Bank of England: early days: some functions

The Bank of England was formed (in 1694) to fulfil the need for a large and stable bank in England (and Scotland where the Bank of Scotland was formed a little later), to compete with the remaining goldsmith-bankers (whose practices were often frowned upon - such as the high interest rates charged for loans) and to make loans to government (at the time of the French wars - which started in 1689). It was given the sole right to issue bank notes (except for smaller banking partnerships), a right that was entrenched in 1833 when its notes were the only notes declared legal tender. Take a look at Balance Sheet 1, a typical balance sheet of a CB, as a backdrop to this discussion.




D. Foreign assets

A. Notes and coins

B. Deposits

E. Loans to government

1. Government

2. Banks' reserve accounts (TR = RR + ER)

F. Loans to banks (BR) @ KIR

C. Foreign loans

In its year of establishment, the Bank of England already was beginning to perform some of the functions of modern central banks: it was the (almost) sole issuer of bank notes (item A) (coins were then a liability of government); it was banker to government (item B1); it was making loans to government (item E). We hasten to add that this is not a true, lasting function. Although it started out in this way, making loans to government (by buying their debt instruments) is highly inflationary. This later gave way to the holding of government securities only for OMO purposes.

We saw earlier that shortly after its establishment, the goldsmith-bankers opened accounts with the Bank of England, and deposited gold coins. These deposits with the Bank of England and its notes became to be held by other banks as reserves - to ensure that withdrawals could always be met. As time went by the Bank of England came to be known as the government's banker and agent and its notes .commanded the greatest confidence and the widest circulation."

The convention of keeping larger balances with the Bank of England ".. .grew as time went on, and when the wide-spread establishment of the joint-stock banks in England began in 1826, the Bank of England had already come to be regarded as the custodian of the cash reserves of the private banks, and thus of the country's gold reserves." In terms of Balance Sheet 1, we can now tick off items D (foreign assets145) and B2 (reserve accounts) of CB functions. This function of "the custodian of the cash reserves of the private banks" was a critical juncture in the history of central banking and monetary policy.

The central banking function of being host to the settlement of interbank claims (over their CB accounts) was embraced in 1854, when ".. .its position as the centre of the English banking system banking structure was further strengthened...when the plan was adopted of settling the differences between the various banks at the end of each clearing by transfers between their respective accounts at the Bank."146 The "Bank" referred to was the Bank of England. Initially this was accomplished by the banks meeting in person at the Bank of England, exchanging cheques and settling the differences. As we saw earlier, this is now achieved in electronic fashion (and has been since the advent of computers).

Bank of England: early days: lender of last resort & Bank rate

The function of "lender of last resort" (as reflected in item F in Balance Sheet 1) was assumed a little later. The phrase was coined by Walter Bagehot (1826-1877), an essayist, journalist and businessman, whose book "Lombard Street: a description of the money market" was regarded as the seminal work on the British banking system and money market at the time. This function was executed mainly in periods of crisis in the early days of the Bank of England. According to De Kock, "___it was brought home to the Bank that in certain circumstances financial panic could easily be brought about by the fear that the requisite banking facilities could not be obtained, and that it could be promptly allayed by the assurance that all legitimate requirements would be met by the Bank, although at temporary higher rates."

The last point is significant: the use of interest rates, and specifically Bank rate148 (as the KIR was termed then), to influence the banking system. As noted earlier, some central banks still use this term; others use base rate, repo rate, discount rate, and so on. Bank rate then became an instrument of monetary policy; Bank rate was used ".with the object of limiting the demand for accommodation to the most urgent and essential needs and securing the contraction of loans as a whole."

Morgan informs us that Bank rate became an important tool of the Bank of England in the nineteenth century: "The main instrument which the Bank used was the variation of the published minimum rate at which it would discount approved bills of exchange...known as Bank the crisis of 1847... it was changed eight times...and from henceforth it was firmly established as the Bank's major policy instrument."

It is evident that the Bank received bills for discount from the banks, and it came about that Bank rate (as is the case today) had a major impact on market rates: "A convention soon grew up by which the other banks varied the rates which they charged for overdrafts with variations in Bank rate.. .a change in Bank rate had an immediate impact on the cost of this form of borrowing. Otherwise, the direct effect of a change in Bank rate was on the rates charged in the discount market." Discount market was a name used for the major part of the money market in earlier days (when discount houses - specialized banks - were the main participants).

As noted earlier, the Bank of England was competing also with the banks in the bills of exchange (i.e. prime lending) market. At the same time it was cognizant of its role of controller of the loan creating activities of the banks, as reflected in its Bank rate often being set at higher rates than the market rate -which inevitably led to the market following this course. Morgan tells us that at the beginning of the second half of the nineteenth century the Bank of England ".. .was torn between these two policies. It had always competed for business.. .and the profit motive urged the directors still to do so. On the other hand, the difficulties of acting both as competitor and controller grew steadily more apparent and in the 1870s, the practice of keeping Bank rate above market rate became established and has continued ever since."

In these times the Bank of England quickly realized when Bank rate was ineffective: when the banks had large reserves - often a result of the Bank's own loan business. You will recall that when a CB extends loans (buys government bonds or in this case bills of exchange), it increases deposits in the banking system. These deposits invariably came back to the Bank of England in the form of deposits by the other banks (= an increase in reserves).

In these circumstances of high bank liquidity the Bank of England resorted to open market operations (OMO - in this case sales of securities). Morgan153 tells us: "...suppose that the Bank sold Consoles [= bonds]; the buyers would pay by cheques on their commercial banks; the payment of these cheques would reduce the commercial banks' balances with the Bank of England. And so they would have smaller reserves and could lend less in the money market these operations were always subordinate to Bank rate, and were used as a means of ensuring that Bank rate was 'effective'." As we saw earlier and will belabour again later, this remains an essential element of monetary policy today.

As we have seen, in the majority of countries, the central bank's KIR has become the primary tool to influence bank loan extension / client loan demand behaviour without resorting to "penal" rates. The other operational "tool" that makes the rate effective is OMO to ensure that the banks are indebted to the CB.

So, by approximately the middle of the nineteenth century the Bank of England pretty much has assumed all of the functions that we all now associate with central banking. It was in this century that most of the European central banks were established, no doubt motivated by the Bank of England. They were followed somewhat later - in the first half of the twentieth century - by the New World countries (America, Canada, South Africa, Australia, New Zealand, Chile, etc) and some Old World countries (China, India, etc). For example, the American Federal Reserve System (of twelve Federal Reserve Banks) was established in 1914, the Central Bank of China in 1928, the Reserve Bank of India and the Bank of Canada in 1935.

There is an item missing from Balance Sheet 1 (representing the balance sheet of the Bank of England in the past), and this is "loans to NBPS". In its early days the Bank was also competing with the private bankers and was involved in discounting commercial bills of exchange ("discounting" refers to buying them at a discount to face value, the difference being the interest earned; it is simply a means of providing loans to the NBPS, which of course is money creation). The money created then was a combination of NBPS deposits and bank notes, mainly the latter. This lending activity of course meant that as time went by there were more and more deposits / bank notes backed by a more or less unchanged volume of gold reserves, making the Bank vulnerable.

As we know, the Bank of England experienced a number of crises, and it was obliged to suspend convertibility of notes and bank deposits on an number of occasions in these times, semi-finally in 1914, and finally in 1931. The end of convertibility of bank notes and deposits into gold was inevitable, and is related to the simple fact of increasing bank lending to the NBPS, and the gold backing bank notes and deposits, while not reducing absolutely, certainly reduced relatively.

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