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Banking On Failure: Central Banking

WORLDWORKS by Joe Pimbley

Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

[su_dropcap style=”flat”]T[/su_dropcap]HE CENTRAL BANK (“CB”) within a country is a government entity that acts like a bank in many respects. A short and well known but not overly helpful description of the CB is that it is “the banker for the country’s banks.” In the U.S., the Federal Reserve System is the CB. For the United Kingdom, Canada, China, Mexico, Japan, and India, the central banks are, respectively, the Bank of England, the Bank of Canada, the People’s Bank of China, the Bank of Mexico, the Bank of Japan, and the Reserve Bank of India.

We discuss in this chapter the history, mission, and activities of CBs. Though something of a tangled mess, the short summary is that a country’s CB supports and regulates the nation’s largest banks and also governs the country’s money. The common phrasing of this second role – “monetary policy” – is a boredom-inducing label for what we should really call “money creation and destruction.”

Banking on FailureAs of early 2016, there are nineteen European countries comprising the Eurozone – defined as countries that have adopted the Euro (EUR) as their shared legal currency. Since a central bank governs the currency (i.e., money), there must exist one CB for these nineteen countries. The European Central Bank (ECB) is this collective CB. Each of the eighteen Eurozone members has its own national CB (NCB) and each NCB sits on the guiding committees of the ECB.

Resource material for this chapter includes (i) W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870, (ii) P. L. Bernstein, A Primer on Money, Banking, and Gold, Random House, 1968, (iii) A. Fergusson, When Money Dies: The Nightmare of the Weimar Collapse, Kimber, 1975, (iv) C. M. Reinhart and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2011, (v) M. N. Rothbard, The Case for a 100 Percent Gold Dollar, Ludwig von Mises Institute, 2001, and (vi) G. E. Griffin, The Creature from Jekyll Island, 5th Edition, 2010.

History of Central Banks

The Swedish Riksbank (1668) and the Bank of England (1694) are the world’s oldest central banks. In addition to century of birth, the two banks shared both a common corporate structure (“joint stock” companies) and the mission of lending to their respective governments.[1] Private investors owned the stock of the two banks thereby implying at least nominal independence from the governments, though the Swedish government “exercised considerable influence over the [Riksbank]”[2] and the early Bank of England (BoE) focused on lending to the government and managing the government’s accounts.[3] Both banks achieved large scale relative to other banks through ties to their governments.

As we noted in earlier chapters, banks receive deposits from customers (both citizens and businesses) and extend loans to clients (generally also citizens and businesses). Early central banks conducted similar activities yet with a greater focus on government as both customer and client for deposits, payment functions, and loans. Both conventional and central banks adopted the “fractional reserve” practice of lending a large portion of deposited funds under the expectation that depositors in aggregate would not seek unusually large withdrawals.

We discussed the seventeenth-century origin of fractional reserve banking in Chapter 6. A bank’s reserve is simply the liquid currency – whether in bank notes or in the precious metal underpinning the currency, if any – that the bank retains in order to meet withdrawal demands. A forty percent reserve, then, means the bank holds currency equal to forty percent of deposits. A healthy bank will also own more than the remaining sixty percent of value in performing loans to creditworthy borrowers. British banks placed all or a portion of their reserves as deposits with the BoE.

The advantage of fractional reserve is that the bank can “put the money to work” through lending what would otherwise be “idle reserves.” This practice works well when times are good. “Times are good” when (i) borrowers repay their loans, (ii) the bank is solvent and widely perceived to be solvent, and (iii) depositors don’t have urgent need for their funds.

In a fractional reserve paradigm, however, the “bank panic” is the antithesis of “times are good.” Such panics in Great Britain, other European countries, and the United States have been numerous and well documented since the eighteenth century.[4] Yet it is in their behavior in bank panics that central banks define themselves and their history.

By the phrase “bank panic,” we mean that a significant number of depositors simultaneously decide to withdraw their funds either from a specific bank or from a group of banks. The depositors’ motivation is the rumor that the bank or group of banks will soon be insolvent (i.e., will not be able to repay funds). It is entirely rational for a depositor with such information, whether validated or merely suspected, to run to the bank and withdraw his or her money. There’s no penalty for withdrawal. The only “penalty” is waiting while many other depositors of the same bank take their money and then finding the insolvency rumors were true. When a bank then declares its insolvency and shuts down, the remaining depositors usually take losses.

Following more than a century of panics, the BoE finally learned a valuable technique for squelching chaotic runs on the London banking community. Paraphrasing Walter Bagehot’s exposition of the second half of the nineteenth century,[5] it is natural for a bank facing elevated withdrawal demands to curtail its lending and scramble to raise as much cash as it can. Thus, the many business borrowers who repay short-term loans cannot borrow again as was their routine during “good times.” Like the banks, the businesses now scavenge for cash and add to the panic. Everybody seeks cash and, as a result, cash becomes more and more scarce. The “bigger the news” that cash is dear the greater the general incentive is to find and husband cash.

