss on the interest rate spread. Such a complete cessation of trade in the interbank market can be a result of both fears that counterparties may become insolvent and adverse selection. To see this, suppose that financial institutions are imperfectly informed about each others’ solvency and that for a potential lending bank to be willing to lend it must set an interest rate that is sufficiently high that, given the expected likelihood of repayment, it makes a sufficient return. But, if there is enough financial turmoil that this interest rate is sufficiently high, banks that are unlikely to become solvent will not borrow. As they exit the pool of potential borrowers the interest rate that must be charged to ensure an adequate return rises further. This causes the highest quality banks that remained in the pool of potential borrowers to withdraw and the interest rate that is high enough to ensure the needed return goes up again. If the situation is severe enough, the market can vanish altogether.

In the long-run, the solution is to identify the quality of financial institutions: assets must be priced and balance sheets made transparent. In the short-run, the central bank may need to ensure counterparty risk, or even act as a universal counterparty.

Unfortunately, the central bank’s role in ensuring financial stability is a political one. It decides the valuation of risky assets and the haircuts applied to them; it sets the interest rates at its discount window; it may decide who to accept as counterparties. This raises the spectre of real or perceived favouritism. While a society may allow the independence of an unelected body in the conduct of a technical task such as inflation targeting, it is less likely to allow it for political tasks. Thus, to maintain the independence of the monetary policy committee, it may be necessary to define the central bank and the monetary policy committee as separate legal entities. The monetary policy committee can be allowed independence, but the central bank – at least in its role as insurer of financial stability must be accountable.

It is also important to recognise the limitations of central banks in the provision of financial stability. In the event of a financial crisis of the magnitude of the current one, viable financial institutions need to be recapitalised. While central banks can carry out the first two tasks, they cannot carry out the third and still meet an inflation target: this must be done by national treasuries, funded by the taxpayers.

5.4.2.2. Lender of Last Resort

5.4.2.2.1. Deposit Insurance

Deposit insurance was, when first introduced, intended to be a substitute for lender of last resort action by the central bank. It now fulfils several purposes, and is seen as supplementing and complementing rather than replacing the lender of last resort role of the central bank. Lender of last Resort evolved in England in the 19th century in response to a problem inherent to fractional reserve banking. Should a bank fail, and be unable to pay its depositors, there is a risk, and one which sometimes materialises, that depositors at other banks, seeing this hasten to their own banks to withdraw their funds. Because all banks are fractional reserve banks, it is possible in principle for other banks then to fail. It is there that the central bank acting as lender of last resort comes in – it lends on collateral to the banking system when the system as a whole is short of cash. This provision of cash calms the fears of depositors, the panic ends, and stability returns to banking. This worked in Britain in the 19th century, and also in other countries such as France, and it worked in Italy when the technique was used at the beginning of the 20th century.

It had also worked in the United States. That is why it was, and remains, a puzzle why in the 1929 panic, and in several immediately subsequent ones, the Federal Reserve did not act in this way. It did lend, but so cautiously as to give no relief to banks or their anxious customers. But be that as it may, it was feared that the Federal Reserve might again prove deficient, so among the numerous laws that followed the onset of the Great Depression in the United States, deposit insurance was introduced. The intention was that because customers would know their funds to be safe, they would not rush in panic to withdraw them, so the banking system would be more secure.

From the point of view of a modern banking system with extensive interbank lending, deposit insurance is of little use in promoting stability. The reason for this is set out below. Nonetheless, it still serves a purpose. It does ensure that retail depositors have confidence in the security of their funds. Further, it helps prevent ad hoc protection, the rushing after the event to compensate depositors. And perhaps most important it lets individuals use banks, a valuable social function, even though they have neither the ability nor the time to investigate and judge their soundness. It inevitably brings problems also.

With complete deposit protection, at whatever limit (or of course with no limit), there is an incentive to put funds, up to that limit, with whoever pays most interest, regardless of the riskiness of the institution concerned. But as UK experience in the Northern Rock episode showed, incomplete coverage does not seem to be politically tolerable.

5.4.2.2.2. The Discount Window

This subject leads us immediately to why deposit insurance does not prevent bank runs nowadays. The point is well illustrated by the Northern Rock episode in the UK. The run that brought down Northern Rock was not the well televised and publicised run by retail depositors. It was a run by Northern Rock’s wholesale market creditors, what has been called a “silent run”. Such creditors do not have the protection of deposit insurance (and rightly so – they are professional investors). For security in a fractional reserve banking system they turn to the discount window, to, in effect, classic lender of last resort. Such a run is met by the central bank discounting securities it is offered by the commercial banks. It has to choose the rate of discount, and the quality of securities it will accept. The quality is generally lowered in such an episode, one reason for the central bank’s raising its interest rate. This action of course provides stability only so long as the system as a whole has enough acceptable collateral, and does not guarantee the security of all institutions. Any institutions which run out of collateral must close down. Use of the discount window in this way is thus consistent with not encouraging imprudence by bankers. It does however show the social role for deposit insurance – for if banks close, the insurance fund protects depositors.

Use of the discount window does expose the central bank to risk of capital loss. There may be none, but the risk is always there, and central banks have a small balance sheet. Accordingly, it is prudent if there is standing behind the central bank an agency which can supply capital if needed – this can nowadays, when central banks are no longer privately owned, only be the fiscal authority.

5.4.2.2.3. Widening the Balance Sheet and its effect on ECB independence

In a crisis the central bank inevitably ends up with a “wider” balance sheet. In other words, it has lowered the quality of the assets that it has accepted as collateral. This in turn poses threats to the central bank’s solvency, and thus makes it more likely that it may call on its shareholder, the government, for fresh capital. Unfortunately, while necessary, this may pose some threat to the central bank’s independence. Dependence on government for day-to-day finance appears as a variable weakening the independence of the central bank in studies of central bank independence, and it usually appears to be significant. There is, however, a qualification to this. In a time of crisis, the government faces tremendous costs if it does not support the central bank, and the government and central bank both know it. There is little opportunity then for the government to gain control. The widening of the balance sheet in a crisis is undesirable, but necessary, and poses no immediate threat to independence. A metaphor would be that as both parties possess the atomic bomb neither dares use it.

5.4.2.2.4. Lifeboats and the role of the Treasury

One of the best known lifeboats in the history of banking is that which rescued Baring’s bank in 1890. Although Baring’s was no longer a large bank, it was still one of large reputation, and it was feared that if it were allowed to fail there would be threat to London as a financial centre, and perhaps to Britain’s gold reserves. That lifeboat was entirely a private sector affair; the main banks in London, and the Bank of England, all put up funds for the sake of their common good.

There have been other such episodes. But such techniques are limited now to banks which are so small that their failure would be of little practical significance. (It is possible that a bank sufficiently small to be rescued by the private sector might be so because it was crucial to the functioning of one market.) Usually, though, lifeboats inevitably involve the Treasury of the country concerned, because the institution at risk is so large that other banks coming together cannot commit enough means to support it, because they are themselves under stress, or because they do not recognise a common interest. In such interventions the central bank is highly likely to be the government’s agent. This need not compromise its independence in any way, however, just as the fact that the Bank of England in 1890 co-ordinated the private sector rescue of Baring’s did not compromise the Bank’s independence regarding the other banks.