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Central banks and their origins

BY LAWRENCE J. | Updated July 05, 2024

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Financial Analyst/Content Writer, RADEX MARKETS Lawrence J. came from a strong technical and engineering background before pivoting into a more financial role later on in his career. Always interested in international finance, Lawrence is experienced in both traditional markets as well as the emerging crypto markets. He now serves as the financial writer for RADEX MARKETS. read more
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The central bank of a country has several key functions that can broadly be summarised as follows:

  • 1. Maintain the monetary stability of its nation’s currency
  • 2. Act as the fiscal authority for commercial banks
  • 3. Act as a lender of last resort

    The following are all central banks: the Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, etc. Their primary responsibility is to maintain the monetary stability of their national or supranational currency. In concrete terms, this means making sure the money does not become too weak nor too strong, which boils down to controlling inflation.

    The central bank has many tools at its disposal to influence inflation, first and foremost of which is setting the interest rate. Traditionally the central bank would push the interest rate one way or another by controlling the money supply. Since the 2008 financial crisis, the monetary landscape has changed to the point where controlling the money supply is not as effective, due to its functionally infinite size. The main tool currently in use is to define the interest rate that commercial banks can earn by depositing their cash reserves at the central bank.

    The end result is the same: the central bank controls inflation by controlling the interest rate. As a rule of thumb, central banks aim for 2-3% inflation and set their interest rate accordingly. Lowering the interest rate to increase liquidity, promoting borrowing, spending and investment, thereby increasing inflation. Raising the interest rate to restrict liquidity, promoting saving and limiting debt, thereby decreasing inflation.

    The secondary responsibility of the central bank is to tell commercial banks how much of their clients’ deposits they must hold in reserve. This dictates how much banks are able to lend to customers, which in turn also affects the amount of money in circulation.

    The third responsibility of the central bank is to act as a lender of last resort, both to distressed financial institutions and even to the government itself. That first part is relatively self-explanatory; the latter opens up a bit of a rabbit-hole.

    A lender of last resort is very useful because it serves as an emergency backup, for instance in the event of a commercial bank default. Poor fiscal management can lead a bank to face liquidity problems, meaning that they cannot honour their financial obligations to their clients, potentially culminating in a bank run that would typically exacerbate the problem. In this scenario, the presence of a central bank can mitigate a lot of the damage. The fact that their deposits are insured by a higher authority means that clients have a safety net that they can rely on, the bank’s liquidity problems are nullified and the banking industry achieves a higher level of financial stability.

    This is sometimes viewed as a double-edged sword however. Such measures are self-evidently beneficial to clients, but they can lead to irresponsible behaviour on behalf of the banks. A commercial bank, knowing they have the full might of the central monetary body to bail them out, may adopt riskier and more dangerous banking practices, producing the opposite of the intended effect.

    Poor fiscal behaviour or clients losing their life savings… On balance, the measure probably does more good than bad.

    But what of the second case? How can the central bank lend to the government? Surely that would be like the government lending to itself, no? This question takes us all the way back to why central banks came into existence in the first place.

    In a nutshell, the answer is war. War is expensive. The existence of entire nations and empires would rely on their ability to fund war efforts. Very rarely did the royal coffers alone permit such an expense. Small, independent banks filled this need for centuries, before a more mutually beneficial paradigm began to emerge in the late 17th century.

    In Europe, small banks were sufficient to cover the costs of war up until 1500 or so, but then warfare simply grew too expensive, particularly naval warfare. Sovereign rulers needed more and more funds to cover the endless territorial squabbles that would go on to define their reign. Up until that point, the state could enter an agreement with a number of small, disconnected banks in order to raise funds. However, this created a very imbalanced situation. What incentive did the state have to honour their debts? What could a small bank do if the state were to default? After all, there were plenty of other banks willing to do business … The lending institutions were all too aware of the risk of the government simply refusing to pay the money back, which is why they charged exorbitant interest rates when lending money. It was a lose-lose situation.

    Central banks created a more congruent financial landscape, one that benefitted both the state and the lenders. The central bank, being the sole purchaser of government debt, had a far more robust seat at the negotiating table. By being able to walk away as a united front and refuse further money lending, they were now in a position to impose significant punishment on the state in the event of default, which in turn made them willing to lend money at a lower rate. The government, having no one else to turn to for cash, was far more reliant on this singular institution, but also benefitted greatly from the lower interest rates on offer. Win-win.

    During this period, currencies were still backed by precious metals, typically gold. This served to tether monetary policy to physical bullion reserves, thereby constraining the amount of money central banks could print. In the early 20th century, countries would gradually fall off the gold standard, which would in turn change the remit of central banks.

    The modern function of a central bank is in fact a very recent development in the grand scheme of things. Before the First World War, the purpose of the central bank was to provide the state with the funds necessary to wage war. Following the end of hostilities, their function gradually morphed into one of fiscal management. In theory, given a lack of convertibility to gold, a central bank can print as much money as it sees fit. The limiting factor is how much that money devalues as a result.

    The modern role of central banks is barely a century old. With all the talk of CBDCs (Central Bank Digital Currencies), one wonders how long it will be before their purview changes again.

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