7: A More Exact Account of the Mode in Which the Bank of England Has Discharged Its Duty of Retaining a Good Bank Reserve
As the central bank of Britain, the Bank of England carries great responsibility for the economic welfare of the nation - but there has been no acknowledgement of this, neither by the bank nor the government.
Specifically, the bank never has by any corporate act or authorized statement acknowledged such duty, and some of the directors have denied it when asked. Also, no resolution of Parliament or declaration of any committee has assigned or enforced any public duty upon the bank - it has been publicly declared by statesmen that the BE is "only a joint stock bank like any other bank."
It seems exceedingly strange that so significant a responsibility would be thus unacknowledged and denied, though the author does acknowledge that its caution stems from "the vestiges of old controversies in which there were vehemently opposed factions that each insisted the bank be managed in a completely different way, and members of Parliament seemed resolved to avoid becoming caught in the cross-winds.
The author presents an article, taken from The Economist during the banking panic of 1866, as an example of such a controversy. The author purported to represent statements made by the governor of the bank, in which it was acknowledge that the BE maintained the banking reserves of the nation, "the sole considerable unoccupied mass of cash in the country" and felt that it had been well managed during the recent financial crisis, especially given that other banking institutions had been swept away by the tides of panic. BE meanwhile remained solvent and, in spite of some suggestion it appeal to government for assistance, refrained from doing so. In the context of the remarks, some mention was made of holding the public trust, and having a duty to the banking community, and of acting to support the members of the mercantile community that had been forsaken by other banks.
The latter drew some consternation from many of the bank directors, who felt that the newspaper had drawn "rash deductions" from a speech that itself was the opinion of the Governor and not reviewed or authorized by the board. One of whom, Thomas Hankey, disputed the article as "the most mischievous doctrine ever broached," to suggest that the BE held any responsibility to preserve or restore the entire economy when the behavior of other banks jeopardized it. In effect, the only duty held by BE, like that of any other bank, is to act responsibility in its custody of funds entrusted to it by its depositors, and to manage its credit affairs wisely in service to its shareholders - and it owes and is owed nothing at all from any other party.
The author pokes a few holes in Hankey's arguments, namely in suggesting that it is merely the author's opinion as opposed to historical fact - i.e., the author did not suggest what ought to be done in such a crisis, but merely describes what the BE had, in fact, done. An important distinction is to be made between BE and other banks - as BE, as the central bank, was the only one with actual monetary reserves, the reserves of all other banks being their deposits to the BE itself.
The author stops there, suggesting it is not his object to revive the controversy, merely to show that the controversy in fact existed, and the vehemence of the response to even the suggestion that the bank held any measure of public responsibility, and the care with which directors since that time have avoided such suggestions in any public statement, is demonstration that the bank disclaims any notion that it is required to act in the public interest.
Considering the actions of the bank, it was clear that the board of directors of the BE acted exactly as could be expected of persons of their position. The BE is run by a group of merchants, who are neither scholars in matters or economics nor particularly concerned with political matters. And following the sensibilities of merchants, they chose the path that seemed the most safe - specifically in terms of protecting their investment in the bank.
Their lack of sophistication has had led tp historical incidents in the early nineteenth century that illustrate how the BE made decisions that were clearly contrary to the most basic principles of economics, and ultimately detrimental to the bank, but suggests "there has been a great improvement" since 1857.
While he won't say that the bank has always kept a sufficient reserve, he feels it has been fair and creditable, and altogether improved over their practice in years past. The author suggests that the decisions of the bank averted a banking crisis in 1864, and the one that occurred a few years later was unlikely to have been caused by any action undertaken by the bank, who retained a reserve sufficient to preserve them when other firms failed.
To preserve the stability of financial markets, the central bank is bound not only to keep a sufficient reserve against a time of panic, but also to use that reserve effectively when any panic should arise. It is an act of self-preservation, in that if all other forms of credit should fail, their own credit will also fail.
Some would deny this connection, and allege that a central bank can allow all others to fail and remain intact. This opinion has been expressed by influential persons in government as well as the financial industry. However, it should be self-evident that any creditor can profit only by the repayment of debts he is owed - and when a panic arises, debtors are less capable of doing so, which means the bank's ability to collect is curtailed. And when payments are not made on existing credit, the bank is unable to underwrite any new credit - which his to say it can still seek to underwrite notes, but the notes will not be accepted for fear that the bank will be unable to honor them.
