Survey of International Finance - Assignment Example

An examination of the key roles of the central bank in an economy and why the lender of last resort function is controversial BY YOU YOUR SCHOOL INFOHERE DATE HERE Introduction In an economy, the role of the central bank is to be an institution that supervises a national currency, manages interest rates and controls the money supply. Central banks establish an economy’s reserve requirements and manage the entire commercial banking system in an effort to develop strategies to ensure that bank runs do not occur. In the event of a major economic crisis or irresponsible bank behaviour, the central bank serves as the lender of last resort when commercial banks experience insolvency or struggle otherwise in the face of a major economic crisis (Baker and Riddick 2012). The basic foundation of a central bank serving as a lender of last resort is that in an economy, panics can occur which leads to bank runs. In such a situation, those maintaining deposits in commercial banks withdraw their funds from the bank as a result of economic speculation or fear over negative economic consequences. During a bank run, commercial banks can become insolvent, requiring the assistance of an institution (the central bank) to ensure that banks maintain liquidity is such a phenomenon occurs. Being the lender of last resort has become controversial, especially considering events during the recent global economic recession where many central banks injected capital into banks that were facing insolvency. Over-reliance on the central bank impacts other sectors in an economy. This essay explores the role of the central bank, emphasising why being a lender of last resort maintains many controversial implications from multiple perspectives. Evidence is that the controversy hails from irresponsible banking management and from poor fiscal policy developments concocted by the central bank itself. Why being the lender of last resort is controversial Central banks supply liquidity insurance to the commercial banking system which consequently endows liquidity insurance to other aspects of an economy, including corporations. Funds available for this action in a central bank encompasses notes held by public investors and reserves (deposits) sustained by a nation’s banks. These funds are manifested by the central bank as a result of autonomous will assuring that its value is comparable to products and services value in the economy. It is through these activities that an economy achieves macroeconomic stability. Concurrently, the central bank mandates the reserves that must be held by banks to insulate them from potential bank runs. Therefore, the central bank guarantees that commercial banks meet stringent standards of ensuring solvency. However, in 2007, many commercial banks faced a significant liquidity problem. Banks encompassing models that extended beyond merely deposits realised that considerable profit could be achieved in providing consumer home loans and in the capital markets. For example, banks began offering adjustable rate mortgages that were becoming highly attractive to many consumer segments unable to procure a mortgage as a result of their personal credit problems. Between the years 2000 and 2005, adjustable rate mortgages were providing banks with substantial profit as a result of having the capability to hike mortgage interest rates for risky consumer segments. In the United States, the Tax Reform Act of 1986 allowed consumers in the country to receive massive tax deductions for interest on mortgage loans, further incentivising consumers to gain home loans at substantially-high interest rates (Volpe and Mumaw 2009). Banks, in their thirst for profit, maintained little foresight that consumers might default on these adjustable rate mortgages. By 2007, major commercial banks engaging in this high risk practice were holding substantial loan-related debt due to default which could not be offset by their deposit reserves. To further illustrate the irresponsibility of banks during this period, Bear Stearns, a global investment bank, maintained an exposure of $2.25 trillion in the credit default swap market, which far exceeded its liquid asset capabilities. Credit default swaps, securitised banks that have the intention of transferring credit risks to a buyer (instead of the seller), were often issued as mortgage-backed securities (Satyajit 2005). Buyers of a credit default swap contract maintain absolute liability in relation to the investment, but are guaranteed to receive a substantial reimbursement in the event that this type of financial security experiences mortgage defaults. With many banks now holding investments, mortgage-backed securities and defaulted consumer mortgages, they faced massive insolvency problems which forced them to turn in desperation to the central bank to receive capital that could avoid bankruptcy. Prior to the 2008 recession, many banks that maintained billions or trillions of Pounds in exposure in the credit default market could not find buyers for these securities which amplified the problem of insolvency (Cohan 2009). At the time, there was poor government regulatory guidelines that controlled banking management activity in the asset-backed securities industry which allowed covetous banking executives to continue to expose