Central Banks and the Credit Crunch of 2007

By: Sam Vaknin

I. The Credit Crunch of 2007

The global credit crunch induced by the subprime mortgage crisis in the United States, in the second half of 2007, engendered a tectonic and paradigmatic shift in the way central banks perceive themselves and their role in the banking and financial systems.

On December 12, 2007, America's Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank, as well as Japan's and Sweden's central banks joined forces in a plan to ease the worldwide liquidity squeeze.

This collusion was a direct reaction to the fact that more conventional instruments have failed. Despite soaring spreads between the federal funds rate and the LIBOR (charged in interbank lending), banks barely touched money provided via the Fed's discount window. Repeated and steep cuts in interest rates and the establishment of reciprocal currency-swap lines fared no better.

The Fed then proceeded to establish a "Term Auction Facility (TAF)", doling out one-month loans to eligible banks. The Bank of England multiplied fivefold its regular term auctions for three months maturities. On December 18, the ECB lent 350 million euros to 390 banks at below market rates.

Interest rates for most lines of credit, though, were set by the markets in (sometimes anonymous) auctions, rather than directly by the central banks, thus removing the central banks' ability to penalize financial institutions whose lax credit policies were, to use a mild understatement, negligent.

Moreover, central banks broadened their range of acceptable collateral to include prime mortgages. This shift completed their transformation from lenders of last resort. Central banks now became the equivalents of financial marketplaces, and akin to many retail banks. Fighting inflation - their erstwhile raison d'etre - has been relegated to the back burner in the face of looming risks of recession and protectionism.

As The Economist neatly summed it up (in an article titled "A dirty job, but Someone has to do it", dated December 13, 2007):

"(C)entral banks will now be more intricately involved in the unwinding of the credit mess. Since more banks have access to the liquidity auction, the central banks are implicitly subsidising weaker banks relative to stronger ones. By broadening the range of acceptable collateral, the central banks are taking more risks onto their balance sheets."

II. Central Banks

Central banks are relatively new inventions. An American President (Andrew Jackson) even dispensed with his country's central bank in the nineteenth century because he did not think that it was very important. But things have changed since. Central banks today are the most important feature of the financial systems of the majority of countries.

Central banks are bizarre hybrids. Some of their functions are identical to those of regular, commercial banks. Other tasks are unique to the central bank. On certain functions it has an absolute legal monopoly.

Central banks take deposits from other banks and, in certain cases, from foreign governments which deposit their foreign exchange and gold reserves for safekeeping (for instance, with the Federal Reserve Bank of the USA).

The Central Bank invests the foreign exchange reserves of its country while trying to maintain an investment portfolio similar to the trade composition of its client: the state.

The Central bank also holds onto the gold reserves of the country. Most central banks have until recently tried to get rid of their gold, due to its ever declining prices. Since the gold is registered in their books in historical values, central banks have shown a handsome profit on this sideline of activity.

Central banks (especially the US Fed) also participate in important, international negotiations. If they do not do so directly, they exert influence behind the scenes. The German Bundesbank virtually dictated Germany's position in the give-and-take leading to the Maastricht treaty. It forced the hands of its co-signatories to agree to strict terms of accession into the euro single currency project. The Bundesbank demanded that a country's economy be totally stable (possessed of low debt ratios and low inflation) before it is accepted into the eurozone. It is an irony of history that Germany itself is no longer eligible under these criteria and would not have been accepted as a member in the very club whose rules it had assisted to formulate.

But all these constitute a secondary and marginal plank of a central banks activities.

The main function of a modern central bank is the monitoring and regulation of interest rates in the economy.

The central bank does this by changing the interest rates that it charges on money that it lends to the banking system through its "discount windows".

Interest rates are supposed to influence the level of economic activity in the economy. This purported linkage has not been unequivocally substantiated by economic research. Also, there usually is a delay between the alteration of interest rates and the foreseen impact on the economy as "transmission mechanisms" set into gear.

This makes an assessment of interest rate policies difficult. Still, central banks use interest rates to fine tune the economy. Higher interest rates lead to lower economic activity and lower inflation. The reverse is also supposed to be true. Even shifts of a quarter of a percentage point are sufficient to send stock exchanges tumbling together with bond markets.

In 1994, a long term trend of increase in interest rates commenced in the USA, doubling them from 3 to 6 percent. Investors in the bond markets lost 1 trillion (that's 1000 billion!) US dollars within twelve months. Even today, currency traders all around the world dread the decisions of the Federal Reserve ("Fed") or the European Central Bank (ECB) and sit with their eyes glued to their trading screens on days in which announcements are expected.

Tinkering with interest rates is only the latest in a series of fads of macroeconomic management. Prior to this - and under the influence of the Chicago school of economics - central banks used to monitor and manipulate money supply aggregates. Simply put, they would sell bonds to the public (and, thus absorb liquidity), or buy them from the public (and, thus, inject liquidity). Additionally, they would restrict the amount of printed money and limit the government's ability to borrow.

