Central Banks

History of Bank of England

The Bank of England was founded in 1694 and is the second oldest central bank to exist after the Swedish central bank, which was established in 1668. William Paterson was one of the founders of the BoE; he raised £1.2 million for the BoE to use as initial capital, which was lent to the government in return for a Royal Charter. In 1844, the government wrote the ‘Bank Charter Act 1844’, this gave a monopoly to the BoE in printing and issuing notes in the London area, (further areas were granted since its establishment and got expanded with a new loan to the government). The remainder of the 19th century saw the BoE further develop its function as a lender of last resort by having a large run of successful bailouts, two major ones being in 1866 (Overend and Gurney) and in 1890 (Barings).

Definition of central bank

To define of a Central Bank varies from textbook to textbook, and from central bank to central bank comprehensively, there will be a comparison between a textbook theoretical definition and definitions provided by central banks themselves. Mishkin defines a CB to be ‘the government agency that oversees the banking system and is responsible for the amount of money and credit supplied in the economy’.

The role and functions of the Bank of England are:

  •  Issue bank notes
  •  Store gold reserves for actors
  •  Carry our monetary policy – set the ‘bank rate’, achieve the government inflation target, carry out quantitative easing
  •  Maintain financial stability – act as a lender of last resort, produce high quality notes that are hard to counterfeit so the public has confidence the tender they use is genuine.

Thus, upon the examination of the above definition of a CB by Mishkin, the BoE and the FED, we can distinguish that a CB is defined by the roles and functions it serves. Although the exact roles and functions of central banks vary between countries, their main goals/functions are to achieve the following:

1) Price Stability i.e. low inflation 2) High Employment (which mainly applies to the US Fed), 3) Economic Growth 4) Financial Market Stability 5) Interest-Rate Stability.

What must be noted is that, while all central banks have a single mandate of achieving price stability (except the FED, who have a dual mandate), they all also have secondary targets, with a hierarchy of importance placed on them by each respective central bank, which they decide at their own discretion.

Price Stability

Price stability is defined as having low and stable inflation, the BoE pursue price stability by having an inflation target of 2%. Likewise, the FED pursues an inflation target of 2%, as it offers them the most reliable chance of attaining their dual mandate of price stability and maximum employment.

High Employment

The goal of high employment is something that the FED places a much heavier emphasis on, in comparison to the other central banks of the world. This is apparent in the fact they have a dual mandate to achieve. This is because of changes in the FED statutes along time in more ‘Keynesian’ years, after the Great Depression etc. In reality, all central banks target inflation but also look at the GDP growth and unemployment; but they are aware economic growth is not determined by monetary policy but supply side policies over the long term.

Economic Growth

While economic growth (a long-term expansion of the productive potential of the economy), is closely linked to the goal of high employment, because high employment means the resources in the economy are being utilised leading to growth. Economic growth is much broader, and is to do with supply-side economic policies i.e. giving tax incentives to firms to invest in new facilities and equipment increasing the productive potential of the economy.

Financial Market Stability

Financial market stability has seen an increase in importance since it was one of the main reasons as to why the financial crisis occurred in the first place was because people lost confidence in their banks and rushed to remove their deposits from their respective banks, this is referred to as a bank run, which was experienced by Northern Rock, and ultimately led to their collapse, and nationalisation.

Interest-Rate Stability

Interest rate stability is very desired, as instability in the interest rate creates uncertainty and makes it much harder for consumers to adjust their spending habits. In particular, it could affect consumers’ willingness to undertake large purchases such as real estate. This is due to the fact consumers are unsure as to when it is the right time to buy so, they can benefit from low interest rates, thus reducing the cost of borrowing.

In relation to firms, it affects their ability to buy capital or invest, as they simply do not know when to invest due to the fluctuations present in the interest rate.

Lender of last resort

The role of ‘lender of last resort’, means that the CB provides reserves to financial institutions when no one else would provide to them to prevent a financial crisis. The LOLR is a tool that is deployed at times of crisis to help maintain financial stability. The LOLR isn’t a goal for the CB to achieve unlike the other goals mentioned in this section; rather it is a function they have the ability to carry out. The BoE is considered the model LOLR due to its strict adherence to the classical rules of LOLR described by Henry Thornton and Walter Bagehot.

The BoE very heavily used the LOLR during the financial crisis of 2008, the most famous case being that of Northern Rock. Northern Rock was the first bank to experience a bank run in 143 years, the last bank run being the Overend and Gurney Crisis of 1866. The aftermath of the financial crisis saw waves of new measures to accommodate commercial banks in case of situations of illiquidity. New schemes such as the Special Liquidity Scheme were introduced in 2008, to help improve the liquidity position of banks by ‘allowing banks and building societies to swap their high quality mortgage-backed and other securities for UK Treasury Bills for up to three years.

Tools available to a CB

To achieve their goals, central banks have at their disposal a range of tools; these include but are not limited:

1) Open market operations 2) Discount lending 3) Reserve requirements and 4) Interest paid on reserves 5) Quantitative easing.

Open market operations

OMO’s is the process of a CB buying and selling bonds in the open market, to increase (by buying) or decrease (by selling) the monetary base, expecting for the money multiplier to increase the money supply. This tool is considered the primary determinants of fluctuations in interest rates and monetary base.

