Central Banks

• All modeled on Bank of England

• Original purpose: lender of last resort

• Banks step in to lend during crises

• In theory, central banks require solid

collateral, charge relatively high interest

• Early banks criticized for being too late

• Allowed busts to go on too long before

intervening

• Even Cuba has a central bank

U.S. Central Banking

• Already world’s largest economy in 1900

• No permanent central bank until 1913

• Booms and busts all over the place

• Bank failed to play its role in 1929

• With no lender of last resort, banks failed

• Central banks have monetary control

• Keynes enters the picture: fiscal policy

• Current role: fight inflation, smooth the

cycle, generate jobs

Central Banks & Economy

• Bankers realized that buying and selling

securities could regulate money supply

• Fed buys, more money—lower rates

• Fed sells, less money—higher rates

• “Fed funds” becomes short-term target

• Rate maintained through buying and

selling securities

• Works when there is demand, growth

When Rates Fail

• Lowering rates+no demand=“pushing

on a string”

• Fiscal policy generates demand

• Central banks can flood money supply

by:

--Taking lower-quality collateral

--Taking new customers—nonbanks

--Lending to other central banks

--Buying its own Treasurys!

Banks & Currencies

• Holding bad assets can hurt currency

• Lowering interest rates can hurt, too

• Must sell debt to finance deficits

• Buyers are now international

• For U.S., it’s China and Japan

• After fiscal and monetary stimuli, banks

must pay off debt, balance budget, or

risk losing international confidence

Central Bank Traps

• Borrowing short term, paying long term

• Quality of balance sheet erodes

• Currency begins to collapse: inflation

• International borrowers go away

• Higher rates to get them back

• Inflation gets worse

• Strikes, demand for higher wages

• Inflation gets worse still

Forex Regulation

• Central banks intervene in concert

• Plaza agreement 1984 a benchmark

• BIS is main self-governing body

• Central banks can only do “symbolic”

interventions in the billions

• Banks hold gold, manipulate its price

• Big deficits are bad for currencies

• Pound, dollar … yen? … euro?

Banks & Nonbanks

• Banks take deposits, lend money

• Now they invest in securities, too

• Nonbanks act like banks—no regs

• Banks keep “reserves” for people who

want their cash

• In “runs,” not enough cash

• BIS imposes standards to prevent that

• “Basel I” and II Now “Basel III”

• Rules define how much reserve needed

Basel Foundations

• How risky is the asset?

• What is it worth? How to value?

• Is it on the balance sheet?

• What is likelihood of default?

• How much reserve is needed given

portfolio of assets?

• Much about Basel III now uncertain

• Should be focus of coverage

IASB & FASB

• What is value of an asset?

• What you paid?

• What it sold at today?

• What you would take for it?

• What is “fair value”?

• “Mark to market” is what it sold at today

• That’s what IASB, FASB have tried

• Has made current crisis worse

Last Questions

• How much leverage can banks use?

• Should banks be playing markets at all?

• How can banks agree on value of “black

box” financial instruments?

• Who will regulate worldwide?

• Can central banks work together, not

compete in times of crisis?