The fall of Overends provides practical example of the failure of such a strategy. While the BE maintained its reserves for the purpose of being able to meet its own obligations, Overends sought to issue additional credit in order to earn interest income, depleting their reserve and rendering them ultimately incapable of servicing their own debt.
Neither an a bank raise capital by sale of stock at a time of crisis. Investors, much like creditors, require a level of confidence in the prospect of making a return on their investment. The notion that a bank in peril can save itself by selling additional shares of ownership presumes that there are a large number of parties who would be interested in investing in a failing business. The notion is simply ridiculous.
Where any bank is believed to be failing, the surest defense against such a prophesy is to disprove it in action: by honoring the demands of depositors to withdraw their funds, and to draw upon their reserves in order to continue to do so, as a means of demonstrating their solvency and restoring public confidence. Where the bank depletes its reserves for any other reason, or refuses to return the funds on deposit, the panic is heightened, confidence is dashed, and the bank is "destroyed by terror."
This is largely due to the function of bank notes in commerce - thy are valued only insofar as they can be redeemed for cash: one party is inclined to accept bank notes on the confidence that they can be redeemed for cash. Where confidence in the solvency of the bank weakens, such parties are not inclined to accept notes, but to demand cash. Those that wish to pay them must then withdraw their deposits to do so, further weakening the reserve, and further damaging confidence in the value of banknotes.
Given that the BE holds a central reserve of all cash, it may be said that the money paid from one party to another requires no reserves in the bank: that the debtor withdraws his funds in the morning, then hands them to a creditor who will deposit them back into the same vault in the afternoon of the same day. The flaw in this line of thinking is that the bank must have the cash to issue at all. Because any funds that are not in reserve have been given out as credit, the bank may quickly exhaust its reserves.
That is, the bank's ability to loan money depends on the amount of its own bills that remain in circulation, that are not redeemed for cash, and this is the amount the bank is capable of returning to depositors. In the situation where a panic arises, the notes of a given bank do not remain in circulation, but are redeemed in great number, depleting its reserves.
The depositor's willingness to trust any bank with his funds is based on the belief that the bank will be able to return the funds on demand. If it were not so, the depositor would not entrust his funds to a bank that he suspects will be unable to repay it.
The situation with a central bank is generally somewhat different, because the government of the nation maintains its own revenues in such a bank: hence confidence in the bank is bolstered by the belief that the government will provide steady and certain deposits to the bank, on which it will retain the ability to issue credit and redeem its own notes.
The bills of such a bank become legal tender: whoever holds them can count upon their value, and does not feel the need to redeem them, but retains them to use in currency to pay any domestic debt, believing them to be as good as the gold they represent. This gives a central bank an ironclad certainty in the stability of its currency, so long as the government of the nation itself remains stable.
The author identifies two steps which a bank may undertake to preserve its reserves in times of panic. First, to raise the interest rate on loans, which discourages borrowing that would deplete its reserves, especially upon the part of persons who do not have any specific use for the funds, or others who borrow idly without concern of making repayment. Second, to use its reserves to honor, without hesitation, any of its own bills. The panic that the bank may not be able to honor its bills is best addressed by the demonstration that the bank actually is honoring its bills, which saps the credibility of alarmists. Failure to do so exacerbates panic and lends credibility to fear.
The author examines the behavior of the BE during some of the banking crises of the nineteenth century, but the detail seems extraneous and oblique. In some instances, the BE is shown to have "acted as unwisely as it was possible to act" and fueled the panic, in others the BE carried on with the business of banking, guarding its reserves to honor its own debts while continuing to issue credit to creditworthy applicants - which is ultimately the course that will benefit a bank, and its depositors and investors, regardless of the economic forecast.
But concerning the BE itself, the bank "never has laid down any clear and sound policy" regarding its operations, and has both advocated and undertaken a clearly erroneous course of action at times. As a result the public, on whose confidence the economy depends, is never sure what course of action the bank will take, and must always have some level of concern for the security of their funds. Naturally, the author feels this situation should be amended: that the bank should make its intentions clear, and by doing so will increase the confidence of its customers.
(EN: I can't entirely agree. Especially in the present day, it makes little difference what a financial institution has to say about its intentions - some will agree with its policy, others will disagree, and many will doubt that it will keep its stated course in times of panic. While a bank should have a sound policy by which to guide its internal operations, the notion that announcing such a policy to the public will guarantee consumer confidence seems exceedingly naive.)