Central Bank Lending

Readers Question:… So, basically we have the FED using it’s money to liquidate the fund’s of other people, and those other people are lending, or a portion of them are lending, the fund’s that they now have because of the FED. Wouldn’t it make more sense for the FED to, instead of purchasing bonds so that those people that held the bonds may become debtors, to rather just lend the money directly to firms at a zero percent interest rate?

Central Banks are responsible for:

  • Maintaining monetary stability (low inflation, positive economic growth)
  • Financial stability (e.g. acting as lender of last resort should commercial banks be short of funds)

Usually, Central Banks have been able to manage their objectives with relatively minimal activity. For example, the Fed managed the US economy mainly through changing the base interest rate. However, the great recession of 2008, created a particularly deep recession in which conventional monetary policy failed to overcome the recession. Therefore, to promote economic activity, they pursued quantitative easing. This involved creating money to buy bonds from commercial banks. It was hoped this would:

  1. Increase liquidity of commercial banks
  2. Reduce bond yields encouraging banks to lend and firms to borrow

Quantitative easing had some impact (see: Impact of quantitative easing) The recession would probably have been worse without it. But, a significant part of extra money was kept by banks to improve their balance sheets. Therefore, the impact on economic activity was limited.

Should Central Banks Lend Directly?

Generally, Central Banks try to avoid moving into the field of directly lending to firms. The problem is that Central Banks are supposed to have a narrow remit. If they start lending to firms, it may be difficult to know how, when and which firms to start lending. For a Central Bank to start lending directly would require a change of constitution and give them even more political influence. There is also a fear Central Banks will lose their credibility should they start becoming an ordinary bank as well. Given their political importance and influence, there would be little appetite for making a Central Bank a key lender in the economy. For example, on the issue of direct lending by the Bank of England, Mervyn King stated:

 “It is not sensible for us to get engaged in making judgments about which sectors of the economy to extend credit to- judgments which are inherently fiscal or political in nature.” Inflation Report

However, in exceptional circumstances, others have argued there is a need for the government or Central Bank to exceed its usual role and directly encourage lending because commercial banks are not doing their job. Japan, which suffered a lost decade of stagnant growth did see its Central Bank  step outside its traditional role and lend directly.

The central bank (of Japan) will provide loans for no less than a year to “support strengthening the foundation for economic growth” in areas including research and development, setting up new businesses, energy and the environment, healthcare, childcare, housing and disaster prevention.

The move is the first of its kind for the central bank, although it has provided guarantees for loans to small and medium enterprises in the past. The BoJ said the lending programme, which was announced at the end of April, would have a maximum size of ¥3 trillion ($32.8 billion), with no more than ¥1 trillion to be disbursed per quarter.

“It seems to be subsidised direct lending to the enterprise sector, rather than a monetary measure, as there is no indication that this is going to be adding to the monetary base – the total size of it is less than 1% of GDP,” (Central Banking.com)

The scale is relatively small. But, it is an example of a Central Bank trying to make a commitment to growth – Hoping this will change expectations and improve growth prospects.

Another option is for a Central Bank to fund a government intermediary bank to improve lending to small and medium term businesses. For example, Adam Posen has criticised the poor infrastructure of UK banks for lending to business. If commercial banks fail to do the job, there is scope for improved private sector or government lending initiatives.


By on May 7th, 2012

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