case study on central bank and its functions

The Case for Central Bank Independence: A Review of Key Issues in the International Debate

ECB Occasional Paper No. 2020248

70 Pages Posted: 6 Oct 2020

Benjamin Vonessen

European Central Bank (ECB)

Katrin Arnold

Affiliation not provided to ssrn, rodolfo dall’orto mas, christian fehlker.

Date Written: October, 2020

This Occasional Paper analyses how significant expansions in central banks’ mandates, roles and instruments can result in challenges to the independence of monetary policy. The paper reviews, in particular, some of the key challenges to central bank independence brought about by the global financial crisis (GFC) of 2007 and assesses their impact on the de jure and de facto independence of selected central banks around the world in the past few years. It finds that although the level of de jure (legal) central bank independence did not deteriorate, the level of de facto (actual) independence of the central banks of some of the largest economies in the world may have weakened. The paper presents counterarguments to the key critiques raised against central banks due to their policy response during the GFC, and concludes that the case for central bank independence is as strong as ever.

Keywords: central bank independence, central bank mandate, financial stability, global financial crisis, price stability

JEL Classification: B1, B2, C4, E3, E4, E5, E6, K3, N1, N2

Suggested Citation: Suggested Citation

Benjamin Vonessen (Contact Author)

European central bank (ecb) ( email ).

Sonnemannstrasse 22 Frankfurt am Main, 60314 Germany

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The Role of Central Banks in Fostering Economic and Financial Resiliency

Professor Summers raised a variety of concerns about current policy and the risks to the financial system in his chat on the conference's second day. One of these concerns relates to the monetary policy projections, which suggest that inflation will remain sufficiently low so that the Fed's policy rate may not increase for several years. This expectation of low rates may create a "dangerous complacency," according to Summers, that will make it more difficult to raise rates. The result may be that nominal policy rates remain too low, producing higher inflation that leads to even lower real rates and even higher inflation. The result could be not only a "substantial pro-cyclical bias in financial conditions" but also a threat to financial stability if the low nominal rates result in excessive financial leverage.

Monetary policy panel session The monetary policy toolkit received some scrutiny in a panel titled "Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?" It was moderated by Julia Coronado, president of MacroPolicy Perspectives. Coronado promised a session with some provocative comments, and each of her panelists delivered. Among the problems addressed by the panelists was central banks' limited ability to counteract economic downturns. Historically, central banks have lowered their nominal interest rate target by several percentage points in response to the onset of a recession, or even the elevated risk of one. The continuing decline in nominal rates, however, has reduced central banks' ability to use rate reductions to fight recessions, instead forcing them to rely more on quantitative easing (or more accurately, large-scale asset purchases). Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, and Willem Buiter, a visiting professor at Columbia University, provided two alternative ways of restoring the central bank's ability to lower nominal rates by more than 1 or 2 percentage points.

Gagnon's analysis was based on the Fisher equation, in which the nominal interest rate is approximately equal to the real rate of interest plus the rate of inflation. Gagnon observed that central banks, including the Fed, had set a target inflation rate of 2 percent back when the equilibrium real rate was higher (likely around 2 to 3 percent). Establishing this target rate resulted in equilibrium nominal interest rates around 4 to 5 percent, which gave central banks considerable room to respond to a recession. However, in the period since the inflation targets were set, equilibrium real rates have fallen by 1 to 2 percentage points. This decline greatly reduced central banks' ability to lower rates without taking them negative. Thus, to restore the ability of central banks to respond to higher inflation, Gagnon argued that central banks' inflation target should be increased to 3 to 4 percent.

Buiter implicitly started from the same point: that the decline in the equilibrium real rate had left central banks with too little room to cut interest rates. However, rather than raising the inflation target, Buiter argued that a better solution would be to accept deeply negative nominal interest rates. Several central banks in Europe, as well as the Bank of Japan, have lowered their rates below zero but never as much as 1 percent below zero. Buiter recommended that central banks take the steps necessary to be able to have deeply negative interest rates if that is appropriate for conditions.

Simon Potter, vice chairman at Millennium Management, noted an international dimension to the Fed's policy setting. Potter observed that many emerging markets had taken on considerably more debt to respond to the ongoing pandemic. He argued that these countries would need fast U.S. growth, and the accompanying increase in exports to the United States to be able to service their debt. Absent such increased debt service capacity, he pointed out that changes in the structure of these countries' debt markets would make rescheduling their debts even more difficult than it had been previously.