To combat the spiraling negative psychology, Bagehot explained that the central bank must lend cash freely into the panic. This action was counter-intuitive. It’s a bit like the advice of correcting a car that is spinning out of control. Physics may tell us that stepping on the accelerator will re-establish control for the driver, but slamming the brakes feels like the right answer! We note that the central bank had to mind its own reserves as well. When other London banks pulled their deposits from the BoE to meet panic withdrawals, the BoE itself was at risk of insolvency.[6]

Continuing with Bagehot’s prescription, the central bank should lend freely into the panic, at a high rate of interest, while requiring the pledge of high-quality collateral. By empirical observation, not by any “theory of human behavior” or “theory of the social good,” this “lender of last resort” role works to stem the panic. There is abundant cash for the asking, so the hoarding psychology subsides. The cash is expensive (i.e., “high rate of interest”), so people and businesses borrow only what they truly need. The stipulation that the borrower must pledge high-quality collateral makes clear that this central bank lending is not a bailout. If the borrower does not have collateral, then the borrower’s problem is balance sheet insolvency rather than liquidity and the central bank should not lend.

Again, in Bagehot’s description, the BoE learned to act in this manner of “lender of last resort” to stem panics because it was the best survival strategy for the BoE itself. To claim that the BoE acted (purely) benevolently or that the British government “required the benevolence” is an arguable misunderstanding of history that detracts from the fascinating lesson.

Further, let us make the evident point that the Bagehot-era central bank “lender of last resort” function is not synonymous with “all business and financial institutions and governments in crisis get low-interest loans to keep everybody afloat.” The historical genesis of “lender of last resort” is the practical solution to instability inherent in fractional reserve banking.

Bagehot also expressed two additional regrets regarding the BoE as Britain’s central bank. London banks and the BoE generally considered a thirty percent reserve to be reasonable while Bagehot considered this low level to be unsafe.[7] As we noted earlier, the larger the reserve the greater the likelihood that a bank will survive a panic. He also asked why Britain should have just one central bank. In Bagehot’s view, there was no reason circa 1870 that a country should have just one institution with “central bank status.” An obvious disadvantage was that failure of the BoE would disrupt everything. The only justification Bagehot could fathom for a solitary CB was that London had grown accustomed to the arrangement.

Yet the rest of the world followed the Swedish and British template by establishing single central banks in developed countries. The U.S., in particular, created the Bank of the United States in 1791 shortly after the country’s founding. Due to highly polarized public thought regarding financial institutions, this first U.S. central bank lived for only twenty years. Though reborn in 1816, the second Bank of the United States sputtered after its own twenty-year run.

By voting passage of the Federal Reserve Act of 1913, the U.S. Congress created the Federal Reserve System (“the Fed”), today’s U.S. central bank. At its beginning, large banks operated the Fed under the supervision of (primarily) government appointees constituting the Federal Reserve Board. In one view, the goal of these large banks was to create a guild, of sorts, to impose standards of prudence such as minimum reserve requirements on all banks.[8] Attributing numerous bank failures in the Panic of 1907 to minimal reserves, poor lending decisions, and insufficient capitalization, enthusiasts hoped that the new Fed would impose uniformity and discipline.

Three aspects of the broad history of central banks of the U.S., Great Britain, and other major countries since 1914 deserve specific recognition. First, the gradual yet global rejection of the gold standard we described in chapter 7 explicitly modified the mission and tools of central banks. Second, with emphasis on the U.S., history’s verdict is that central banks responded ineffectively to the Great Depression of the 1930’s.[9] Finally, beginning in 2008 and continuing through 2016, the world’s dominant central banks have acted aggressively with their governments to manage consequences of the Credit Crisis. We defer discussion of this recent past and present. It is this topic – the central banks’ recent actions and the perceived need for such actions – that motivates this book.

The next excerpt for Chapter 8 will discuss “Stated Mission of Central Banks”

[1] M. D. Bordo, “A Brief History of Central Banks,” Economic Commentary, Federal Reserve Bank of Cleveland, December 2007.
[2] See Money and Power – the History of Sveriges Riksbank at http://www.riksbank.se/en/The-Riksbank/History/Money-and-power-the-history-of-Sveriges-Riksbank/ .
[3] See http://www.bankofengland.co.uk/about/pages/history/default.aspx#1 .
[4] See, for example, C. M. Reinhart and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2011.
[5] See W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870.
[6] We note that the BoE did not have unlimited ability to “print money” in the nineteenth century as it does today. The ultimate failure for any central bank with a gold, silver, or other tangible standard was the inability to make payment in the underlying standard asset. Great Britain maintained a gold standard in the nineteenth century.
[7] See chapter 2 of W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870.
[8] See G. E. Griffin, The Creature from Jekyll Island, 5th Edition, 2010. This book takes a decidedly negative view of the motives of bankers and public figures who collaborated in the creation and operation of the Fed.
[9] M. Friedman and A. J. Schwartz, The Great Contraction, 1929-1933, Princeton University Press, 2008.

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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