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Bankers' Banks- The Role of Central Banks in Banking Crises

Central banks are relatively new inventions.vigilance in the past. Let me explain this
An American President (Andrew Jackson) evenstatement:In most countries in the world,
cancelled its country's central bank in thebank supervision is a heavy-weight department
nineteenth century because he did not thinkwithin the central bank. It samples banks, on
that it was very important. But things havea periodic basis. Then, it analyses their
changed since. Central banks today are thebooks thoroughly and imposes rules of conduct
most important feature of the financialand sanctions where necessary. But the role
systems of most countries of theof central banks in determining the health,
world.Central banks are a bizarre hybrids.behaviour and operational modes of commercial
Some of their functions are identical to thebanks is so paramount that it is highly
functions of regular, commercial banks. Otherundesirable for a central bank to supervise
functions are unique to the central bank. Onthe banks. As I have said, supervision by a
certain functions it has an absolute legalcentral bank means that it has to criticize
monopoly.Central banks take deposits fromitself, its own policies and the way that
other banks and, in certain cases, fromthey were enforced and also the results of
foreign governments which deposit theirpast supervision. Central banks are really
foreign exchange and gold reserves forasked to cast themselves in the unlikely role
safekeeping (for instance, with the Federalof impartial saints.A new trend is to put the
Reserve Bank of the USA). The Central Banksupervision of banks under a different
invests the foreign exchange reserves of the"sponsor" and to encourage a checks and
country while trying to maintain anbalances system, wherein the central bank,
investment portfolio similar to the tradeits policies and operations are indirectly
composition of its client - the state. Thecriticized by the bank supervision. This is
Central bank also holds onto the goldthe way it is in Switzerland and - with the
reserves of the country. Most central banksexception of the Jewish money which was
have lately tried to get rid of their gold,deposited in Switzerland never to be returned
due to its ever declining prices. Since theto its owners - the Swiss banking system is
gold is registered in their books inextremely well regulated and well
historical values, central banks are showingsupervised.We differentiate between two types
a handsome profit on this line of activity.of central bank: the autonomous and the
Central banks (especially the American one)semi-autonomous.The autonomous bank is
also participate in important, internationalpolitically and financially independent. Its
negotiations. If they do not do so directly -Governor is appointed for a period which is
they exert influence behind the scenes. Thelonger than the periods of the incumbent
German Bundesbank virtually dictatedelected politicians, so that he will not be
Germany's position in the negotiationssubject to political pressures. Its budget is
leading to the Maastricht treaty. It forcednot provided by the legislature or by the
the hands of its co-signatories to agree toexecutive arm. It is self sustaining: it runs
strict terms of accession into the Euroitself as a corporation would. Its profits
single currency project. The Bunbdesbankare used in leaner years in which it loses
demanded that a country's economy be totallymoney (though for a central bank to lose
stable (low debt ratios, low inflation)money is a difficult task to achieve).In
before it is accepted as part of the Euro. ItMacedonia, for instance, annual surpluses
is an irony of history that Germany itself isgenerated by the central bank are transferred
not eligible under these criteria and cannotto the national budget and cannot be utilized
be accepted as a member in the club whoseby the bank for its own operations or for the
rules it has assisted to formulate.But allbetterment of its staff through
these constitute a secondary and marginaleducation.Prime examples of autonomous
portion of a central banks activities.Thecentral banks are Germany's Bundesbank and
main function of a modern central bank is thethe American Federal Reserve Bank.The second
monitoring and regulation of interest ratestype of central bank is the semi autonomous
in the economy. The central bank does this byone. This is a central bank that depends on
changing the interest rates that it chargesthe political echelons and, especially, on
on money that it lends to the banking systemthe Ministry of Finance. This dependence
through its "discount windows". Interestcould be through its budget which is
rates is supposed to influence the level ofallocated to it by the Ministry or by a
economic activity in the economy. ThisParliament (ruled by one big party or by the
supposed link has not unequivocally proven bycoalition parties). The upper levels of the
economic research. Also, there usually is abank - the Governor and the Vice Governor -
delay between the alteration of interestcould be deposed of through a political
rates and the foreseen impact on the economy.decision (albeit by Parliament, which makes
This makes assessment of the interest rateit somewhat more difficult). This is the case
policy difficult. Still, central banks useof the National Bank of Macedonia which has
interest rates to fine tune the economy.to report to Parliament. Such dependent banks
Higher interest rates - lower economicfulfil the function of an economic advisor to
activity and lower inflation. The reverse isthe government. The Governor of the Bank of
also supposed to be true. Even shifts of aEngland advises the Minister of Finance (in
quarter of a percentage point are sufficienttheir famous weekly meetings, the minutes of
to send the stock exchanges tumbling togetherwhich are published) about the desirable
with the bond markets. In 1994 a long termlevel of interest rates. It cannot, however,
trend of increase in interest rate commenceddetermine these levels and, thus is devoid of
in the USA, doubling interest rates from 3 toarguably the most important policy tool. The
6 percent. Investors in the bond markets lostsituation is somewhat better with the Bank of
1 trillion (=1000 billion!) USD in 1 year.Israel which can play around with interest
Even today, currency traders all around therates and foreign exchange rates - but not
world dread the decisions of the Bundesbankentirely freely.The National Bank of
and sit with their eyes glued to the tradingMacedonia (NBM) is highly autonomous under
screen on days in which announcements arethe law regulating its structure and its
expected.Interest rates is only the latestactivities. Its Governor is selected for a
fad. Prior to this - and under the influenceperiod of seven years and can be removed from
of the Chicago school of economics - centraloffice only in the case that he is charged
banks used to monitor and manipulate moneywith criminal deeds. Still, it is very much
supply aggregates. Simply put, they wouldsubject to political pressures. High ranking
sell bonds to the public (and, thus absorbpolitical figures freely admit to exerting
liquid means, money) - or buy from the publicpressures on the central bank (at the same
(and, thus, inject liquidity). Otherwise,breath saying that it is completely
they would restrict the amount of printedindependent).The NBM is young and most of its
money and limit the government's ability tostaff - however bright - are inexperienced.
