The Central Banks Balance and the Financial Crisis - Essay Example

The Central Bank’s Balance Sheet and the Financial Crisis The Central Bank’s Balance Sheet and the Financial Crisis The global financial crisis flared up in the second half of the fiscal year 2007 and due to some very specific circumstances, policies and responses, it continued to get worse and stretch out over half the following decade till the year 2012. Talking in strictly economic terms, the majority of the blame for this crisis can be attributed to the government’s actions, interventions and policies. (Taylor, 2008). In theory, financial crises are usually the fault of monetary surpluses which cause a rapid boom in the economy and then a severely deflating downfall towards a bust. The financial crisis of 2007 was caused by one such boom in the housing market, which was followed by a bust that almost brought the world economy to a point of collapse. (Taylor, 2008). In 2003, the monetary policy was so loose that the interest rates fell considerably below the adequate level and remained at that level till 2004, whence they eventually started to rise right up to 2006 where they plateau-ed out. An easy monetary policy in 2003, with low interest rates meant that the money supply in the economy increased sharply, causing the creation of monetary excesses right up to the year of the crisis. The interest rate levels in the years leading up to the crisis were no accident, they had been set by the monetary policy makers, the reasons of which the FED gave the public no straight answers about. The government’s policy makers had actually employed this expansionary monetary policy to avoid a deflation in the economy. And it was the effects of the employment of this monetary policy that lead to the rapid boom in the housing market and the consequent destructive bust. Even though this was the strongest in terms of impact, the rapid boom and bust of the housing market was not the complete extent of the effects of the monetary policy; CPI inflation rose to 3.2% where as the average normal level was supposed to be around 2%. During the period 2002-2004, the United States was running a current account deficit which meant that the savings for the economy were greater than the investment in that period. What happened to the housing market was anticipated to have an adverse effect on the financial markets, however the adversity was compounded due to the rampant use of sub-prime mortgages, subsequent delinquencies and foreclosures in the midst of government backed agencies like Freddie Mac and Fannie May going bankrupt. (Taylor, 2008). However, what extended the crisis is another story. The crisis became destructive in 2007 when interest rates rocketed and was made worse by the counter-party risk issue. However, policy makers misdiagnosed it as having roots in liquidity issues rather than risk. Misdiagnosis resulted in mistreatment, and thus the crisis was prolonged. In 2008, the crisis actually got worse. Many have argued that this was because the U.S government did not intervene to bail out Lehman Brothers. However, in reality it is not until after that stage things really plummeted south. (Taylor, 2008). This picture is however still simplistic. Monetary policy might have been the main factor that led to the financial crisis, but it is to be kept in mind that the monetary policy is not a factor in isolation. There are things that affect the monetary policy as well. One of the most important things that impact monetary policy is the amount of capital held by the Central Bank. An IMF working paper discusses how and to what extent the Central Bank Balance Sheet may affect monetary policy. Deviations from optimal interest rate levels act as constraints on the monetary policy. According to a test based on an algorithm formed for this study, this paper found that there is in fact a correlation between the two. The lower the levels of Central Bank capitals shown in its Balance Sheet, the bigger the gap between optimal interest rate levels and actual operating ones in the economy. Thus, by improving the financial status of the Central Bank, constraints on the monetary policy can be alleviated. However, as the gap between optimal interest rate levels and actual observed interest rate levels closes up, the influence of the Central Bank’s financial position becomes less relevant as an affecting factor to monetary policy. (Gustavo et al 2012). The Bank for International Settlements is holding a conference the agenda of which is the role of the Central Bank in setting monetary policy. The monetary policy was at the vanguard when authorities answered concerns about the recent financial crisis. Central Banks used their balance sheets to set straight the havoc created by money and credit markets. They have also aimed at recapitalizing the banking system. These actions suggest a strong link between the monetary policy and financial stability and thus the Central Bank Balance Sheet. (Bank for International Settlements, 2012). Central Banks use their capital levels to achieve their monetary policy objectives. Sometimes a loss making Central Bank balance sheet can still meet its monetary policy agendas during a deflationary period in an economy. International factors also come into play which may deter a weak Central Bank Balance Sheet to meet is monetary policy aims. Central Banks normally don’t have liquidity constraints, however their credibility is still determinable by looking at their level of capital. (Bindseil, Manzanares, & Weller, 