Central banking largely evolved the way it did due to the exigencies of wartime finance. The central government needs control over its financial operations in wartime, and any attempts to interfere by the private sector would be viewed as akin to sabotage. For a free-floating sovereign (and currency pegs are typically broken during major wars), the system guarantees that the financial flows will continue to flow.
Central bank balance sheets (in the modern era, at least) are relatively simple. There is a split between banks with a currency peg and those without. After that, the key point to keep in mind that the minimum size of the central bank balance sheet is not under the control of the central bank — other actors create a minimal demand for their liabilities. The only freedom of action for central bankers is growing beyond the minimum, which they did not do before the days of Quantitative Easing (QE). The article finishes off with a discussion of consolidation.
This text overlaps material found in my book Understanding Government Finance.
As the name suggests, central banks are at the centre of the banking system. The objective of a well-run banking system is that you do not have to worry about how it works. So long as everything under the hood is operating, you do not need to enquire how the money gets from one account to another. By not worrying about those details, we tend to only focus on the flashy bits of central banking (e.g., trying to hit an inflation target) instead of the banking system regulation part.
Central banks, as the name suggests, are in fact banks. This rather straightforward perspective was lost in the decades after World War II, when central bankers bought into mainstream thinking and they thought of themselves as “benevolent central planners.” Instead of worrying about mundane distractions like credit risks within the system, the researchers were running around pretending they were 1960s control systems engineers optimally determining the trade off between growth and inflation. Of course, this neglect of banking led to the rather awkward Financial Crisis in 2008, where central bankers suddenly had to get a handle on banking risks once again. Since then, central bankers have been quite vigilant about banking risks — at least the ones that are similar to the last crisis.
First Republic Bank was forced into a take over by J.P. Morgan Chase, and was yet another Californian victim of bad banking risk management. My bias was that First Republic was not large enough to worry about, so I cannot offer any insights into the event. My main complaint is that this appears to be another bank that blew itself up with interest rate risk, which makes my life of writing a banking primer more difficult. I had always made allowances for bad bank risk management in the United States, but I had underestimated how large an incompetent bank can get.
Other than for the unfortunate owners of securities issued by First Republic (and apparently wealthy people in San Francisco who wanted overly generous mortgages), the demise of this bank is not a big deal by itself for the macroeconomy. Instead, the issue is whether there are still other weak links in the banking system? I am not in a position to have a strong opinion on that question, but it would be a question worth looking in to. My bias is to not pay too much attention to interest rate risk — credit risk is the killer for financial systems. Although I am seeing people pointing to commercial real estate risk, I do not think I could point to a time in recent decades where somebody was not worried about credit risks in commercial real estate.
The usual worry is that the Fed hikes until something breaks — which is exactly how I describe previous cycles.1 Since the current bank failures were due to interest rate risk, we can blame them on Fed action. The question is whether these are enough to derail the economy? Although the Monetarist-inclined are worried about M2, my concern is credit growth (since Fed balance sheet shenanigans are forcing reallocations of financial assets which do not have much economic impact). One measure of credit that I like — commercial & industrial (bank) loans outstanding (above) — has rolled over.
As can be seen in the chart, C&I loans rolling over only tended to happen in recessions. However, we did see a lack of growth in the mid-2010s without a recession (circled episode), so I would be cautious about panicking.
I am not in the forecasting business, and do not want to be calling for recessions every six months. Although there are certainly negative vibes, one can still argue that they are consistent with a “soft patch,” which is a part of lengthy modern business cycles. You pays your money, and you takes your chances.
There is a survivorship bias in that observation. It could be explained by (1) business cycles being typically ended by financial fiascos, and (2) the Fed tending to hike rates until the expansion ends, with (1) and (2) being independent.
I just wanted to comment on bank deposits, which has been attracting some attention. My initial reaction is that we should expect some reversal in deposit growth as the Fed reverses its balance sheet growth. However, the figure above was not exactly what I expected.
The term “currency swap” is the term that we usually see, although there are a few variants. The variants are differentiated by the way in which interest rates are calculated. The cross-currency basis swap1 is the floating rate/floating rate version of a “currency swap,” and is the 800 pound gorilla of cross-currency funding trades. This is the wholesale hedging tool, and other foreign exchange hedging instruments are priced off these swaps. Although “cross-currency basis swap” sounds cool, I will just “currency swap” in this article, since I am not concerned about the interest rate terms.
Note: This is a draft of a section that will go into my banking primer manuscript.
Note: Once again, this is a draft of a manuscript section from my banking book. It will be in a chapter on modelling banking.
Editorial note: this article is meant to be an introductory section of a chapter on banking in economic theory. I am going to make a bunch of wild assertions that are supposed to be dealt with later in the chapter. I expect that I will have follow up articles filling in details later.
This article continues the previous discussion of bank net interest margins. In it, I discussed how changes in the yield curve changed the net interest margin (NIM) for banks. This showed up historically — when bank balance sheets were shattered by the combination of holding long-dated mortgages with low fixed coupons versus having a sky-high short-term rate imposed by deranged Monetarists. In this article, I address a common macroeconomic story: yield curve inversions cause recessions by the alleged effect on NIM. As a spoiler, I do not think that story holds water in “modern” banking systems.
One of the topics that comes up whenever government bond curves re-price is the relationship between the yield curve and bank net interest margins (NIM). This then morphs into a second question: does a yield curve inversion cause a recession by the (alleged) effect of the yield curve on bank interest margins, reducing the willingness of banks to lend?
