Talk to seminar on ‘The regulatory response to the financial crisis of

summer/autumn 2007’ by Tim Congdon

Charthehouse Square, London EC1, on 30th January 2008

What is the central bank?

• Monopoly issuer of legal-tender bank notes (‘cash’).

• Sole (or virtually sole) banker to the government.

• Banker to the banking system, which looks on ‘cash’ as its ‘money’ in much the same way that non-banks look on bank deposits as their money.

What should the central bank do? 1.

Uncontroversial, - the central bank can and should take deposits from

the government and banks, even if (following Ricardo, Hankey, etc.) it never lends to banks or any other private sector organisation, and

- the central bank can and should set short-term interest rates by open market operations which alter the level of bank’s deposits with it (i.e., their cash reserves).

What should the central bank do? 2.

Controversial, - should the central bank have an understanding,

perhaps an‘implicit contract’, with a bank or banks whereby it/they can borrow cash from it in unlimited amounts as long as they can offer good collateral?,

- why do some organizations (‘banks’) qualify for such loans whereas other organizations do not?, and

- on what basis, in terms of price, quantity and duration, should such lender-of-last-resort loans be extended?

Benefits of central banking

• Lower cost of bank finance to non-banks, and

• Increased flexibility of bank finance to non-banks.

Quantifying the benefits from central banking 1.

What determines banks’ margin over their cost of funds? Let banks’ assets (A) equal their safe asset cash (C) plus their loans (L), and c is the ratio of cash to total assets. Then L = (1 – c).A. Assume for simplicity that the cost of funds is nil. If rb is the rate of interest charged on loans, then profits (P) = rb. (1 – c).A.

Quantifying the benefits from central banking 2.

This quickly allows us to obtain an expression for the rate of return on capital in terms of both the cash ratio (c) and the capital/assets ratio, as follows

P/K = rb. (1 – c).A/K.

Further, rb = P/K . (1/1 - c) . K/A

Quantifying the benefits from central banking 3.

According to Phillips in his classic 1921 Bank Credit, ‘the essence’ of banking ‘consists in the practice of extending loans far in excess of either the capital or the cash holding of the bank in question’. An argument can be made the central banking facilitates the reduction in both the cash ratio and the capital/assets ratio in commercial banking. If the rate of return on bank capital is stable, the consequence is a fall in the price of bank loans.

Quantifying the benefits from central banking 4.

P/K c K/A r b , expressed as a %

Rate of return Cash Capital/ Loan

on capital ratio assets ratio margin

0.175 0.8 0.45 39.40.175 0.6 0.35 15.30.175 0.4 0.25 7.30.175 0.2 0.15 3.30.175 0.05 0.08 1.50.175 0.01 0.04 0.7

The behaviour of US banks' capital/deposit and cash/deposit ratios, 1935 - 2004

0

5

10

15

20

25

% of deposit liabilities

Ratio of US banks' equity capital to deposits

Ratio of US banks' cash reserves to deposits

More recent developments 1.

• Shift towards seeing solvency as the dominant issue in bank regulation – because central bank can always provide liquidity to a solvent bank, can’t it? The Basle rules.

• Hardly any mention of cash and liquidity ratios in the 1998 Bank of England Act. Again regulation seen in terms of solvency only.

More recent developments 2.

UK’s tripartite regulatory structure for banking seems to have been largely motivated by requests from HCFIs (highly complex financial institutions) and others for a single regulator (i.e., the FSA) for financial services, but led to obvious structural flaws, e.g., mixing up of deposit insurance with compensation fund for insurance claims on bankrupt insurance companies, the removal of bank balance-sheet oversight from the Bank of England.

What should the central bank do? 2.

(repeated!) Controversial, - should the central bank have an understanding,

perhaps an‘implicit contract’, with a bank or banks whereby it/they can borrow cash from it in unlimited amounts as long as they can offer good collateral?,

- why do some organizations (‘banks’) qualify for such loans whereas other organizations do not?, and

- on what basis, in terms of price, quantity and duration, should such lender-of-last-resort loans be extended?

My answers to these questions

- Question 1. Yes, the central bank should act as lender of last resort to the commercial banks, as (in a fiat money world) the social cost of providing ‘liquidity’ is trivial relative to the benefits. Arguably the contractual arrangements should be explicit.

- Question 2. A state-owned lender of cash to non-banks would be a dangerous and unpredictable competitor to banks. Hence, a clear rationale for a commercial relationship – with borrowing and lending between them – exists only between banks, particularly clearing banks, and the central bank.

My answers to these questions - Question 3. I. Price. Lender-of-last-resort loans should be at a

penal rate, but they should not be so high as to undermine the ability of the borrower to repay. (1/2% over banks’ normal cost of funds should be sufficient.)

- II. Quantity. With good collateral, unlimited, but – if the collateral is inferior – some multiple of the borrowing bank’s capital.

- III. Duration. As long as is necessary for the liquidation of the borrowing bank’s assets at a price close to par, i.e., at the outset for an indefinite period. ‘Deadlines’ are, almost certainly, inappropriate. The essence of a liquidity problem is the lack of time to make arrangements in an uncertain world, with erratic and unpredictable price movements. The essence of the answer is to give the borrower time.