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This chapter deals with stability issues in the banking sector and the financial system. In particular, the first part of the chapter uncovers the principal causes of banking and financial crises. The second part looks at how central banks can foster financial stability by, for example, acting as lender of last resort or supervising commercial banks and the payment infrastructure.
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Time Magazine, 20 January 2014.
Of note, financial stability matters not only for economic reasons. Financial crises can also destabilise the political system. Indeed, in many cases, financial crises have led to social unrest caused by widespread frustration over the loss of savings, high inflation, mass unemployment, and so on.
For a thoughtful academic essay on the good and bad effects of the financial sector on society, see Zingales, Luigi, 2015: Does Finance Benefit Society?, Journal of Finance 70, pp. 1327–1363.
Other parts of the banking business, not discussed in detail here, include the exchange of money and wealth management. Furthermore, a whole range of financial services, including the raising of large amounts of capital for companies and governments, the arrangement of mergers and acquisitions, and the emission and trading of various securities, such as bonds and shares, on financial markets are summarised under the term ‘investment banking’.
In reality, the banking sector consists of a variety of depository institutions, savings institutions, investment banks, and various other financial intermediaries often appearing under slightly different names in different countries. The balance sheet of Fig. 5.2 is highly stylised and reflects the situation of a typical deposit bank.
See Admati, Anat, and Martin Hellwig, 2013: The Bankers’ New Clothes, Princeton University Press, pp. 93ff. See also Saunders, Anthony, and Marcia Millon Cornett, 2008: Financial Institutions Management - A Risk Management Approach, McGraw Hill, Ch. 10.
For a review of the economic effects of deposit-insurance schemes, see Demirgüc-Kunt, Asli, and Enrica Detragiache, 2004: Does deposit insurance increase banking system stability? An empirical investigation, Journal of Monetary Economics 49, pp. 1373–1406. There is a lively debate as to whether deposit-insurance schemes have indeed stabilised the banking system. One drawback of issuing guarantees on deposits is that doing so can give commercial banks a false sense of security and induce them to take higher risks when, for example, issuing bank loans. On this issue, see also Sect. 5.8.
Historical examples resembling a pure deposit bank include the medieval ‘exchange banks’, which were established to facilitate large commercial transactions, limit the uncertainties arising from a multi-coin currency system, and serve as coin depots. Exchange banks typically held assets in the form of bullion and coins against liabilities in the form of bank deposits (book money), but they did not issue paper money (unlike the note-issuing banks described in Sect. 2.1). Early exchange banks were founded in commercial centres in Southern Europe such as Barcelona (1401), Genoa (1407), and Venice (1587). In 1609, the ‘Amsterdamsche Wisselbank’ (or exchange bank of Amsterdam), which is often seen as an early ancestor of modern central banks, was founded. As an internationally connected financial centre, Amsterdam was at the time awash with coins of various origins and quality. To deal with these coins, merchants were forced to make large commercial transactions through the Wisselbank, which would check the quality of the coins before depositing them and issuing a commonly recognised form of book money against them. See, for example, Kindleberger, Charles, 2006: A Financial History of Western Europe, Routledge, pp. 46ff.
For a discussion on the layout of the Chicago Plan, see Fisher, Irving, 1935: 100% Money, Allen and Unwin.
Investment banks are discussed in footnote 4 of this chapter. A money-market fund refinances itself primarily by issuing short-term debt and reinvesting the corresponding financial means in liquid assets. Money-market funds are typically employed to manage the excess liquidity of large investors.
After a political revolution, foreign invasion, or civil war, it is of course possible that the public monopoly in issuing currency collapses. More commonly, governments (as represented by the central bank) do not fully honour their promises to pay on, for example, issued banknotes by creating inflation and, hence, reducing the purchasing power of the currency.
Originally, ‘lender of last resort’ was a jurisprudential term. In particular, in French, ‘dernier ressort’ referred to a court, whose judgement was final in the sense of not being open to appeal. The monetary meaning of ‘lender of last resort’ implies that commercial banks cannot formally protest at another authority when the central bank refuses to provide emergency liquidity assistance.
