of ‘central bank reserves’. Another is a requirement for the bank to hold enough ‘liquid assets’ to meet potential withdrawals – which could be central bank reserves or government bonds or cash. Originally in the UK this was fixed as a set percentage or ‘fraction’ of all its outstanding loans. Should the percentage drop below this critical level, it would need topping up, by offering the central bank government bonds, for example, or by borrowing from the central bank at the prevailing interest rates. This system is known as ‘fractional reserve banking’. The UK subsequently dropped this reserve ratio and instead now tries to achieve the same thing by requiring important banks to pass a ‘stress test’, to check that they can withstand a crisis. Other countries, including the US, still maintain such a ratio, also called a liquidity ratio, of around 10 per cent. Canada and Australia, like the UK, do not.
This also addresses the issue of how to resolve payments between banks. If one bank owes a net amount to another, this can ultimately be settled by making transfers between their reserve accounts at the central bank.
Pulling the monetary levers
In countries such as India, where the state owns many of the banks that lend funds to the general public, it is easy enough for the government both to dictate to banks and to control the money supply. In most developed countries, however, the banks have largely been independent commercial enterprises so the central bank has to exert control indirectly. Although the terminology differs from country to country, the means are more or less common.
The first lever of control is through interest rates. Interest rates can be thought of as the charge for renting out money. If you were renting someone a car you would take into account many factors. What is the risk that the renter might drive off into the sunset and never return? What could I otherwise have done with the car during that time? Will the engine wear out during that period? What are other people charging for that kind of car?
Renting out money involves similar considerations. You have to assess the risk that the borrower might default or disappear. You have to consider the rate of inflation, and thus the likelihood that when you get your money back it will be worth less. And of course you have to check what your competitor banks are offering since they might undercut your rates.
Within these constraints, banks can charge whatever they like. But they are also influenced by what the central bank declares to be the ‘minimum lending rate’ – in the US the ‘discount rate’. This is the rate at which the central bank will lend to the commercial banks. They may, for example, need to borrow from the central bank if they have to boost their central bank reserves, or they need a reliable source of ready cash should they be faced with a sudden bout of withdrawals. The commercial banks can smooth out some of these daily fluctuations by borrowing from each other, but they also have the option of borrowing from the central bank. Commercial banks making loans to their customers will generally use the central bank rate as a starting point, while adding a percentage point or two to cover their expenses, the likelihood of default, and the desired profits.
Interest rates
When it comes to setting interest rates, governments have several things to worry about. The first is inflation. The Bank of England, for example, is charged by the British government with the responsibility of keeping inflation below 2 per cent. If the Bank sees inflation creeping up, it may therefore decide to increase interest rates. Higher interest rates will discourage borrowing, or encourage people to repay existing loans, which can reduce the money supply and economic activity and thus help dampen inflation. If the central bank raises the rate at which it lends to commercial banks, this puts pressure on the banks to pass on the costs to their customers by raising the interest rates they themselves are charging.
The other main consideration when setting interest rates is employment. Stifling economic activity may have the merit of reducing inflation. This is fine if most working people have jobs. But there is always the risk of overdoing it, of slowing the economy down so much that there is a rise in unemployment. So governments have to strike a balance. Interest rates too low: inflation. Interest rates too high: unemployment.
This may give the impression that it is possible to fine-tune the economy to achieve the optimum balance. If only. In practice, economies respond to changes in interest rates, if at all, in the same way the proverbial oil tanker responds to a tweak to the tiller. The response time can be very long, up to a year; indeed, so long that, by the time any interest-rate changes take effect, the circumstances might have changed so dramatically that the central bankers would have been better steering in the opposite direction. And even if the general course was correct, there is always the risk of undershooting or overshooting. In the UK, the decisions are made by a group of wise persons, the Monetary Policy Committee, which generally changes rates quite slowly, typically by one quarter of one percentage point in either direction. Because these changes are so small, they are generally quoted in smaller units. One percentage point can also be referred to as 100 ‘basis points’ – so in this case the change would be only 25 basis points.
This interest-rate tinkering appeared to work until the financial crisis. After this the situation became so dire that governments desperate to revive their ailing economies slashed interest rates so that they were close to zero – where they have remained ever since. This particular lever thus got stuck and could do little more to stimulate the economy. In fact, banks were reluctant to lend money at any interest rate because of fears that the borrowers would go bust.
The Libor scandal
Banks are not forced to take loans from the central bank. They can instead borrow ready cash from elsewhere, including from each other in what is called the ‘interbank’ market. Ultimately, the rate at which they do so will be set by market forces – by the amount of spare cash the banks have at the time. The actual rate in London, for example, is called the London Interbank Offered Rate – Libor – which is also used as a reference point for banks elsewhere and for credit-card companies. Until recently, Libor was based on a fairly casual reporting system on the assumption that the bankers would simply tell the truth. This was a mistake. In 2008, it was revealed that for many years bankers had often chosen to lie, saying that they could borrow more cheaply than they actually could, so that they would appear to be in a healthier position than they really were – which is fraud. In 2013, the Royal Bank of Scotland, for example, acknowledged that, between 2006 and 2010, 21 traders and one manager had tried to rig Libor. To settle US and UK investigations, it agreed to pay fines of $612 million.4
Lending between banks, honest or not, might seem to cut the central bank out of the picture. But not entirely. The central bank itself also intervenes through what are called ‘open-market operations’. If it wants to reduce the amount of cash in the banking system it has the option not only of increasing the base rate but also of hoovering up some cash by offering to sell government bonds at attractive rates. As will be explained later, a bond is a promise to pay whoever buys it a certain sum of money each year and to return the whole sum after a pre-determined period. Once these government bonds have been sold, they can then be traded on the open market. If, on the other hand, the central bank wants to stimulate economic activity because it is worried about rising unemployment and wants to increase the money supply, it does the reverse. It goes back to the bond market offering to pay whatever it takes to buy back such bonds, thus injecting more cash into the system.
On occasion, however, banks may be so chronically short of money, and nervous that fellow banks might go bust overnight, that they refuse to lend to them at any interest rate. This was the situation following the credit crunch from 2008. Banks hit by losses stemming, among other things, from mortgage defaults in the US, were so spooked that they clung onto the cash they had, so that interbank credit largely dried up. In these circumstances, the central bank can deploy another of its weapons, by acting as a ‘lender of last resort’. If a commercial bank is basically solvent – in that it has sufficient deposits and capital, but just does
