Spooked by the failure of Silicon Valley Bank (SVB) as well as the resulting contagion, major central banks in the developed economies have launched coordinated action to enhance liquidity in the banking system.
Top of the list is the establishment of US dollar liquidity swap line arrangements among the six participating central banks, namely the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the US Fed and the Swiss National Bank.
Liquidity swap lines are agreements between two central banks to exchange currencies.
As the contagion from the SVB collapse spreads into the system, the overseas operations of some of the systemically important banks are not able to meet their US dollar liquidity obligations, hence the need for central bank interventions.
But to understand the evolution of these interventions, it is vital to look at the historical patterns of central bank development.
The first pattern describes a central bank that begins life as a government-chartered bank with the government as the primary customer.
A central bank was created by the government for the government to help with fiscal needs. In exchange for this fiscal support, the government would issue the bank with the monopoly of banknote issuance.
The best example is the Bank of England and the Bank of France.
In the second pattern, the government takes over an existing commercial bank and turns it into a central bank.
The bank would then lend money to the government on easy terms in exchange for a monopoly of banknote issuance. The best example is the Swedish Riksbank (since 1668).
The final pattern of central bank development, which is a little bit more modern, is called the bankers’ bank model where the central bank plays the role of the lender of the last resort.
The system then evolves into fiscal support to the government and maintains macroeconomic stability. The US Federal Reserve System is the best example.
The lender-of-last-resort function is what gives central banks the power to print and provided large quantities of cheap money to financial markets.
It also empowers the central bank to do whatever it takes to maintain financial sector stability.
In Walter Bagehot’s Lombard Street (a description of the money market), he paints a picture of ‘whatever it takes’ to maintain financial stability: "We lent it," said Mr Harman, on behalf of the Bank of England, "by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice.
Seeing the dreadful state in which the public was, we rendered every assistance in our power.'' After a day or two of this treatment, the entire panic subsided, and the `City' was quite calm.
The ultimate idea behind the lender-of-the-last-resort is to drive down interest rates and hope that people and businesses borrow and spend more in the economy. Essentially, credit-fueling the economy.
As Walter writes in Lombard Street on the role of credit in an economy, there are two core principles as far as production is concerned.
First, as goods are produced to be exchanged, it is good that they should be exchanged as quickly as possible.
Secondly, since every producer is mainly occupied with producing what others want, and not what he wants himself, it is desirable that he find, without effort, without delay, and without uncertainty, others who want what he can produce.
Simply put, credit is ‘additive,’ or additional—that is, in times when credit is good productive power is more efficient. Credit produces that marginal purchasing power necessary to power supply and demand.
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