These provocative comments did not go unchallenged, however, as the other panelists raised concerns about the feasibility and/or desirability about each of these policy recommendations in the subsequent discussion that Coronado moderated.

Global dollar policy session A panel on the conference's second day had the provocative title "Is the Financial System's Backbone, the U.S. Dollar, Also a Transmitter of Stress?" The panel's moderator was Federal Reserve Bank of Dallas president Robert Kaplan, who began the discussion by highlighting the importance of the USD in both international trade and international financial markets.

Thomas Jordan, chairman of the governing board of the Swiss National Bank, also noted the dominance of the USD in international markets and discussed its implications from the Swiss point of view. He noted two ways in which Switzerland is especially vulnerable to developments regarding USD. First, Swiss banks hold substantial amounts of USD assets and liabilities. Second, the Swiss franc is a safe haven currency that experiences increased demand in times of international financial stress. These result in Switzerland having a strong interest in global financial stability and especially in the stability of USD-funding markets. In this respect, Jordan observed that the Federal Reserve's swap lines with other central banks, including the Swiss National Bank, has been "very crucial." The swap lines provide an important liquidity backstop that recently proved valuable during the COVID-19 crisis.

After these remarks by the panelists, Kaplan moderated a question-and-answer session that took a closer look at these and other issues.

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World Scientific Studies in International Economics: Volume 30

The role of central banks in financial stability.

• Edited by: 
• Douglas D Evanoff ( Federal Reserve Bank of Chicago, USA ) , 
• Cornelia Holthausen ( European Central Bank, Germany ) , 
• George G Kaufman ( Loyola University Chicago, USA ) , and 
• Manfred Kremer ( European Central Bank, Germany )
• Add to favorites
• Download Citations
• Track Citations
• Recommend to Library
• Description
• Supplementary

The two most topical issues in current financial markets deal with the causes of the recent financial crisis and the means to prevent future crises. This book addresses the latter and stresses a major shift in most countries toward a better understanding of financial stability and how it can be achieved. In particular, the papers in this volume examine the recent change in emphasis at central banks with regard to financial stability. For example: What were the cross-country differences in emphasis on financial stability in the past? Did these differences appear to affect the extent of the adverse impact of the financial crisis on individual countries? What are perceived to be the major future threats to financial stability? These and related issues are discussed in the book by well-known experts in the field — some of the best minds in the world pursuing financial stability. Following the global financial crisis, significant reforms have been initiated in many countries to address financial stability more directly, frequently focusing on macroprudential policy frameworks in which central banks play a more active role.

Sample Chapter(s) The (Changing) Role of Central Banks in Financial Stability Policies (51 KB)

• The (Changing) Role of Central Banks in Financial Stability Policies (Peter Praet)
• The Role of Central Banks in Financial Stability: How Has It Changed? (Willem H Buiter)
• Pursuing Financial Stability at the Federal Reserve (Janet L Yellen)
• Financial Stability: Lessons Learned from the Recent Crisis and Implications for the Federal Reserve (Nellie Liang)
• Role of Central Banks in Financial Stability: Lessons from the Experience of the Bank of Japan (Takeo Hoshi)
• Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets (Carlos A Vegh and Guillermo Vuletin)
• Can We Identify the Financial Cycle? (Mathias Drehmann, Claudio Borio and Kostas Tsatsaronis)
• Low Interest Rates and Housing Bubbles: Still No Smoking Gun (Kenneth N Kuttner)
• Classic FIT and Lean FIT: Is Inflation-Targeting Guilty of Causing the Financial Instability of 2007–2009? (Takatoshi Ito)
• Bank Capital Regulations: Learning the Right Lessons from the Crisis (Asli Demirgüç-Kunt)
• International Monetary Reform: Exchange Rates or Interest Rates? (Ronald McKinnon)
• Threats to Financial Stability in Emerging Markets: The New and Very Active Role of Central Banks (Liliana Rojas-Suarez)
• In Defense of Wall Street: The Social Productivity of the Financial System (Ross Levine)
• Output Growth Variability: The Role of Financial Markets (Alexander Popov)
• Occupying the Wrong Street? The Social Productivity of the Financial Sector: Some Comments (Gerard Caprio, Jr.)
• Bankers and Brokers First: Loose Ends in the Theory of Central Bank Policymaking (Edward J Kane)
• The Elusive Scale Economies of the Largest Banks and Their Implications for Global Competitiveness (Joseph P Hughes)
• The Ex Ante versus Ex Post Effect of Public Guarantees (Evren Damar, Reint Gropp and Adi Mordel)
• Real and Imaginary Resolution Options for Large Financial Institutions (David A Skeel, Jr.)
• Is Our Economy's Financial Sector Worth What It Costs Us? (Benjamin M Friedman)
• The Eurozone Crisis: Causes, Remedy, and Misperceptions (Richard C Koo)
• Macroprudential and Monetary Policies (Frederic S Mishkin)
• The Eurozone Crisis (Richard Portes)
• The Way Forward — Central Banks with Financial Stability Mandates: The Case of the Eurosystem (Anne Sibert)
• Examines the changing role of central banks with regard to financial stability. This includes regulatory reform across a number of countries
• Contributors include representatives of central banks, regulatory and supervisory agencies, financial institutions, trade associations, and academic institutions from around the globe

