Central Banks play an important role in monetary
policy in their countries. If one traces their history it goes back to the era
of the goldsmith, where paper money originated. In the United States,
depositors left their gold at goldsmiths’ vaults, and in return, they received
paper as a claim for their gold to redeem. This paper circulated as paper money
and paper money was in effect in the United States until 1970’s, when the
United States abandoned the gold system.
The Bank of England was created in 1694 as a monopoly,
provided liquidity, because it required depositors to hold an amount of
deposits, and could back out any bank. The Bank of England eventually became a
government bank and independent. In the 1800’s, the United States past the
National Banking Act, and required banks to keep deposits with the Treasury to
back their currency. Eventually in 1913 the United States adopted the UK model,
and created the Federal Reserve by an act of Congress.
The Federal Reserve required banks to keep deposits in
currency in the event a bank faced a liquidity problem; hence the Federal Reserve
became a lender of last resort. If banks wanted to borrow money, they would
bring their securities to the FED as collateral.
The FED required the banks to hold a minimum amount of
deposits on reserve, called the reserve requirement. The problem was that this
was not enough since banks began to fail and were responsible for several
financial crises. The first such failure created the banking crisis of 1929
with all the banks shutting down and created a bank run, and eventually the
first recession in the US. To prevent from recurring the FED created the
Federal Deposit Insurance Corporation as deposit insurance. It also controlled
the money supply and interest rates.
The FED also created the Federal Open Market Committee,
which decided rate at which banks borrowed overnight, called the Federal Funds
Rate. It is an overnight interest rate on loans to bank members among
themselves. This was a tool that stabilized the economy.
If one looks at the balance sheet of banks they have
assets and liabilities. Liabilities are depositors money. So if one deposits
money in the bank in cash, it not only becomes an asset for the bank, but also
a liability. If depositors request their money the bank has to come up with the
money. But can one imagine what would happen if ALL depositors charge at the
same time in banks requesting their money? What would happen to liquidity of
the financial system? And what causes such a bank run?
So banks are required to hold a percentage of their
deposits in reserve, and as a way to attract this US FED offered them an
interest rate. This was a tool to control the economy, since a rise in the
reserve requirement would require banks to hold more on reserve, thus affect
the money supply. Banks would require to keep more on reserve, thus lend less
to businesses, thus shrink the money supply.
As for the interest rate charged for overnight
borrowing between banks, called the Federal Funds rate, the US central Bank
controls this by buying and selling Treasury bills in the open market. This is
called Open Market Operations. It affects supply and demand for short term
credit.
It seems that whatever central banks did to prevent
financial crises failed since they were recurring from time to time. After the
recession of 1939, there were other banking crises like the savings and loans
of the 1980’s, which the US government came to their rescue by providing over
$150 billion, the 2008 banking crisis where again the US government came to the
rescue of the banking system, but not all and rescued many commercial banks and
those that were involved in mortgages, in the savings and loans. The US did not
bail out Lehman brothers, even though it was an investment bank.
These moves were to prevent a bank run and restore, or
not destroy confidence in the banking system. The same happened in 2007 with Northern
Rock Bank in the UK. The deposit insurance prevented a bank run.
In Basel Switzerland at a meeting of the G20, they
decided what to do with bank regulations so they set a recommendation which
will be gradually implemented until 2019. In fact they made so many changes
that they named it Basel I, Basel II, and Basel III (2010), which is where we
stand today. Base I decided to set besides reserve requirements, capital
requirements. A requirement on how much capital banks should hold, in the event
their risky securities go bad, and set risk weighted assets. It is clear that
many banks gave out loans affluently, to satisfy political cliques. In Greece
for example, many loans were given out by banks without collateral, but since
the banks were(are in the process of ) recapitalization, many banks were
prevented from defaulting. It was a form a a bank rescue by the Troika and as a
requirement in the Memorandum signed by Greece in its bail out from default.
So the idea was to set percentage to various risky securities
and the amount the bank must hold on reserves. So for example, for government
bonds, they would set 0%, since there is not risk associated. For municipal
bonds issued by cities, you have more risk; hence banks must hold 20% in
capital requirements, while loans to businesses, 100% weight.
So risk weighted assets was the amount of capital
banks must hold. In Basel III, common equity (issued by raising shares) must be
4.5%, plus 2.5% as a capital buffer, or 7%, plus another 2.5% if regulators believe
it is necessary, in times of financial difficulties in raising capital like in
a financial crisis. For example, Greek banks with capital investment overseas
have difficulty in selling their assets to raise capital since the financial
crisis has spread.
The whole idea was in predicting a bubble, avoiding a
bank run. But because banks were in the business of issuing bonds, commercial paper
to borrow, and loans, and since the
public is in no way capable of judging the quality of such investments, or what
the banks do with the capital raised, they decided to keep a tight monitoring
on them. This is the Morale Hazard problem. Having common equity would be enough
to sustain a banking crisis than trying to issue new shares or selling
corporate loans.