2004). Central Banks cannot become insolvent as long as the currency they issue is still being used as a legal tender. However, it is important for the functions of a Central Bank to be performed as required for it to have a positive and healthy capital balance, particularly to keep inflation in check and achieve the desired level of price stability. This issue however, has only come under the spotlight of mainstream finance related discourse fairly recently. It is argued that the central bank’s capital levels are indicators of its financial independence and stability and of their expected profitability. A financially strong central bank is one that has enough monetary resources to fulfill its duties effectively. On the other hand, a Central Bank that is financially weak may have to start selling its more liquid assets so that it can strive to cover its running costs. There will thus come a point where the central bank will have exhausted all its sellable resources. The consequent measures that the central bank might have to employ will raise the money supply in the market, which would lead for interest rates to fall. A loose monetary policy of this sort might bring on a strong bout of inflation for the economy. (Bindseil, Manzanares & Weller, 2004). This paper illustrates through a simple model how a central bank’s capital levels can impact its capacity to fulfill its duties. One basic assumption needs to me made here; the central bank is not constrained by liquidity issues and thus does not face insolvency or bankruptcy. According to this model and calculations based on it, we find that higher capital with the central banks means higher levels of profits. Furthermore, the higher the interest rates as dictated by the going monetary policy, the lower the capital requirement at the central bank. Another main point is that for long term profitability, growth and success, the initial capital levels are not as important as the rate of growth the Central Bank shows over the years. There is a dichotomous relation between the central bank’s capital and its performance, but external international factors also come into play. There may be several reasons why a central bank may show a deficit in its balance sheet; (i) bailing out the banking system after a financial crisis (ii) a highly dollarized economy (iii) financing of the budget deficit using government tenders and really low interest rates. (Bindseil, Manzanares & Weller, 2004). Furthermore it is to be kept in mind that when there is negative central bank capital, the following situations may arise. The central bank’s management has a personal incentive to lower interest rates to get out of this situation, this may trigger inflation by increasing the monetary base in the economy to restore capital levels of the central bank; however this move may push the economy faster towards a financial crisis. Also, negative central bank capital weakens the bargaining position of the central bank with the government and thus has to be more pliant to the government’s demands. This will also have its due effect on the economy’s financial situation as it will now be driven by the government’s aims rather than those of the financial markets’. Inflationary expectations will rise rapidly because the people expect instability from the central government. Finally, holders of the monetary base will not like this situation because the central bank might stand to lose their right to issue the currency as legal tender and they as holders of this currency might lose their wealth. (Bindseil, Manzanares & Weller, 2004). If these holders lose trust in the central bank and withdraw their support, the economy can spiral into destruction. Thus it can be concluded from this that, the importance of a central bank’s capital and its consequent relation to a possible financial crisis depends strongly on the likelihood that it might lose its right to issue the currency as a legal tender. There are also operational risks involved with the level of central bank capital held a point in time. For example, if the central bank is at risk, resources that would normally be used for core functions will be redirected towards other directions even if it is detrimental to the economy. Moreover, whenever the capital falls below a certain threshold the government will need to bail out the central bank which will also cause immense strain on the economy. (Bindseil et al 2004). During 2008, the balance sheet figures of the FED almost doubled to about $2.2 trillion, making the FED the largest bank in the United States by some measures. (Stella, 2009). In 2008, the financial markets were seizing up and the economy was experiencing adversely affecting negative growth rates. Amidst this, the FED employed some policy measures by turning to uncommon monetary policy measures among others. These measures had some drastic implications on the FED’s own balance sheet. Almost a year ago, the FED had only held simple holdings adding up to around $800 billion in treasury securities. The policies implemented by the FED in 2008 caused their balance sheet to expand quite rapidly in a very short period of time. And their balance sheet now came to include diversified and numerous assets and facilities. Initially these expansion effects on the balance sheet were the cause of providing short term funding to the flailing markets to restore their stability to them. Provision of these short term funding were not in isolation, they were a part of a wider policy objective. Due to the sheer