3.1 The Bank of England

The relationship between the balance sheets of commercial banks and the central

bank, and the effects on both of various ows, are examined further in section 3.4.

3.1.3Banker to the government

In some, but not all, nancial systems the government holds its accounts with

the central bank rather than with the commercial banks. Where this is the case,

payments between the government and the private sector will involve transfers

inside the central bank between the government’s accounts and the accounts held

by commercial banks. For example, if customers of bank A make net payments

to the government (as they will when paying taxes, for example), funds are debited

from bank A’s account at the central bank and credited to the government account.

In fact, if there are net payments (payments in excess of receipts) from the whole

of the private sector to government (as there are on occasions), the whole of the

commercial banking system may nd itself being debited to the point where there

is a serious shortage of funds available to commercial banks. On the other hand,

net payments from government to the private sector as a whole will lead to an

expansion of commercial bank deposits at the central bank.

3.1.4Supervisor of the banking system

Central banks are often responsible for the supervision of the banking system.

This involves some form of licensing, control over the appointment of directors of

commercial banks and the laying down and monitoring of key nancial ratios

in commercial banks’ balance sheets. The reason for all supervision of nancial

institutions originates with ‘asymmetric information’ – the fact that customers of

the institutions are less well informed and thus more at a disadvantage about the

affairs of the intermediary than the intermediary is itself.

The case for banking supervision is further strengthened by worries about the

consequences of bank failure. It is widely felt that bank failures are especially serious

and damaging to the economy. If an insurance company becomes insolvent, for

example, policyholders will nd that they no longer have the cover for which they

had paid their latest premium. There is plainly a loss to policyholders, consisting of

the wasted premium plus the risk of temporary lack of cover, plus the inconvenience

of nding a new policy. However, this loss is not likely to affect their behaviour

in any dramatic way and it is unlikely that the failure of one insurance company

will have direct repercussions on others. The failure of a bank, however, means that

many depositors will lose not just some fraction of their wealth but also their means

of payment. This again originates from bank deposits functioning as money. If they

lose their means of payment, people are bound to take instant steps to remedy the

situation. This will involve the rapid sale of other assets. The price of these assets

is then bound to fall, and since other nancial institutions hold these assets as part

of their portfolio, the value of their assets declines and they in turn could become

insolvent. This chain of events is a way of saying that the ‘negative externalities’ of

bank failure can be severe.

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Chapter 3 • Deposit-taking institutions

For this reason, banks generally enjoy two advantages over other nancial institu-

tions. The rst is that they have access to a ‘lender of last resort facility’ provided

by the central bank (discussed in 3.1.2 above). The second is a system of deposit

insurance, operated by the banking supervisory body, whereby clients of a bank

which fails are guaranteed that at least a proportion of their deposits will be safe.

Box 3.2 gives a summary of the terms that apply to deposit insurance in the UK at

the time of writing.

Box 3.2

UK deposit insurance in 2005

The scheme, operated by the FSA, covers banks, building societies and credit unions

(deposit-taking rms) listed on the FSA’s Register of Authorised Firms. If a bank, build-

ing society or credit union goes out of business, the scheme pays the rst £2,000 in full

of the amount that clients have on deposit. It also pays 90 per cent of the next £33,000.

This means a maximum compensation of £31,700.

If depositors have more than £35,000 deposited in a bank, building society or credit

union, the extra amount (above £35,000) is not eligible for compensation. How much of

this extra amount a depositor will recover from an insolvent bank, building society or

credit union will depend on how much of the bank, building society or credit union’s

assets can be recovered.

Source: www.fsa.gov.uk

Given these advantages, it is not surprising that banks must be prepared to accept

a high degree of supervision in return. If this were not the case, it would be at least

a possibility that banks might behave in a reckless manner, in pursuit of additional

prot, knowing that if their schemes went wrong, the lender of last resort might

help them, while the supervisory body would protect bank depositors from losing

all their deposits. (The idea that protection schemes can encourage people or rms

to behave more recklessly than they would otherwise is known as ‘moral hazard’ and

is discussed in connection with insurance companies in the next chapter.)

The need for supervision may be widely accepted, but it does not have to be done

by the central bank. As we noted above, supervision of the banking system is one of

the activities which can potentially give rise to conicts of interest if carried out by

a central bank which has independent responsibility for the conduct of monetary

policy. In Germany, for example, the responsibility for banking supervision rests with

the Aufsichstsamt, the Federal Banking Supervisory Ofce. In the UK, supervision of

the banking system has traditionally been carried out by the Bank of England. Its

most recent authority stemmed from the Banking Act 1987 which required the Bank

of England to exercise the following powers:

l	licensing of all deposit-taking institutions (except building societies);
l	ensuring that institutions have adequate capital, liquidity and controls;
l	ensuring they make adequate provision for bad debts;
l	checking that directors of banking institutions are ‘t and proper persons’.

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