Tag: Financial Crisis

Repo Loans

Repo loans are a type of loan, typically from one bank to another, with a very short term for repayment. One day repo loans are common. Despite the name, “repo loans” have nothing to do with repossessions.

Background

Repo loans came about after the US finally chartered a single, all-powerful central bank in December 1913. Before that time there were two weak US banks, that failed, and countless regional banks.

Let’s step back for a minute. Banks take in deposits and lend money. Some banks, depending upon laws that vary country-to-country (and over time) also invest the money. Banks keep a certain amount of their depositor’s money, called a reserve, and lend or invest the rest.

This usually works fine but if there’s any one day that has the need for more capital than normal, say to complete a deal, banks borrow money for that one day only. Banks who did not have access to these short-term funds could not complete deals which was harmful to the overall economy.

In response, the newly created Federal Reserve created repo loans, to lend banks short-term funds and keep liquidity in the system.

Repo Loans Spread

Soon enough, banks started lending repo loans to other banks and the Federal Reserve, and all other central banks became a bank of last resort. That is, a bank could borrow money from the Federal Reserve but it would be on more onerous terms than other banks, alerting regulators (and, initially, depositors) that a bank was suffering financial distress.

After the Great Depression in the US banks were divided into two types. There were retail banks that held government-guaranteed deposits and loaned money. However, they were extremely restricted in their investment activities. Then there were investment banks that could only work for businesses but could and did invest.

Retail banking became boring. But investment banking was a wild ride. Well-known investment banks included Goldman Sachs, Morgan Stanley, Bear Stearns, and Lehman Brothers.

Bear Stearns famously relied upon one-day repo loans for the vast majority of their liquidity. The bank loans money out on a longer-term higher-interest project and relied on one-day low-interest loans to stay afloat. One day interest rates were low because the risk was perceived as somewhere between low and non-existent: how could a giant bank go out of business overnight?

2008 Financial Crisis

This worked well for decades until the financial crisis when other banks feared that Bear Stearns could, indeed, declare bankruptcy and fail to repay their one-day loans. First, they increased borrowing costs and eventually refused to lend at any rate.

Allegedly worried about financial mayhem, the New York Federal Reserve stepped in. In 2008, Tim Geithner brokered an emergency sale of the bank to the more stable JP Morgan Chase. This signaled the beginning of the financial crisis.

Despite problems in the past, the repo loan market continues to fuel the modern financial world.

Central Banks

Background

The first central bank was Swedish Riksbank. The Swedish government chartered it to act as a clearinghouse for commerce. In 1694, the Bank of England was founded. It’s primary purpose was to purchase government debt. Napoleon chartered the Banque de France to stabilize currency after the French Revolution.

Early central banks, and their modern counterparts have many functions. One of the best-known is they issue currency and hold a monopoly over money. They also enable non-central banks to operate, issue other banks loans, purchase state debt, create money, and manage inflation.

Controversially, central government-chartered banks can become a lender of last resort during financial crises.

Purpose of central banks

One often misunderstood component is that central banks are private institutions, not unlike other banks. The difference is they enjoy monopoly powers other banks do not – including and especially the ability to issue currency – and their only customers are other banks. Their original customers are other banks. Their only product is short overnight loans. However, most notably during the Financial Crisis of 2007-2008, the US Federal Reserve loaned money directly to bail out banks and private businesses.

While central banks issue currency, most tied their currencies to gold. While the gold standard was abandoned during the 20th century, many central banks still have vast amount of gold. The US Federal Reserve has over 400 tons of gold in the vault under its bank in New York City.

Nevertheless, many central banks print currency tied to nothing, called fiat currency. Other central banks tie their currencies to other fiat currencies or a combination of fiat currencies.

Countries have gone without central banks, but it usually does not end well. The US had an 80-year period with no central bank: states made their own banks which issued their own currency. There were bank runs, massive fraud, and payments took forever to clear as the various individual banks worried about fraud. A financial crisis in 1907 convinced the US government of the need for one central bank and, in 1913, the Federal Reserve was created.

Modern central banks

During the 20th century, central banks added overall economic health to their focus. Before then, their primary goal was to make sure the money supply was stable and ensure payments between banks. They evolved and, today, central banks also try to reduce unemployment and prevent recessions.

The heads of most central banks are economists.