"Bankers' Banks": The Role and Functions of Central Banks in Banking Crises

By: Sam Vaknin, Ph.D.


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I. The Credit Crunch of 2007-2012

As 2011 came to a close and in the first months of 2012, the European Central Bank (ECB) initiated a massive injection of liquidity into Europe’s embattled banking system. The ECB provided 3-year loans amounting to half a trillion euros at nominal and minimal interest rates. At first, the risk-averse banks re-deposited the funds with the ECB. Later, however, they embarked on an arbitrage operation of unprecedented proportions using the cheap money to purchase sovereign bonds with historically high coupons issued by the likes of Italy and Spain. Thus, the ECB ended up fostering yet another unsustainable bubble in sovereign obligations and threatening the balance sheets of the very institutions it seeks to prop up when the bubble inevitably bursts.

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.

In March 2008, the Fed lent 29 billion USD to JP Morgan Chase to purchase the ailing broker-dealer Bear Stearns and hundreds of billions of dollars to investment banks through its discount window, hitherto reserved for commercial banks. The Fed agreed to accept as collateral securities tied to "prime" mortgages (by then in as much trouble as their subprime brethren).

The Fed doled the funds out through anonymous auctions, allowing borrowers to avoid the stigma attached to accepting money from a lender of last resort. 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 and commercial paper. 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. In September 2008, the Fed even borrowed money from the Treasury when its own resources were depleted.

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."

Regulatory upheaval is sure to follow. Investment banks are likely to be subjected to the same strictures, reserve requirements, and prohibitions that have applied to commercial banks since 1934. Supervisory agencies and functions will be consolidated and streamlined.

Ultimately, the state is the mother of all insurers, the master policy, the supreme underwriter. When markets fail, insurance firm recoil, and financial instruments disappoint - the government is called in to pick up the pieces, restore trust and order and, hopefully, retreat more gracefully than it was forced to enter.

The state would, therefore, do well to regulate all financial instruments: deposits, derivatives, contracts, loans, mortgages, and all other deeds that are exchanged or traded, whether publicly (in an exchange) or privately. Trading in a new financial instrument should be allowed only after it was submitted for review to the appropriate regulatory authority; a specific risk model was constructed; and reserve requirements were established and applied to all the players in the financial services industry, whether they are banks or other types of intermediaries.

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.

III. The Case of Macedonia 1991-2006

The National Bank of Macedonia (NBM) is highly autonomous under the law regulating its structure and its activities. Its Governor is selected for a period of seven years and can be removed from office only when he is charged with criminal deeds. Still, it is very much subject to political interference. High ranking political figures freely admit to exerting pressures on the central bank (even as they insist that it is completely independent).

In Macedonia, until recently, when a new Law of the Central Bank was enacted, annual surpluses generated by the central bank were transferred to the national budget and could not be utilized by the bank for its own operations or for the staff training and re-skilling.

The NBM is young and most of its staff, though bright, are inexperienced. With the kind of wages that it pays it cannot attract the best available talents. The budgetary surpluses that it generates could have been used for this purpose and to hire world renowned consultants (from Switzerland, for instance) to help the bank overcome the experience gap.

So, in the past the bank had to do with charity received from USAID, the KNOW-HOW FUND and so on. Some of the help thus provided was good and relevant - other advice was, in my view, wrong for the local circumstances. Take bank supervision: it was modeled after the American and British experiences, whose bank supervisors are arguably the worst in the West (if we ignore the Japanese).

The bank also had to cope with extraordinarily difficult circumstances since its very inception. The 1993 banking crisis, the frozen currency accounts, the collapse of the savings houses (culminating in the TAT affair). Older, more experienced central banks would have folded under the pressure. Taking everything under consideration, the NBM has performed remarkably well.

The proof is in the stability of the local currency, the denar. Currency stability is widely thought to be the main function of a central bank. After the TAT affair, there was a moment or two of panic and then the street voted confidence in the management of the central bank, the denar-deutschmark rate reverted to where it was prior to the crisis.

Still, bank supervision needs to be overhauled and lessons need to be learnt. The political independence of the bank needs to be enhanced. The bank must decide what to do with TAT and with the other failing institutions. The issue of who can own banks is high on the agenda with the liquidation of Makedonska Banka, forced on it by the central bank in 2007.

Failing banks can be sold to other banks as portfolios of assets and liabilities. The Bank of England sold Barings Bank in 1995 to the ING Dutch Bank.

The central bank could - and has to - force the owners of failing financial institutions to increase their equity capital (by ploughing in their personal property, where necessary). This was successfully done (again, by the Bank of England) in the 1991 case of the BCCI scandal.

The State of Macedonia could decide to take over the obligations of the failed system and somehow pay back the depositors. Israel (1983), the USA (1985/7) and a dozen other countries have done so recently.

The central bank could increase the reserve requirements and the deposit insurance premiums.

But these are all artificial, ad hoc, solutions. Something more radical needs to be done:

A total restructuring of the banking system. Savings houses have to be abolished. The capital required to open a bank or a branch of a bank has to be lowered (to conform with world standards and with the size of the economy of Macedonia). Banks should be allowed to diversify their activities (as long as they are of a financial nature), to form joint venture with other providers of financial services (such as insurance companies), and to open a thick network of branches.

And bank supervision must be separated from the central bank, so that it could criticize the central bank and its policies, decisions and operations on a regular basis.

There are no reasons why Macedonia should not become a financial centre of the Balkans and there are many reasons why it should. But, ultimately, it all depends on the Macedonians themselves.

Interview granted to “Kapital”, Republic of Macedonia, February 2011

In small countries, there are incestuous relationships between the central bank and the banking system. The same people move from the private to the public sector and back; the central bank defends the interests of the banking system in order to maintain its stability and profitability; the central bank covers up for political intervention in the banking system and the resulting bad loans. The solution is to remove the function of bank supervision from the the central bank. Bank supervision should be a separate, autonomous, expert, and apolitical body.

Ideally, the governor of the central bank should be elected by a committee of professionals from a list of candidates submitted by the government. The body that vets the new governor should be composed of professors of economics, former governors, former Ministers of Finance, retired bankers, and even foreign experts. No incumbent politicians or active bankers should be members. The recommendation of the Committee should be approved or rejected by the Board of Directors of the central bank. If it is accepted by the Board, the chosen person automatically becomes governor (subject to approval by parliament), without further government involvement.


In reality, though, to render the process transparent, the following steps would suffice:

1. The government will publish a kind of TENDER for the job of governor and anyone qualified could apply (in Bulgaria both the government AND the opposition submit candidates) OR the government will establish a public "Register of Candidates" from which the governor will be elected (like in Australia);

2. The government's reasons for recommending someone or rejecting another will be PUBLISHED and time will be given to contest the decision or for the public's input (USA, Israel);

3. The Board of Directors will choose the next governor from a LIST submitted by the government and their reasons will also be made public (most countries in the world).

4. Parliament will have the right to REJECT the candidate (like in the USA).


Also Read

The Business of Risk

Moral Hazard and the Survival Value of Risk

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

Hawala, or the Bank that Never Was

Austrian Banking - An Interview with Wolfgang Christl

Bankers in Denial


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