their institutions to considerable risk even at the expense of the long-term stability of the national economy. The central bank, in an effort to ensure financial stability, provided bailout funds to these banking institutions that had recklessly engaged in adjustable rate mortgage provision and maintained high risk credit default contracts which far exceeded their liquidity capabilities. The Bank of England and the U.S. Federal Reserve provided billions upon billions to ensure that international banks did not face ongoing insolvency problems that would have devastated the global economy. The impact of this provision of bailout funds by central banks had massive consequences in many sectors of their respective economies. As the lender of last resort, the central banks overstepped their legal authority to provide assistance to insolvent firms (Humphrey 2010), in a desperate attempt to stabilise the global economy at the expense of taxpayers who rely on central bank capital to ensure micro and macro-level economic security. This illustrates why being the lender of last resort is extremely controversial. In an age of commercial banking irresponsibility and recklessness, banks recognise that the central bank will be an insurer that will step in during a crisis situation and provide capital even if the commercial bank engaged in careless strategy without regard toward the macro-level implications of poor strategy on a regional or international economic system. The central bank, by all legal statutes and authorities, should have (arguably) allowed these banks to fail as a result of their improper and reckless strategies in the same fashion as any other non-banking institution which fails as a result of their irresponsible management strategies. Whilst the aforementioned has placed blame on commercial banks and their irresponsibility in strategy development, culpability can also be placed on central banks and its level of oversight competencies as an overseer of commercial banks and economic policy. Central banks maintain the responsibility for ensuring that there is financial stability within an economy (De Grauwe 2013). One obligation is for the central bank to moderate long-term interest rates. The central bank creates policies that improve reserves in the banking system which, in turn, promotes more lending at a lower interest rate. This accelerates growth in important aspects of an economy including credit. No better example of central bank interest rate regulation can be provided than during the Great Depression. In the 1920s, emerging industrial nations were experiencing substantial economic growth that was occurring as a result of better consumer incomes and modernised production systems. Growth had experienced stability which was leading to over-confidence in the banking lending systems, credit markets, and the long-term capability of industries to ensure timely loan repayments. In the year 1929, debt had grown by 300 percent in comparison to GDP due to over-reliance on loans to finance business operations. This situation was leading to rapid inflation which prompted the American central bank to raise interest rates. Rather than having the desired inflationary impact, commercial loan issuances and procurement were de-incentivised and the United States’ credit-based economy witnessed massive decreases in the nation’s total money supply. In a situation where money supply is decreased, it leads to currency deflation (Boyes and Melvin 2005). This illustrates that in some fashion, the central bank during the late 1920s forced itself to become a lender of last resort as a result of poor fiscal policy and lack of foresight into the implications of raising interest rates on investor, bank management and public behaviours. A sudden, deflationary economy began to cause investors and banking managers to lose confidence in the global economy where interest rate increases were designed to mitigate inflation. Lack of confidence created a situation where commercial banks were witnessing bank runs, impacting their solvency levels, and where demand for industrial product output began to disappear as the unemployment rate increased rapidly as a result of firm and bank illiquidity. Industrial firm repayment of debt became complicated, further exacerbating banks’ ability to ensure solvency. In the situation of the Great Depression, it might be (arguably) the fault of the central bank for attempting to increase interest rates during a period of uncertainty and where debt to GDP had reached an unprecedented stage in global history. Therefore, to ensure that commercial banks maintained a position of positive liquidity, the central bank, as a product of its own lack of competency in controlling interest rates effectively, was forced to become a lender of last resort to struggling banks which, by no fault of their own management, became embroiled in an illiquid situation. To illustrate, the central bank has set the interest rate in the United States at nearly zero percent, and to raise the interest rate marginally would be met with considerable public backlash whilst letting it remain at this unprecedented level would also meet with erosion of investor confidence and banking management confidence. The central bank now utilises such activities as quantitative easing as a means of stabilising the