Bank of Last Resort

Originally published in the Informanté newspaper on Thursday, 20 July, 2017.

The last few months, the Bank of Namibia has been in the news almost constantly after its take-over of SME Bank, and the past few weeks especially, given that bank’s liquidation. This is, of course, the result of Chapter 17, Article 128 of the Namibian Constitution, that states, “There shall be established by Act of Parliament a Central Bank of the Republic of Namibia which shall serve as the State's principal instrument to control the money supply, the currency and the institutions of finance, and to perform all other functions ordinarily performed by a central bank.”

The Bank of Namibia is that central bank. As to how central banks came to be, well. As with most institutions in the modern age, central banks originated from the last great empire – the British Empire. Back in the 1690’s, the Kingdom of England was involved in a war with France, and King William III’s government found it difficult to procure funds for this war. Credit of a government, up until that point, was tied to the reigning monarch, and different ones had different levels of fiscal responsibility. Monarchs are notorious for not wanting to relinquish authority until they have no other choice, and so too here. 

Up until that point, the printing of currency was under the sole authority of the king, which is why he was having credit issues. Lenders did not want to lend money to a king who would just print more currency, and thus devalue the money they lent to him. Thus, the Bank of England was born, to which was entrusted not only the accounts of all of government, but also the exclusive right to issue bank notes. When the Bank of Namibia was established this was one of the responsibilities it gained.

Initially, all of the money printed by the bank was backed by gold, but the first cracks in this system appeared in 1797, when a bank run to convert paper money into gold occurred. The Bank of England suspended conversion into gold, and in the analysis of the bank run afterwards, it was resolved that the central bank should not only act to stabilize the currency, but also act as a lender of last resort for other banks. And so the final few functions normally attributed to central banks was born.

So the Bank of Namibia is also Namibian banks’ lender of last resort. What does this mean? Well, to explain that, we need to examine the concept of fractional-reserve banking. While banks originated simply as a place to store depositors’ money, the problem was that inflation always ate away at that store of value. As such, big depositors usually did not store their money for long in a bank, before using it to invest in a venture that would enable them to growth their money at least a bit more than inflation.

Businesspeople would thus often approach a bank to try and find out who would be able to assist them in financing their ventures, and soon the banks realized there was an additional service they could offer. Many depositors would invest willingly when offered such chances, but several found the additional hassle too much. Others would have liked to invest, but had too little to offer. So banks started offering interest of deposits held by them, with the understanding that they would take these deposits, pool them, and invest it in ventures to earn greater returns. Banks thus no longer just offered deposits, but loans as well. As a result, only a fraction of deposits would be held in cash as a reserve for deposits – hence ‘fractional-reserve banking.’

This presented a problem, however – if banks lent out too much of the money deposited, then they’d have nothing to give those depositors who wanted to withdraw their deposits. When that happened, word would spread amongst the depositors of a bank, and they’d all run to the bank to withdraw their deposits. With loans generally being on longer terms than deposits, the bank would quickly run out of cash, and would have to recall all loans – often driving them out of business. This is what is called a ‘bank run.’

So when that bank run in 1797 occurred, it was established that central bank would act as lenders of last resort. When a bank ran out of cash for depositors, it would supply that cash to the bank to prevent a bank run – but there was a price to be had. For this to work, the lender of last resort institutes several regulatory measures to try and prevent it needing to do so on a regular basis – to try and mitigate the moral hazard it presented to banks. This ranges from instituting the fraction of deposits that must be kept in reserve, up to and including taking over management of a bank that requires such assistance to see what lapses occurred to require such assistance in the first place. 

When we take a look at the SME Bank, then, we can see this is almost exactly what happened. When a large depositor wanted to withdraw an investment, the bank could not produce the cash required. Based on the information the Bank of Namibia had, the bank should not have been in this position. As such, it took the drastic step of taking over management to see what went wrong. As such, the ill-advised investments at that bank came to light, and the Bank of Namibia realised that the investments were not recoverable, and thus could not extend liquidity as lender of last resort, as that would throw good money after bad. As a result, they placed the bank in liquidation.

So the Bank of Namibia in the final act did perform its duties as central bank admirably, but it did reveal several lapses that should not have occurred. After all, it was their duty to regulate the bank to such a degree that this would not be possible – taking over management and liquidation is its nuclear option, and the assessment of a bank’s investments is part of its regulatory mandate. Let us hope that the Bank of Namibia takes this lesson to heart – otherwise the Namibian nation will lose its faith in its central bank, and that never bodes well for a nation’s future.

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