This essay aims to discuss the functions of a central bank and takes the example of the Federal Reserve of the US as a central bank, and attempts to outline how it tried to solve the macro-economic problems arising out of the credit crunch and to what extent it was successful. The paper is divided into sections following the discussion points as stated above.
A central bank is an institution that is mandated by constitutional decree to function along with certain principles and entrusted with managing the fiscal side of the country’s economy.
The Fed Reserve and Bank of England are examples of central banks. These banks have many functions, some of which are listed below. The central bank manages the monetary policy and sets interest rates to spur growth and rein in inflation. The role of the central banks has become prominent in these days of globalisation, and laissez-faire economics since the financial system has become more integrated and needs intervention by the central banks from time to time to keep the system together (Central Bank. The Encyclopaedia Britannica. Deluxe ed. 2001)
The key functions of a central bank are:
- Regulating the money supply.
- Managing the foreign exchange and gold reserves in a country.
- Managing the cost of credit and its availability.
- Acting as the “lender of last resort”.
Regulating the money supply
This includes regulating the size of the nation’s money supply and setting the interest rates and other policy instruments to curb inflation and spur growth.
The central banks regulate the money supply by expanding and contracting their assets over a period of time. For e.g. the cash reserve ratio or CRR is used by the central bank to either mop up excess liquidity in the system or inject liquidity in times of low growth. The CRR is the ratio of the reserves that the commercial banks must hold as a proportion of their liabilities. The CRR is a policy instrument that the central bank uses to nudge the commercial banks to maintain a certain amount of liquidity in the system (Central Bank. The Encyclopaedia Britannica. Deluxe ed. 2001).
Typically, the central banks in developed countries do not tinker much with the CRR though this is often a tool for fighting inflation in developing countries. The example of China and India, which use the CRR as part of their monetary policy, is illustrative of the central bank’s intervention in the economy.
Managing the foreign exchange reserves (Greenspan, 2007).
Managing the cost of credit and its availability
The central banks manage the cost of credit by using the prime lending rate or PLR and by intervening in the open market to mop up excess liquidity. The main instruments that are available to the central bank are the interest rates that take the form of the main lending rate or prime lending rate as it is known in different countries.
The prime lending rate is the interest rate that the commercial banks would get for short term deposits with the central bank. Since this affects the lending rates of the banks as well, any reduction in the prime lending rate would mean that the commercial banks would also cut their lending rate, and this would, in turn, make the availability of credit and access to credit cheaper (Greenspan, 2007).
Managing the foreign exchange reserves
The central bank also intervenes in the foreign exchange market to stabilise the currency in times of foreign exchange turmoil. This takes the form of intervention in the open market to buy and sell the home currency as well the foreign currency. It buys the home currency when the exchange rate relative to the USD is going down and sells home currency when it is appreciating. Though the former option is not used that widely in countries that have export-led economies, the latter option of selling home currency to keep the exchange rate favourable to the USD is a normal practice in developing countries (“Central Bank”. The Encyclopaedia Britannica. Deluxe ed. 2001).
Lender of last resort
The central bank acts as the lender of last resort by loaning funds to the commercial banks that are in a crisis of payments. This has happened recently in the US in the case of the “bailout” of the investment bank Bear Sterns by the Federal Reserve.
Role of the Federal Reserve in managing the Sub-prime crisis
The role of the Federal Reserve in managing the sub-prime crisis has revolved around:
- Reduction in the base rates.
- Open market operations.
- Auction of the Term auction facility.
- Bailout of Bear Sterns and JP Morgan.
Reduction of base rates
The Fed has been cutting the base rates at which it lends to other banks. These are the interest rates as policy instruments that determine the level of credit and the money supply in an economy. The Federal Funds rate (the rate at which the Fed loans money to other banks overnight) was cut from 5.25% to 2% over a period of six months starting from September 2007 through March 2008. Similarly, the discount rate (the rate at which commercial banks borrow from the regional offices of the Federal Reserve) was lowered from 5.75% to 2.25% – this is according to the Press release by the Federal Reserve, available on the website of the Federal Reserve.
These rates are used by the central banks to rein in inflation or spur growth in the economy. Any reduction of the base rates or the interest rates would mean that the rate at which the commercial banks borrow from the central bank is lower. This means that more credit is available in the economy as a whole, and this would spur growth. On the other hand, this would bring inflationary pressure on the economy because of an increased money supply. The real estate market, like any other component of the economy, depends on the availability of credit and cheaper credit would mean that more and more prospective buyers would find it easier to borrow for buying real estate (Mckinsey Quarterly, Print Edition 2007). Also, the commercial banks (as we have seen above) will lend at cheaper rates. The combined effect of this would be to lower the mortgage rates, and this would lead to a boom in the mortgage market.