Discount lending/discount rate

Consumers have the ability to visit a commercial bank to take care of our borrowing needs, commercial banks have the opportunity to do the same, however on a much larger scale. They do this by approaching other commercial banks and borrowing from the ‘interbank lending market’, the rate at which they borrow is referred to as ‘LIBOR – London interbank offered rate’ or in the US it is referred to as the ‘Federal Funds Rate’. This being the interest rate at which commercial banks offer to lend funds to another commercial bank. However, the rate at which a CB lends money to a commercial bank is said to be the ‘discount rate’. The discount rate is the penalty rate charged for extraordinary (overnight) lending. This interest rate is usually 1% higher than the Federal Funds Rate, the 1% acting as a penalty because the FED prefers interbank lending.

Reserve requirements

Reserve requirements are a regulatory tool, which makes it ‘obligatory for depositary intuitions to keep a fraction of their deposits in accounts with their CB’. From 1981 until 2009, commercial banks made a voluntary pledge as to the levels of reserves they kept with the BoE. Now, commercial banks must keep a minimum reserve requirement. However, there is a country that is an exception to this, the central bank of Canada.

Interest paid on reserves

After the financial crisis, regulatory measures were heavily implemented on the reserve requires as stated above, in order to prevent a bank run from occurring, something that happened to Northern Rock in 2008, right in the midst of the crisis. On the 14th of September 2007 the BoE provided liquidity, however, it wasn’t enough to prevent Northern Rock from needing severe intervention, in this case (nationalisation). Since then, as mentioned above, there is now a minimum level of reserves each commercial bank must keep with their CB. As an incentive, any amount of extra reserves kept at the central bank benefit from gaining interest. The FED currently offers 1.25% interest rate on excess reserves (IOER).

Quantitative easing

Quantitative easing (QE) is a very unconventional tool in comparison to OMO’s, which are the most regularly used tool by central banks. It is the process of creating new money instantly via electronic methods to buy financial assets such as government bonds.  This instant injection of money is meant to increase the money supply, and thus return inflation to its target level.

Independence

The economic theory present in academia in the period of the 1960’s up until 1980’s, saw the emerging concept of independence of central banks, papers such as Barro and Gordon 1983 (cited from Capie and Wood 2013) gave prominence to this form of thinking. New Zealand was the first to be intuitive and take a practical step forward from the academia to implement this thinking. This meant that they were the first country to mandate independence to their national CB in 1989 by the ‘Reserve Bank of New Zealand Act’. The successful implementation by New Zealand led to numerous other countries following suit; the Bank of Japan (BoJ), the European CB (ECB) and the Bank of England (BoE), with the BoJ act 1997, the Maastricht Treaty 1997 and the BoE Act 1998 respectively. The timing of these structural changes is not mere coincidence, rather this change in the institutional framework was carried out at a time of economic prosperity, the respective countries saw growth of 1.077% (Japan), 2.721% (EU) and 3.191% (UK).

Due to its historical significance, a CB is now seen to be an integral part of the economic structure of a nation. Being an institute and policy maker in its own right, it is responsible and accountable for a country’s monetary policy. However, in recent times it has come under critique by economists for the handling of the 2007-2008 Financial Crisis. Up until 2006, central banks and central bankers were considered to be ‘omnipotent’ in the eyes of the public and government, as quoted from Gabriel Stein. Independence can be classified into three different types: legal, goal and operational.

Legal

Legal independence is simply whether a CB has been given independence from a legal perspective. The majority of countries do have legal independence given to them by statute law. In the example of our two case studies the BoE and FED, both have legal independence via the BoE Act 1998 and the Federal Reserve Act 1913 respectively.

Goal

Goal independence is whether, the goals that have been set for a central bank to achieve, were they decided by the central bank or by any other institution. In this format, we slowly start to unravel differences in the level of independence between our two examples. The main goal of the BoE is to attain price stability by a low inflation target of 2%. The Chancellor of the Exchequer sets this inflation target every year in the annual budget statement.[xxxii] Thus, the BoE does not have goal independence.

On the other hand, the Federal Open Market Committee, a branch of the FED, decides the inflation target for the FED. Therefore, the FED is also goal independent too. Because the FED has a dual mandate, it has the ability to pick and choose between goals and justify why they haven’t managed to carry out a policy effectively simply by stating there is a conflict of goals. However, the BoE is accountable to the government and if the inflation target is missed by +/-1%, they must write a letter to the chancellor explaining why they’ve missed their target.

Operational

Finally, we have operational independence; operational independence is whether the central bank has the ability to pursue its goals in whatever way it believes has the best chances of achieving their goals. The BoE in terms of operational independence can be regarded as an independent institution, as the central bank is able to choose any tool they have available to them to pursue their goals. They are free from governing by the government, as the ‘bank’s strategy and key decisions on spending’ are determined by the Court of Directors. The FED also has operational independence, but one could argue to a much larger extent. There are several reasons; the Board of Governors serve a fourteen-year term. This long-term position means that any political influence is drastically reduced, as a Board of Governor does not have to worry about being removed from office if he or she does not conform to the political pressures presented to him/her. This means that they can carry out actions with the intention of benefitting the US economy, rather than to benefit a political power to influence elections etc. The term is also not renewable, so any Board of Governors do not have any incentive to carry our favours in an attempt for re-election.