borrow. Even prior to that fashion there wasWith the kind of wages that it pays it cannot
a widespread belief in the effectiveness ofattract the best available talents. The
manipulating exchange rates. This wasbudgetary surpluses that it generates could
especially true where exchange controls werehave been used for this purpose and to higher
still being implemented and the currency wasworld renowned consultants (from Switzerland,
not fully convertible. Britain removed itsfor instance) to help the bank overcome the
exchange controls only as late as 1979. Theexperience gap. But the money is transferred
USD was pegged to a (gold) standard (and,to the budget, as we said. So, the bank had
thus not really freely tradable) as late asto do with charity received from USAID, the
1971. Free flows of currencies are aKNOW-HOW FUND and so on. Some of the help
relatively new thing and their long absencethus provided was good and relevant - other
reflects this wide held superstition ofadvice was, in my view, wrong for the local
central banks. Nowadays, exchange rates arecircumstances. Take supervision: it was
considered to be a "soft" monetary instrumentmodelled after the Americans and British.
and are rarely used by central banks. TheThose are the worst supervisors in the West
latter continue, though, to intervene in the(if we do not consider the Japanese).And with
trading of currencies in the internationalall this, the bank had to cope with
and domestic markets usually to no avail andextraordinarily difficult circumstances since
while losing their credibility in theits very inception. The 1993 banking crisis,
process. Ever since the ignominious failurethe frozen currency accounts, the collapse of
in implementing the infamous Louvre accord inthe Stedilnicas (crowned by the TAT affair).
1985 currency intervention is considered toOlder, more experienced central banks would
be a somewhat rusty relic of old ways ofhave folded under the pressure. Taking
thinking.Central banks are heavily enmeshedeverything under consideration, the NBM has
in the very fabric of the commercial bankingperformed remarkably well.The proof is in the
system. They perform certain indispensablestability of the local currency, the Denar.
services for the latter. In most countries,This is the main function of a central bank.
interbank payments pass through the centralAfter the TAT affair, there was a moment or
bank or through a clearing organ which istwo of panic - and then the street voted
somehow linked or reports to the centralconfidence in the management of the central
bank. All major foreign exchange transactionsbank, the Denar-DM rate went down to where it
pass through - and, in many countries, stillwas prior to the crisis.Now, the central bank
must be approved by - the central bank.is facing its most daunting task: facing the
Central banks regulate banks, licence theirtruth without fear and without prejudice.
owners, supervise their operations, keenlyBank supervision needs to be overhauled and
observes their liquidity. The central bank islessons need to be learnt. The political
the lender of last resort in cases ofindependence of the bank needs to be
insolvency or illiquidity.The frequent claimsincreased greatly. The bank must decide what
of central banks all over the world that theyto do with TAT and with the other failing
were surprised by a banking crisis looks,Stedilnicas?They could be sold to the banks
therefore, dubious at best. No central bankas portfolios of assets and liabilities. The
can say that it had no early warning signs,Bank of England sold Barings Bank in 1995 to
or no access to all the data - and keep athe ING Dutch Bank.The central bank could -
straight face while saying so. Impendingand has to - force the owners of the failing
banking crises give out signs long beforeStedilnicas to increase their equity capital
they erupt. These signs ought to be detected(by using their personal property, where
by a reasonably managed central bank. Onlynecessary). This was successfully done
major neglect could explain a surprise on(again, by the Bank of England) in the 1991
behalf of a central bank.One sure sign is thecase of the BCCI scandal.The State of
number of times that a bank chooses to borrowMacedonia could decide to take over the
using the discount windows. Another is if itobligations of the failed system and somehow
offers interest rates which are way above thepay back the depositors. Israel (1983), the
rates offered by other financingUSA (1985/7) and a dozen other countries have
institutions. There are may more signs anddone so recently.The central bank could
central banks should be adept at readingincrease the reserve requirements and the
them.This heavy involvement is not limited todeposit insurance premiums.But these are all
the collection and analysis of data. Aartificial, ad hoc, solutions. Something more
central bank - by the very definition of itsradical needs to be done:A total
functions - sets the tone to all other banksrestructuring of the banking system. The
in the economy. By altering its policies (forStedilnicas have to be abolished. The capital
instance: by changing its reserverequired to open a bank or a branch of a bank
requirements) it can push banks to insolvencyhas to be lowered to 4 million DM (to conform
or create bubble economies which are bound towith world standards and with the size of the
burst. If it were not for the easy and cheapeconomy of Macedonia). Banks should be
money provided by the Bank of Japan in theallowed to diversify their activities (as
eighties - the stock and real estate marketslong as they are of a financial nature), to
would not have inflated to the extent thatform joint venture with other providers of
they have. Subsequently, it was the same bankfinancial services (such as insurance
(under a different Governor) that tightenedcompanies) and to open a thick network of
the reins of credit - and pierced both bubblebranches.And bank supervision must be
markets.The same mistake was repeated inseparated from the central bank and set to
1992-3 in Israel - and with the samecriticize the central bank and its policies,
consequences.This precisely is why centraldecisions and operations on a regular
banks, in my view, should not supervise thebasis.There are no reasons why Macedonia
banking system.When asked to supervise theshould not become a financial centre of the
banking system - central banks are reallyBalkans - and there are many reasons why it
asked to draw criticism on their pastshould. But, ultimately, it all depends on
performance, their policies and theirthe Macedonians themselves.



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