Many banks have problems managing the expected withdrawals depositors make and often have to borrow money to cover the shortfall. This service was originally provided by a number of private wholesale banks, which lent money in emergency situations to prevent bank runs. Over time a number of wholesale banks were merged together and given regulatory powers over the banks that they would lend to. When this merger happened it was the birth of the Central Bank, which acted as a lender of last resort for banks with short term cash flow problems.
Since then central banks have taken on a greater role within the economy. The main secondary role of the central bank is to control money supply. The amount of debt that can be lent by banks is set by the central bank through the reserve requirement. The reserve requirement is a percentage of the funds banks have, which have to be held to cover depositor’s withdrawals. By increasing or decreasing the required reserve the availability of debt, which can be lent out to borrowers alters. The greater the required reserve the less money that can be lent out and the higher the price of debt, the interest rate, becomes. Conversely the lower the required reserve the more money that can be lent out and the lower the price of debt, the interest rate, becomes.
The Bank of England has two main functions. The first is the original function of the private wholesale banks, to lend to other banks to prevent bank runs and enable them to function in an effective manner. The second is the control of the money supply within the economy, when alterations to the reserve requirements set by the Bank of England are made to control inflationary and deflationary gaps. Both of these functions are made possible by the Bank of England’s control of the supply of debt. This control has been enhanced over time by allowing the Bank of England to create money through functions like Quantitative Easing.
During the rescue of Northern Rock and the subsequent bank bailouts the Bank of England failed to provide its primary function of acting as a lender of last resort. The size of the bailout required was so great that Bank of England Governor Mervyn King refused to lend the funds required to prevent a bank run. The Government had to step in and act as lender of last resort meaning the primary function of the Central Bank was no longer provided by the Bank of England. The secondary function of the Bank of England in regards to money supply control has also failed. The Bank of England sets a two percent inflation target that it is supposed to meet to maintain “economic stability”, however in recent months the rate of inflation has stayed far above this target.
Interest rates cannot rise due to the impact on the wider economy, which would be devastating for homeowners and businesses alike. The ability of the Bank of England to control inflation by increasing the interest rate is a bygone era. The lax control of the interest rate in the past has flooded the market with cheap debt that now has to be repaid. Due to the need to make these repayments possible the interest rate has to remain low to prevent default. Interest rates could fall further or become negative, however this would not necessarily provide the desired effect of increased consumption and may make the scale of debt even worse, kicking the can further down the road. The only real function the Bank of England can perform effectively is pump priming, which will devalue the purchasing power of the currency later in the business cycle.
Perhaps it is time to push for the reintroduction of private wholesale banks to provide emergency loans and to stop using the Bank of England as an aggregate demand control mechanism?