Type on 06/11/2012

Updated ed on 30/01/2013

FRONT MATTER

• Douglas D Evanoff ,
• Cornelia Holthausen ,
• George G Kaufman , and 
• Manfred Kremer
• Pages: i–xi

https://doi.org/10.1142/9789814449922_fmatter

• Acknowledgments

I. Special Addresses

The (changing) role of central banks in financial stability policies.

• Peter Praet

https://doi.org/10.1142/9789814449922_0001

More than four years have passed since the onset of the financial crisis. Over these years, central banking functions have been stretched to the limits…

The Role of Central Banks in Financial Stability: How Has It Changed?

• Willem H. Buiter
• Pages: 11–56

https://doi.org/10.1142/9789814449922_0002

• The Rediscovery of Financial Stability by the Central Banking Community of the Advanced Economies
• Financial Stability: What is It?
• Regulate Risky Behavior, Not Institutions
• Regulation and Resolution Need to be Global in Scope
• Leaning against the wind in asset markets and credit markets
• A little seigniorage arithmetic
• The ability and willingness to use the anticipated and unanticipated inflation taxes
• Technical/economic obstacles to an inflationary solution of the U.S. and euro area sovereign debt problems: The seigniorage Laffer curve
• Quasi-Fiscal Activities of the Central Bank
• Instruments of the Modern Central Bank
• The Institutional Division of Labor for Financial Stability: Who Does What?
• Competence and Independence
• Legitimacy, Accountability, Transparency

Pursuing Financial Stability at the Federal Reserve

• Janet L. Yellen
• Pages: 57–66

https://doi.org/10.1142/9789814449922_0003

• Overview of the Macroprudential Approach
• Identifying and Addressing Structural Forms of Systemic Risk
• Identifying and Addressing Cyclical Forms of Systemic Risk
• Current Challenges

II. The Role of Central Banks in Financial Stability: Historical Review and Critique

Financial stability: lessons learned from the recent crisis and implications for the federal reserve.

• Nellie Liang
• Pages: 69–81

https://doi.org/10.1142/9789814449922_0004

• Lessons Learned
• Implications for the Federal Reserve

Role of Central Banks in Financial Stability: Lessons from the Experience of the Bank of Japan

• Takeo Hoshi
• Pages: 83–104

https://doi.org/10.1142/9789814449922_0005

• Introduction
• Financial Instability in the 1920s
• Convoy System to Prevent Bank Failures
• Bank of Japan After the New Bank of Japan Act of 1998
• Monetary Policy and Prudential Policy
• Lessons from the Experiences of the Bank of Japan

Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets

• Carlos A. Vegh  and 
• Guillermo Vuletin
• Pages: 105–129

https://doi.org/10.1142/9789814449922_0006

• Graduating Class
• Graduation and “Fear of Free Falling”
• Graduation and “Fear of Free Falling”— Regression Analysis
• Conclusions
• Appendix 1. Definition of Variables and Sources
• Appendix 2. Countries in the Sample
• Appendix 3. Data on Cyclicality of Monetary Policy, Fear of Free Falling, and Institutional Quality

Can We Identify the Financial Cycle?