Prior to the money supply craze, and for decades, there was a widespread belief in the effectiveness of manipulating exchange rates. This was especially true where exchange controls were still being implemented and currencies were not fully convertible. Britain removed its exchange controls only as late as 1979. The US dollar was pegged to a (gold) standard (and, thus not really freely convertible) as well into 1971. Free flows of currencies are a relatively new thing and their long absence reflects this deeply and widely held superstition of central banks.

Nowadays, exchange rates are considered to be a "soft" monetary instrument and are rarely used by central banks. The latter continue, though, to intervene in the trading of currencies in the international and domestic markets usually to no avail and while losing their credibility in the process. Ever since the ignominious failure in implementing the infamous Louver accord in 1985, currency intervention is considered to be a somewhat rusty relic of the old ways of thinking.

Central banks are heavily enmeshed in the very fabric of the commercial banking system. They perform certain indispensable services for the latter. In most countries, interbank payments pass through the central bank or through a clearing organ which is somehow linked or reports to the central bank. All major foreign exchange transactions are funneled through - and, in many countries, still must be approved by - the central bank. Central banks regulate banks, licence their owners, supervise their operations, and keenly monitor their liquidity. The central bank is the lender of last resort in cases of banking insolvency or illiquidity (aka a "run on the banks").

The frequent claims of central banks all over the world that they were surprised by this or that a banking crisis look, therefore, dubious at best. No central bank can say, with a straight face, that it was unaware of early warning flags, or that it possessed no access to all the data. Impending banking crises give out signals long before they erupt. These precursors ought to be detected by a reasonably managed central bank. Only major neglect could explain why a central bank is caught unprepared.

One sure sign is the number of times that a certain bank chooses to borrow from the central bank's discount windows. Another is if it offers interest rates which are way above the rates proffered by other financing institutions. There are many more tocsins and central banks should be adept at reading them.

This heavy involvement of central banks in the banking system is not limited to the collection and analysis of data. A central bank, by the very definition of its functions, sets the tone to all other banks in the economy. By altering its policies (for instance: by changing its reserve requirements), it can push banks into insolvency or create asset bubbles which are bound to burst.

If it were not for the easy and cheap money provided by the Bank of Japan in the eighties, the stock and real estate markets would not have inflated to the extent that they have. Subsequently, it was the same bank (under a different Governor) that tightened the reins of credit and pierced both bubble markets. The same mistake was repeated in 1992-3 in Israel - and with the same consequences. The pattern recurred in the USA with the Fed during the late 1990s and early 2000s.

This precisely is why central banks, in my view, should not supervise the banking system. When asked to supervise the banking system, central banks are really expected to criticize their own past performance, their policies, and their vigilance.

In most countries in the world, bank supervision is a heavy-weight department within the central bank. It samples the balance sheets and practices of banks periodically: it analyses their books thoroughly and imposes rules of conduct and sanctions where necessary.

Yet, the role of central banks in determining the health, behaviour and methods of operation of commercial banks is so paramount that it is highly undesirable for a central bank to supervise them. To reiterate, bank supervision carried out by a central bank means that the central bank has to criticize itself, its own policies and the way that they were enforced as well as objectively review the results of past supervision. Central banks are thus asked to cast themselves in the impossible role of self-sacrificial and impartial saints.

A new trend is to put the supervision of banks under a different "sponsor" and to construct a system of checks and balances, wherein the central bank, its policies and operations are indirectly criticized and reviewed by the supervision of banks. This is the case in Switzerland where the banking system is extremely well regulated and well supervised.

There are two types of central bank: the autonomous and the semi-autonomous.

The autonomous central bank is politically and financially independent. Its Governor is appointed for a period of time which is incommensurate with the terms in office of incumbent elected politicians, so that he is not subject to political pressures. The autonomous central bank's budget is not provided by the legislature or by the executive arm. It is self sustaining: it runs itself as a corporation would. Its profits are used in leaner years in which it loses money.

Prime examples of autonomous central banks are Germany's Bundesbank and the American Federal Reserve Bank.

The second type of central bank is the semi autonomous one. This is a central bank that depends on political parties and, especially, on the Ministry of Finance. Its budget is allocated to it by the Ministry or by the legislature.

The upper echelons of such a bank - the Governor and the Vice Governor - can be impeached by politicians. This is the case with the National (People's) Bank of Macedonia which has to report to Parliament. Such dependent banks fulfill the function of an economic advisor to the government. The Governor of the Bank of England advises the Chancellor of the Exchequer (in their famous weekly meetings, the minutes of which are published) about the desirable level of interest rates. The situation is somewhat better with the Bank of Israel which can play around with interest rates and foreign exchange rates - but is still not entirely freely.

Also Read

The Greatest Savings Crisis in History

The Typology of Financial Scandals

The Bursting Asset Bubbles

(Case Studies: The Savings and Loans Crisis, Crash of 1929, British Real Estate)

Danger - Banks Ahead!

Is Our Money Safe?

The European Bank for Retardation of Development

HawalaBusiness Management Articles, or the Bank that Never Was

Austrian Banking - An Interview with Wolfgang Christl

Bankers in Denial


» More on Banking