expansion in the level of the FED’s balance sheet, it has now become a top priority of the FED. The FED has about $1.8 trillion in different securities at this point and this number is increasing rapidly. This sector of the balance sheet is expected to grow steadily over the years and is to reach the $2.1 trillion mark in the very near future. Expanding the FED’s balance sheet by asset accumulation has had several effects which are part of the portfolio balance channel. Firstly, it is intended that this move will support economic activities by keeping long term interest rates at a lower level. With large asset holdings the FED can increase the price of an asset to have an effect of increasing the quality of that instrument. Moreover, it can now restore balance to markets with a one-sided trade imbalance. The size of the FED’s balance sheet has allowed it to have a strong presence in these markets and situations and has aided it to implement the needed policies in the market. Since the FED’s balance sheet’s expansion had been done along with injection of funds into the financial markets, the question remains how the financial conditions will be tightened in the market now and what effect this will have. The balance sheet currently has more than $1 trillion in reserves and is expected to continue growing which will keep reserve balances relatively large for years to come in the future. In order to maintain control over the interest rates in the short term by the policy makers, the federal funding should be targeted. They could adjust this by adjusting the interest rate on reserves. The measures taken by the FED have ensured that should conditions worsen in the future like they did in 2007/2008, they will have effective policy measures to fall back on. However the rapid expansion of the FED’s balance sheet will require correction in the future. (Sack, 2009). The global financial crisis of 2007/2008 has also had an effect on the Canadian economy and the Bank of Canada. Like the Central Bank in America, the Bank of Canada also took some initiatives by providing short term lending to the important financial institutions in its economy to keep them afloat and bring them out of the turmoil they were in as a result of the financial crisis. In this regard, the Bank of Canada did indeed have similarities with the Central Bank of the USA. However it was seen that the Canadian financial markets weren’t as adversely affected as were those in across the border in the United States of America. The Bank of Canada, in addition to increasing funding also took other measures to improve the liquidity crunch, for example by accepting loan portfolios as collateral. With the end of the year 2008, the policy measures taken by Central Banks world over started to take intended effect and the worst of the financial crisis began to fade away. This had its effects in the Canadian money markets and financial institutions as well, where the liquidity situation improved slowly but surely. In 2009, the conditions of the financial markets kept improving steadily, which allowed for the Central Bank of Canada to cut back on the high levels of liquidity support it had been offering its market since the crisis started. In the second half of 2009, the Bank of Canada went back to its pre-crisis position and policies. However it is to be noted that the policy measures taken by the Bank of Canada were much more succinct than the ones adopted by the Central Bank of America. The US policy makers had first misdiagnosed the problem and followed up with mistreating it as well for some time which had resulted in the financial crisis in the USA to get worse before the policy makers finally realized their mistake and corrected it by implementing the correct policy measures. In Canada however, this did not happen, the Bank of Canada hit the nail on its head by implementing those policy measures which were relevant and effective by solving the problem of liquidity in an economy badly hit by the global financial crisis. As a result, the Canadian economy didn’t have to suffer as much as the American economy and were able to recover faster and more easily from the crisis of 2007/2008. (Zorn & Wilkin, 2009). References Bank for International Settlements. (2012). BIS/ECB Workshop on "Monetary Policy and Financial Stability". Available at http://www.bis.org/events/conmpfs090910.htm Gustavo A., Pedro C., and Camilo E. T. (2012). Does Central Bank Capital Matter for Monetary Policy? IMF Working Paper 12/60, February. Available at http://www.imf.org/external/pubs/ft/wp/2012/wp1260.pdf Lorie Z., Wilkin C. (2009). Bank of Canada Liquidity Actions in Response to the Financial Market Turmoil. Bank of Canada Review, autumn 2009. Available at: http://www.bankofcanada.ca/wp-content/uploads/2010/06/zorn.pdf Sack, B. P. (2009) The FED’s Expanded Balance Sheet. Federal Reserve Bank of New York, Speech. Available at: http://www.newyorkfed.org/newsevents/speeches/2009/sac091202.html Stella, P. (2009). The Federal Reserve System Balance Sheet: What Happened and Why it Matters.IMF Working Paper 9/120, May. Available at: http://www.kif.re.kr/KMFileDir/128883956842663750_IMF%20wp09120.pdf Taylor, J. B. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong. Retrieved July 27, 2012, from http://www.stanford.edu/~johntayl/FCPR.pdf Ulrich B., Manzanares A., Weller B. (2004). The role of Central Bank Capital Revisited. European Central Bank Working Paper No. 392, September. Available at: http://www.ecb.int/pub/pdf/scpwps/ecbwp392.pdf Read More