economy in an environment where interest rates have been manipulated so frequently in the last decade that movement upward or further downward would have considerable macroeconomic consequences. Without a centralised authority to control the management competency of fiscal policy determined by various international central banks, the central bank’s attempt to manipulate interest rates to ensure financial stability can force this authority into a situation where it must become the lender of last resort due to its own lack of foresight into the long-term economic condition of a nation. Investors and commercial banks might argue that it is the central bank, itself, and its poor fiscal policy, that could create an insolvency problem related to the capital market and the banking industry that forces the central bank to become a lender of last resort. The central bank’s own competency in controlling fiscal policy and interest rates is what makes its becoming a lender of last resort so controversial. This was witnessed with American Federal Reserve Chairman Timothy Geithner who was called before Congress repeatedly to justify his methodologies in controlling American fiscal policy. As one individual put it: “Geithner is at heart a grifter, a petty con artist with the right manners and breeding to lie at the top echelons of American finance” (Stoller 2014, p.1). The lingering impact of quantitative easing and other questionable fiscal policies have led to many European austerity packages that are still in place in an effort to control lingering impacts on the economy of the 2008 recession. In the United States, lingering impacts of poor fiscal policy have led to several threats of government shutdown that maintained long-term consequences of using central bank reserves for a short-term bailout of struggling banks with liquidity problems in 2008. Hence, it should be said that in the age of corporate and banking recklessness, the central bank having to serve as the lender of last resort is controversial as central banks appear to use short-term methodology to stabilise an economy during a crisis situation when, in reality, these situations could have been better controlled with more competent central bank leadership. This was witnessed with the Bank of England providing billions of Pounds of capital support for struggling UK banks and also the United States with the Federal Reserve providing support for insolvency with banks and other firms. The central bank should be stabilising an economy by establishing more appropriate interest rate determinations, better controlling money supply and inflation rates. By being a resource that irresponsible banks and other institutions can turn toward when their poor decision-making has impacted the global economy, central bank interventions as a financial insurer to these institutions becomes a product of moral questionability which has implications for all stakeholders in a society. Conclusion The examples of the 2008 recession and the 1929 Great Depression serve as only two examples of why the central bank’s role as lender of last resort is so controversial. Poor fiscal management by the central bank, itself, can lead to forcing itself to become a lender of last resort. Concurrently, not having appropriate regulatory authority to control the irresponsible actions of corporate leaders and banking institutions force the central bank to determine bailout packages and other capital injections for banks that face illiquidity problems as a result of human recklessness and greed. If there were more appropriate regulatory guidelines forcing compliance to responsible banking strategy and central banks with leadership that understand how to more effectively control fiscal policy from a long-term perspective, the central banks around the world might very rarely have to become that lender of last resort. Fiscal policy development, corporate activity and banking activity are inter-dependent and the central bank must be instrumental in competently determining these inter-linkages when establishing fiscal policy and setting reserve requirements for banks. When the central bank does not effectively measure these intertwined dimensions of the economy, forcing itself to become a lender of last resort becomes controversial as this insurance could often be avoided through more careful examination of a national economy. References Baker, H.K. and Riddick, L. (2012). Survey of international finance. Oxford: Oxford University Press. Boyes, W. and Melvin, M. (2005). Economics, 5th edn. Cengage Learning. Cohan, W.D. (2009). House of Cards. New York: Doubleday. De Grauwe, P. (2013). The European central bank as lender of last resort in the government bond markets, Economic Studies, 59(3). Humphrey, T. (2010). Lender of last resort: what it is, whence it came, and why the Fed isn’t it, Cato Journal, 30(2), pp. 333–364. Satyajit, D. (2005). Credit derivatives: CDOs and structured credit products, 3rd edn. London: Wiley. Stoller, M. (2014). The con artist wing of the democratic party, Vice Media. [online] Available at: http://www.vice.com/read/tim-geithner-and-the-con-artist-wing-of-the-democratic-party (accessed 3 April 2015). Volpe, R.P. and Mumaw, K.E. (2009). Financial illiteracy and the subprime mortgage crisis, Journal of Business and Accounting, 2(1), pp.17-31. Read More