• Mathias Drehmann ,
• Claudio Borio , and 
• Kostas Tsatsaronis
• Pages: 131–156

https://doi.org/10.1142/9789814449922_0007

• Frequency-based filter analysis
• Turning-point analysis
• Frequency-based filter analysis: Short-term and medium-term cycles
• Turning-point analysis: Short-term and medium-term cycles
• What happens around financial crises?
• Methodology for the combination of series
• Selection of series
• Policy Context: Regime-Dependence and “Unfinished Recessions”

III. Central Banks and Asset Price Bubbles

Low interest rates and housing bubbles: still no smoking gun.

• Kenneth N. Kuttner
• Pages: 159–185

https://doi.org/10.1142/9789814449922_0008

• The user cost framework
• A dynamic user cost model
• The credit channel
• The risk-taking channel
• Existing literature
• Results from an error-correction model
• The U.S. experience
• A cross-country exploration

Classic FIT and Lean FIT: Is Inflation-Targeting Guilty of Causing the Financial Instability of 2007–2009?

• Takatoshi Ito
• Pages: 187–205

https://doi.org/10.1142/9789814449922_0009

• Flexible Inflation Targeting (FIT) and Bubble
• Digression: The Japanese Bubble Experience
• Middle Ground: Should the Central Bank Target Asset Prices?
• Collecting and Calculating Housing Price Data
• Legal Framework to Avoid Too-Big-to-Fail
• Commitment to FIT with Financial Stability
• Concluding Remarks

IV. Current, Past, and Potential Future Threats to Financial Stability

Bank capital regulations: learning the right lessons from the crisis.

• Asli Demirgüç-Kunt
• Pages: 209–217

https://doi.org/10.1142/9789814449922_0010

• The Analysis and Results
• Policy Implications

International Monetary Reform: Exchange Rates or Interest Rates?

• Ronald McKinnon
• Pages: 219–236

https://doi.org/10.1142/9789814449922_0011

• Interest Differentials, Carry Trades, and Worldwide Inflation
• Carry Trades and International Monetary Reform
• A New International Monetary Agreement?
• The Supply Constraint on Bank Credit
• A Concluding Note on Stagflation in the United States

Threats to Financial Stability in Emerging Markets: The New and Very Active Role of Central Banks

• Liliana Rojas-Suarez
• Pages: 237–253

https://doi.org/10.1142/9789814449922_0012

• Capital Flow Volatility in the 2000s: The Dominance of Events in Advanced Economies
• The Capital Inflow Problem: A Common Concern Under Different Growth Models
• Central Bank Responses in Emerging Markets: Can There be Enough Instruments in Countries that Do Not Issue Hard Currency?

V. The Social Productivity of the Financial Sector

In defense of wall street: the social productivity of the financial system.

• Ross Levine
• Pages: 257–279

https://doi.org/10.1142/9789814449922_0013

• Cross-country evidence
• U.S. evidence on finance, growth, inequality, and the poor
• Banks, markets, and growth
• Financial Innovation and Growth

Output Growth Variability: The Role of Financial Markets

• Alexander Popov
• Pages: 281–295

https://doi.org/10.1142/9789814449922_0014

• Finance, Output Growth, and Output Volatility
• Finance, Output Growth, and Output Skewness

Occupying the Wrong Street? The Social Productivity of the Financial Sector: Some Comments

• Gerard Caprio, Jr.
• Pages: 297–305

https://doi.org/10.1142/9789814449922_0015

We have before us in the session three different and yet complementary “takes” on what is meant by the social productivity of the financial sector, and three calls, directly or indirectly, for further research. Ross Levine looks at the ways that finance adds to social welfare by contributing to growth and income equality and analyzes the evidence. Alexander Popov adds another variable of possible concern, the volatility of the growth process, surely an important issue in the tumultuous wake of one of the worst financial crises of all time. Josh Lerner, in his paper with Peter Tufano, is concerned about the role of financial innovation and whether it makes our lives better or worse. All three papers are worth your attention…

VI. Open Issues in the Regulatory Debate: Failure Resolutions, Bailouts, Moral Hazard, and Market Discipline

Bankers and brokers first: loose ends in the theory of central bank policymaking.

