Central Banks All modeled on Bank of England Original purpose: lender of last resort Banks step in to lend during crises In theory, central banks require solid collateral, charge relatively high interest Early banks criticized for being too late Allowed busts to go on too long before intervening Even Cuba has a central bank

U.S. Central Banking Already world’s largest economy in 1900 No permanent central bank until 1913 Booms and busts all over the place Bank failed to play its role in 1929 With no lender of last resort, banks failed Central banks have monetary control Keynes enters the picture: fiscal policy Current role: fight inflation, smooth the cycle, generate jobs

Central Banks & Economy Bankers realized that buying and selling securities could regulate money supply Fed buys, more money—lower rates Fed sells, less money—higher rates “Fed funds” becomes short-term target Rate maintained through buying and selling securities Works when there is demand, growth

When Rates Fail Lowering rates+no demand=“pushing on a string” Fiscal policy generates demand Central banks can flood money supply by: --Taking lower-quality collateral --Taking new customers—nonbanks --Lending to other central banks --Buying its own Treasurys!

Banks & Currencies Holding bad assets can hurt currency Lowering interest rates can hurt, too Must sell debt to finance deficits Buyers are now international For U.S., it’s China and Japan After fiscal and monetary stimuli, banks must pay off debt, balance budget, or risk losing international confidence

Central Bank Traps Borrowing short term, paying long term Quality of balance sheet erodes Currency begins to collapse: inflation International borrowers go away Higher rates to get them back Inflation gets worse Strikes, demand for higher wages Inflation gets worse still

Forex Regulation Central banks intervene in concert Plaza agreement 1984 a benchmark BIS is main self-governing body Central banks can only do “symbolic” interventions in the billions Banks hold gold, manipulate its price Big deficits are bad for currencies Pound, dollar … yen? … euro?

Banks & Nonbanks Banks take deposits, lend money Now they invest in securities, too Nonbanks act like banks—no regs Banks keep “reserves” for people who want their cash In “runs,” not enough cash BIS imposes standards to prevent that “Basel I” and II Now “Basel III” Rules define how much reserve needed

Basel Foundations How risky is the asset? What is it worth? How to value? Is it on the balance sheet? What is likelihood of default? How much reserve is needed given portfolio of assets? Much about Basel III now uncertain Should be focus of coverage

IASB & FASB What is value of an asset? What you paid? What it sold at today? What you would take for it? What is “fair value”? “Mark to market” is what it sold at today That’s what IASB, FASB have tried Has made current crisis worse

Last Questions How much leverage can banks use? Should banks be playing markets at all? How can banks agree on value of “black box” financial instruments? Who will regulate worldwide? Can central banks work together, not compete in times of crisis?