Last month I had the pleasure to contribute to the IIMR/IEA annual monetary conference (8 November 2017) in London, ‘Has Financial Regulation Gone Too Far? And do banks really need all the extra capital?‘. I gave a short talk in session 3, ‘The role of the central bank in financial regulation‘, chaired by Charles Goodhart (LSE), on the essential nature of central banks as banking institutions. It may sound silly to state the obvious but, as my good friend, mentor and excellent colleague – Pedro Schwartz – always reminds me, we should not take for granted the fundamentals in economics, even less in money and central banking. Let me then start by saying that modern central banks were established to cope with two major tasks: (1) to be the bankers of the State (the Bank of England and other continental European central banks are good examples of this, see here) but also (2) to become the bankers of the banks in monetary systems operated under a fractional reserve (again, the Bank of England is the first modern central bank in this regard); the latter is what we call the lender of last resort function of central banks.
In the early years of the establishment of central banks, with the running of the gold standard, strictly speaking, there was no monetary policy nor the pursue of a macroeconomic target as we understand it now; but a bank of issue with a privilege position in the monetary market, and mainly focused on maintaining the convertibility of its currency at the pre-announced rate. It was only quite recently (historically speaking), after the abandonment of the gold standard in the interwar years, that central banks have explicitly adopted or given other tasks, and indeed macroeconomic tasks, such as keeping price stability or achieving economic growth.
But we should not forget that central banks are at the core of the monetary system and the banking sector, providing financial services to a ‘club’ of commercial banks which create money in the currency issued by the central banks. Which money? ‘Bank money’, that is, bank deposits under a fractional reserve system. This money constitutes the bulk of the money supply in modern economies, and it is vital for the central bank to keep a steady growth of the amount of money in circulation to preserve stable and long term economic growth; thus avoiding too much money during the expansion of the economy or too little in a banking crisis. What I state in my talk is that privately-owned central banks are genuinely interested in maintaining financial stability, and thus will be willing to intervene in a liquidity crisis much more promptly and efficiently than a central bank under the shadow – if not the control – of the State. This is something I have supported in other articles (recently in this article), and my colleague at the IIMR, Tim Congdon, has written on (see chapter 7 in ‘Central Banking in a Free Society‘).
This is the video of the talk:
Comments are very welcome as ever!
Juan Castañeda
PS. To the best of my knowledge the characterisation of central banks as the bankers of a ‘club’ was first coined by Charles Goodhart in his seminal 1988 book, ‘The Evolution of Central Banks‘, a book anyone interested in the history and functions of central banks must read. However, unlike Goodhart’s position in his book, I do not see a conflict of interest for a self-interested central bank to become a lender of last resort in times of crisis. Actually, central banks did make a profit when lending in times of crisis, such as the Bank of England in several banking crises in the 19th century.
the old lady of threadneedle street 