this stage it is worth mulling over what ‘solvent’ means. If you have simple financial affairs and have $20,000 in the bank and total outstanding bills of only $10,000, then you are solvent. On the other hand, if you only have $10,000 but owe $20,000 you are in a less happy position. As an individual, you may not worry about this, on the grounds that you have a job which keeps enough money flowing in to pay the interest on the loans. But technically, if you have no other assets, you are insolvent. This is more of a problem for companies, including banks, which legally are not allowed to continue trading while insolvent. If you are insolvent, then creditors may take you to court to have you declared legally bankrupt.
But being insolvent is not the same as being ‘illiquid’. You might think that being illiquid – which sounds equivalent to solid – is a good thing. But for a bank it can be a problem. Return to the situation where you were declared technically insolvent, but then you suddenly remembered that you owned a house worth $100,000. Immediately you realize that you are solvent. Phew! However, because most of your assets are tied up in bricks and mortar and you don’t have much ready cash, you are considered illiquid. In the long term you should be OK but in the short term you may need to borrow some money to pay your immediate bills, perhaps using your house as security.
Banks too can be solvent but illiquid. They might, for example, lend someone the cash to buy a house and not expect to see all the money back for 20 years. This loan represents an asset for the bank but not one it can use immediately, so if it were faced with a lot of withdrawals it could face a liquidity crisis. While it is still probably solvent, since the loans it made still count as assets, it has nevertheless become illiquid.
The lender of last resort
In this case it may well need to borrow from the central bank – the lender of last resort. The Bank of England took on this responsibility from around 1825. Recognizing the value of having a central bank for these and other purposes, many other countries followed suit. The Banque de France emerged from 1800 and in 1875 the Bank of Prussia became the Reichsbank. The US equivalent, the Federal Reserve System (the ‘Fed’), was created in 1913 following a series of financial panics. The Fed is not just one institution but a system, which includes a central governmental agency in Washington DC, a Board of Governors, and 12 regional Federal Reserve Banks, which perform central banking functions within their own regions. The most important of these is the Federal Reserve Bank of New York which, as well as regulating New York banks, is responsible for the Fed’s open-market operations.
Having a ‘lender of last resort’ offers a degree of security. The downside is ‘moral hazard’ – a situation where people protected from the consequences of their actions are tempted to take greater risks. Bankers, knowing that they have a central bank safety net, may make dangerous bets in search of higher profits and personal bonuses. Even if the bets fail, the bank is likely to survive. Governments will step in because bank failures are dangerous. Politicians fear the fallout from angry small depositors, but also know that the banks are intricately interconnected through webs of interbank lending so that the failure of one bank to repay an overnight loan could topple many other dominoes.
Another concern is that the central banks themselves might be subject to political manipulation. A government approaching an election may, for example, be tempted to reduce interest rates and expand the money supply to make people feel suddenly richer, even though soon after the election this could cause inflation. To guard against this ‘boom and bust’ strategy, most central banks in developed countries operate with a degree of independence. This can be achieved partly through long-term directorships. Although the directors or governors of central banks are political appointees, their terms of office will generally extend beyond the life of most governments. In the US, for example, the seven board members of the Fed are appointed for a term of 14 years, with one member’s term expiring every other year. Nevertheless, the independence of central banks has limits. In practice most governments at times of economic crisis lean on central banks to take politically expedient decisions.
The Bank of England was nationalized in 1947 and essentially acted as a part of the government. But from 1997 it was granted operational independence, which meant that it was given the overall task of managing interest rates and the money supply. As noted earlier, it has been charged with keeping inflation at around two per cent – but is free to adjust interest rates as it sees fit in order to achieve this. The European Central Bank, which is in charge of monetary policy in those countries using the euro, has a similar target, as does the Bank of Canada. For the Reserve Bank of Australia the target is two to three per cent and for the Reserve Bank of New Zealand it is one to three per cent. In the US the Fed has two targets. The first is concerned with keeping down inflation, the other with maintaining high levels of employment. This is a trickier task since the two targets often conflict.
Policing the banks
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