Banking On Failure: The Mission Of 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.

The previous excerpt for Chapter 8 discussed “History of Central Banks”

Stated Mission of Central Banks

THE STATED MISSIONS of central banks in all countries have evolved over time and are roughly comparable among the leading Western economies. In the U.S., this mission is “to foster the stability, integrity and efficiency of the nation’s monetary, financial and payment Banking on Failuresystems in order to promote optimal macroeconomic performance.”[1] For the BoE in Great Britain, we find the mission is “to promote the good of the people of the United Kingdom by maintaining monetary and financial stability.”[2]

One’s literal reading of either of these concise mission statements might lead one to conclude that the CB’s mission is “sound money” (i.e., don’t let the government or anything else debase the currency) and “maintain functioning payment systems.” But such a straightforward interpretation would miss the mark. The Fed separately describes its duties as falling into four areas; monetary policy (giving as much weight to “maximum employment” as it does to “stable prices”); supervising and regulating banks; maintaining stability of the financial system and containing systemic risk; and performing banking services for banks and governments.[3] The BoE similarly describes itself as having the first three of these duties.[4]

Activities of Central Banks[5]

Let’s begin by repeating the earlier definition that the CB is “the banker for the country’s banks” and also the government’s banker. In the U.S., it is the Fed that facilitates payments between the nation’s banks and between the government and the banks. The “Fedwire Funds Service,” for example, provides the immediate transfer of funds from one financial institution to another.[6] Just as typical citizens keep much of their “cash” as deposits in bank accounts, banks themselves hold most of their cash as deposits in the Fed. Deposits with the Fed are the banks’ “reserves.” In a Fedwire transfer, then, the Fed simply deducts funds from one bank’s reserves and adds the funds to the other bank’s reserves.[bctt tweet=”The complexity of the CB’s mission becomes dazzling when we ponder monetary policy.” via=”no”]

Before jumping into the monetary tools and actions of central banks, let’s highlight what the CBs should not do. Consider the hyper-inflation of the German Weimar Republic in the early 1920’s.[7] Mildly over-simplifying, the German central bank printed absurd volumes of paper money to attack the country’s severe problems. As prices rose (i.e., as inflation took hold), the central bank accelerated the printing presses. The CB literally exhausted its capability to print colorful pieces of paper otherwise known as currency. Economic and human disaster ensued.

At its most basic level, averting such extreme debasement of currency is the raison d’être for independent central banks. One strand of global history is the desire of governments to debase their currencies to provide immediate benefits to the governments, not the people, of easier debt repayment and additional spending. Debasement leads to ruin.[8] The historical role of CBs, in theory, is to oppose the debasement. An excellent measure of “debasement” is the inflation rate. A positive rate of inflation implies the devaluation (debasement) of the currency by this same annual rate. Thus, the phrases “stable prices” and “sound money” are effectively synonymous with “zero inflation.”

Available tools and activities for a central bank’s management of the inflation rate are the reserve requirement, the discount rate, open market operations (including quantitative easing and repurchase agreements), and interest on excess reserves. We focus primarily on the Fed in the U.S. although the principles apply to all central banks in similar economies.

As we noted in chapter 6, the central bank sets the reserve requirement for the nation’s banks. The reserve requirement is the minimum fraction of a bank’s demand deposits that it must hold “in reserve” with the CB (i.e., in the bank’s own deposit account with the CB) or as “vault cash.” For context, we say again that the Fed reserve requirement in 2016 is 10% – a level set in 1992.[9] Banks cannot lend their reserves to borrowers because they’re stuck in the deposit account with the CB. Thus, if the CB wishes to reduce overall bank lending, it can raise the reserve requirement. Conversely, lowering the reserve requirement will enable, but not force, banks to lend more. Since bank lending dominates the money supply,[10] nudging lending up or down will promote rising prices (inflation) or falling prices (deflation), respectively.

Like the reserve requirement, the CB controls directly the discount rate – the interest rate the CB requires when it lends to a bank. During “good times,” especially prior to 2007, a bank would typically borrow from its CB only under financial duress. Following our earlier discussion of Walter Bagehot and nineteenth-century Britain, the central bank would lend as “lender of last resort” at a high rate of interest (the “discount rate”). In principle, the CB can use this discount rate as a monetary policy tool. By increasing or decreasing the discount rate, the CB discourages or encourages bank borrowing, respectively. The greater the bank borrowing from the CB, the more likely it is that the bank will lend to borrowers in the real economy.

We also recall that the CB’s “lender of last resort” function required the borrowing bank to pledge high-quality collateral to the CB. The CB has discretion to define “high-quality collateral” and the “OC ratio” in which “OC” stands for “over-collateralization.” To borrow $100 million, for example, a bank may need to pledge $102 million of government debt securities. In this case the OC ratio would be 102%. By lowering the OC ratio and/or broadening the types of collateral denoted as “high-quality,” the CB will make this “discount window” borrowing more attractive for the bank and thereby act to increase the money supply.

Historically, setting the discount rate has not been a highly effective tool of monetary policy simply because discount window lending has been infrequent. In the past, banks avoided borrowing from the CB for fear of disclosing their precarious position to the world. The popular descriptive phrase was “the stigma of the discount window.” With the Credit Crisis beginning in 2008, however, global central banks ardently pressed loans on their countries’ banks to dispel liquidity panics. In the best example, the ECB lent more than €1 trillion to Eurozone banks in “long-term refinancing operations” (LTRO) in late 2011 and early 2012. Unlike typical CB discount window lending, these ECB LTRO loans specified a low interest rate of one percent per annum and permitted a broad range of collateral quality with market value arguably less than the loan amount.[11]

In the next excerpt, we will continue the discussion of monetary policy tools with the most effective tool over the longest period of time – “open market operations.”

[1] See the statements of the Federal Reserve Bank of Chicago, the Federal Reserve Bank of Richmond, and the Federal Reserve System.

[2] http://www.bankofengland.co.uk/about/Pages/strategicplan/default.aspx

[3] See the statement of the Board of Governors of the Federal Reserve System.

[4] http://www.bankofengland.co.uk/about/Pages/default.aspx

[5] We defer to another chapter discussion of supervising and regulating banks and the larger financial system.

[6] See http://www.federalreserve.gov/paymentsystems/fedfunds_about.htm . For a broader discussion of Fed payment services, see http://www.federalreserve.gov/paymentsystems/default.htm .

[7] A. Fergusson, When Money Dies: The Nightmare of the Weimar Collapse, Kimber, 1975.

[8] See, for example, our reference to Keynes in chapter 7: J. M. Keynes, The Economic Consequences of the Peace, Rogers Fischer Publishing, 1919.

[9] See J. N. Feinman, “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, 1993.

[10] See, for example, M. McLeay, A. Radia, and R. Thomas, “Money creation in the modern economy,” Bank of England Quarterly Bulletin 2014 Q1, 2014.

[11] J. M. Pimbley, “The ECB should stop taking counterfeit collateral,” Creditflux, February 2012.

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.