Open market operations
The Fed also intervened in the open market, providing much needed short-term liquidity to the banks. The Guardian (2008) stated that this was the “week that the Fed tried to save the world from Financial Meltdown”. As we see in this section and the succeeding sections, the Fed, by intervening in the open market, pumped money into the markets and it along with the Bank of England, sent a strong message to the markets that it would take all necessary steps to prevent the financial system from collapsing.
Term auction facility
The Fed increased the Term Auction lending facility – a measure by which the Fed along with other banks provided liquidity to the commercial banks when the other instruments like the Federal funds rate and the discount rate were limited in their impact – from $60 billion in previous months to over $100 billion by the end of March 2008.
Bailout of Bear Sterns
The most visible sign of the Fed’s involvement in the sub-prime crisis was the bailout of the investment bank Bear Sterns by J P Morgan Chase. The Fed let J P Morgan Chase avail of a credit facility to buy Bear Sterns for $2 a share. This prevented the collapse of Bear Sterns and the resultant systemic meltdown that would have happened if Bear Sterns had reneged on its commitments. This action of the Fed was tantamount to nationalising the assets of the bank and was reminiscent of a socialist pattern. However, market analysts justified the action in the larger interests of the economy.
How regulation failed to prevent the sub-prime crisis
The subprime crisis was allowed to go out of hand because of poor regulation of the lenders. The fact that the Fed stepped in to buy out Bear Sterns was a case of acting a bit too late. One area where financial guaranty insurers expanded over the years involves Mortgage-backed securities relating to loans to borrowers who are classified as subprime or having a credit history that was less than preferred. These mortgage-backed instruments have fallen in value due to the “subprime lending crisis” after a large number of defaults in the housing market occurred involving these mortgages.
How successful was the Fed in handling the sub-prime crisis
The way in which the Fed acted to manage and “resolve” the crisis arising out of the losses suffered by banks due to underperforming sub-prime assets has been praised and criticised at the same time. The praise has been for the way in which the Fed lowered the base rates as well as provided liquidity to the banks that needed it the most. But, as pointed out in the previous sections, there was criticism that the Fed acted a bit late, and as the International Herald Tribune pointed out.
Though the crisis seems to have subsided a bit, nonetheless, the disclosures by many banks, including HSBC, of a write-down of their assets and reporting of losses by Citigroup and the other banks means that the worst is not over yet. The present scenario looks like everyone is bracing for a long haul of uncertainty and weak growth. As the Guardian (2008) notes, “the credit crisis has been quite unpredictable, and no one is sure when the next problem would appear”. This sums up the prevailing mood of the economy, and we have to keep our fingers crossed on the same.
Regulatory changes initiated by the Fed
The regulatory changes are likely to lead to higher costs and longer loan-processing times, but these changes should be viewed more as an incentive to improve operations, better innovation on products, and improve the risk-management capabilities. The reduced availability of capital for easy credit, greater compliance costs, and lower profit margins for the medium to small lenders may prove to be the solution that the industry needs badly.
The future course of action
It is certain that there is going to be new regulation passed by Congress to deal with the fallout of the subprime crisis. But the overall view is that the new regulation is not likely to be crippling. Already, there have been a significant number of self-regulatory actions taken within the industry, like, for instance, stricter underwriting standards and bigger down payments. These may have the potential to take the sting out of the regulatory spirit. The availability of loans to subprime borrowers has already been reduced significantly because of the market correction. The market system being as it is they are already acting in a self-correcting manner, thereby making the regulators not wish to appear to be denying the sub-prime borrowers a chance to own a home (McKinsey Quarterly, Online Edition, Number 4, and June 2007).
This paper has looked at the functions of a Central bank and how it manages the economy with the monetary policy and available instruments at its disposal. The central bank, along with the government, acts in tandem to steer the economy out of crises as well as to spur growth and control inflation. In this globalised world, the role of the central bank is paramount in managing an integrated economy. Central bankers from Alan Greenspan to Ben Bernanke have been feted and criticised for each of the policy measures they have taken. In the context of the sub-prime crisis, it is more than important for the central banks to keep a “watch” on the economy and ensure that the functioning of the financial system is smooth. This paper has attempted to synthesise the functions of a central bank to the role of the Federal Reserve in the sub-prime crisis.
Greenspan, Alan (2007) The Age of Turbulence: Adventures in a New World. Allen Lane. London.
Chubak, David & Connell Sean (2007).Handling the sub-prime crisis. McKinsey Quarterly. Web.
Central Bank (2001). The Encyclopaedia Britannica. Deluxe ed.
Andrews, Edmund. Fed Shrugged as sub prime crisis spread. The International Herald Tribune. 2008. Web.
Board of Governors of the Federal Reserve System (2008). Web.
Elliot, Larry. The week the Fed tried to save the world from financial meltdown. The Guardian Online. 2008. Web.