Central banks are not the only lenders of last resort within the financial system. For example, the International Monetary Fund (IMF) can act as the international lender of last resort for crisis-hit countries (see Sect. 8.6).
For a thorough discussion of the lender-of-last-resort principles see Goodhart, Charles, 1999: Myths about the lender of last resort, International Finance 2, pp. 339–360.
This practice is often wrongly referred to as charging a ‘penalty rate’ above the market interest rate. However, such a penalty rate does not work, when financial markets freeze amid a crisis. Concretely, such collapses typically manifest themselves in sudden, massive increases in market interest rates. Applying an even higher interest rate in a lender-of-last-resort intervention would simply indicate that the central bank is unwilling to provide emergency liquidity assistance at acceptable conditions.
In economics, the adverse-incentive effects arising from regulatory interventions are described using the somewhat cumbersome expression ‘moral-hazard effect’. Moral hazard is not restricted to rescuing banks. These problems are endemic in, for example, the insurance business, where generous coverage can undermine the incentive to take adequate care of the insured object. Many other examples can be found in other areas of economics and politics.
The Bank for International Settlements (BIS) was founded in the 1930s to settle German reparations resulting from World War I more efficiently (see Sect. 2.4). Aside from some remaining tasks regarding international payments, the BIS today serves mainly as a forum for the exchange of ideas on monetary and financial issues. Membership in the BIS is restricted to the most important central banks around the world. Since the 1980s, another key task of the BIS has been to develop international minimum standards for capital requirements. Referring to the Swiss city where the BIS is headquartered, the corresponding measures are called the ‘Basel rules’ or ‘Basel accords’. In the aftermath of the Global Financial Crisis, these rules have been substantially revised and extended resulting in the so-called ‘Basel III’ requirements.
For example, the Basel III rules define the tier 1 ratio, which should be at least 4.5% and refers to the nominal capital or share capital for stock-traded companies as well as retained earnings. The total (tier 1 and 2) capital ratio, which should be at least 8%, includes common equity and retained earnings, as well as supplementary capital such as undisclosed reserves, revaluation reserves, or hybrid instruments sharing characteristics of debt and equity. Furthermore, counter-cyclical capital buffers, which should be increased in boom times and may be lowered during a crisis, surcharges for large banks, and additional liquidity requirements, have been introduced.
These issues reflect some of the problems that were partly responsible for the 2008 financial crisis. In particular, valuing assets based on market prices (so-called ‘mark-to-market’) can aggravate a banking crisis when the collapse of security prices inflicts immediate losses on commercial banks, which, in turn, further undermines the confidence in the stability of the banking system. This is an example of the vicious fire-sales mechanism discussed in Sect. 5.3. Furthermore, in determining the risk-weights, assets, such as mortgage-backed securities, were seen as safe and, hence, had to be backed by relatively little capital. However, during the crisis, it turned out that these securities were much riskier than originally thought and, due to the collapse of the US real-estate market, were subject to large losses that essentially initiated the Global Financial Crisis (see also footnote 9 of Chap. 4).
The first quote is attributed to Marianne Thornton, the sister of Henry Thornton, who was one of the founding fathers of the classical lender-of-last-resort doctrine (see Sect. 5.5).
Two examples are cited in footnotes 3 and 8 of Chap. 2. Another notorious scandal arose from the bank of Charles Ponzi, who at the beginning of the 1920s promised depositors in Boston (USA) an annual interest rate of up to 45%. However, these interest rates could only be sustained via a pyramid scheme, in which newly deposited money was immediately used to pay other depositors. Until today, this type of fraud is still referred to as a ‘Ponzi scheme’. To date, the largest financial scandal occurred around the financier Bernard Madoff in 2008, who for decades had operated an investment fund based on the principles of a ‘Ponzi scheme’. The eventual collapse resulted in losses amounting to billions of US dollars.
- Money, Credit, and Banking
- Chapter 5
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