• Edward J. Kane
• Pages: 309–325

https://doi.org/10.1142/9789814449922_0016

• Misconceptions about Crises and Crisis Response
• Central Bank and Government Rescue Programs
• Rethinking Systemic Risk
• Usefulness of Capital Requirements has been Oversold
• Undone by the Regulatory Dialectic
• Recommendations for Reform
• Traditional Reporting and Incentive Frameworks are Inadequate

The Elusive Scale Economies of the Largest Banks and Their Implications for Global Competitiveness

• Joseph P. Hughes
• Pages: 327–345

https://doi.org/10.1142/9789814449922_0017

• Evidence of Scale Economies at the Largest Financial Institutions
• How are Economies of Scale Typically Measured and Why Do They Elude Many Investigations?
• How are Scale Economies Measured While Accounting for Endogenous Risk-Taking?
• Do Too-Big-to-Fail Subsidies Account for the Estimated Scale Economies at the Largest Institutions?
• What are the Implications of the Estimated Scale Economies at the Largest Institutions for Restricting Their Scale and for Their International Competitiveness?

The Ex Ante versus Ex Post Effect of Public Guarantees

• Evren Damar ,
• Reint Gropp , and 
• Pages: 347–364

https://doi.org/10.1142/9789814449922_0018

• Methodology
• Guarantees and Risk-Taking
• The Net Effect of Guarantees—The Role of Charter Values
• Normal Times versus Crisis Times
• Discussion and Conclusion
• Appendix 1. Listed Banks Implicated by the DBRS Introduction of the SA Methodology on October 6, 2006
• Appendix 2. Difference-in-Differences: Wholesale Funding Market Access

Real and Imaginary Resolution Options for Large Financial Institutions

• David A. Skeel, Jr.
• Pages: 365–382

https://doi.org/10.1142/9789814449922_0019

• Origin myths and their implications
• Key problems with Dodd-Frank resolution
• Potential benefits
• The bankruptcy process
• Benefits of bankruptcy
• The limitations of bankruptcy
• The role and status of bankruptcy judges
• Is Bail-in the Solution?
• Next steps for Dodd-Frank and bankruptcy reform
• A more ambitious program: Chapter 14

VII. Policy Panel: Where to from Here?

Is our economy's financial sector worth what it costs us.

• Benjamin M. Friedman
• Pages: 385–389

https://doi.org/10.1142/9789814449922_0020

In 1867, when the American economy was still largely agricultural, Horace Greeley, the editor of the New York Tribune , threw out the following challenge in a lecture that he gave in Lower Manhattan: “There are 500,000 farmers, probably, in the State of New York today, who, if you were to ask each of them how much per bushel his corn had cost him to grow for the last twenty years, I doubt if fifty of the 500,000 could tell you. And this is but one instance out of ten thousand. Now, every grower of agricultural products should inquire and ascertain, year after year, ‘What does this cost me? What does it bring me?‘‘‘‘…

The Eurozone Crisis: Causes, Remedy, and Misperceptions

• Richard C. Koo
• Pages: 391–408

https://doi.org/10.1142/9789814449922_0021

• Eurozone in Balance Sheet Recession
• Destabilizing Intra-Eurozone Capital Flows
• An Endgame Solution
• Navigating the Transition Period
• ECB Could Buy More Government Bonds to Counter Lender-Side Problems

Macroprudential and Monetary Policies

• Frederic S. Mishkin
• Pages: 409–422

https://doi.org/10.1142/9789814449922_0022

• Views Before the Crisis
• Lessons from the Crisis
• Macroprudential Policy
• Monetary Policy

The Eurozone Crisis

• Richard Portes
• Pages: 423–431

https://doi.org/10.1142/9789814449922_0023

The Eurozone crisis of autumn 2011 is a sequel to the financial crisis of 2008–2009. It would have been much easier to contain and resolve had there been no global financial crisis, no deep recession in the advanced countries. It is therefore too facile, indeed wrong, to say that the Eurozone crisis is essentially or even mainly due to inherent faults in the monetary union. Nevertheless, the crisis has exposed genuine faults that were neither manifest nor life-threatening before 2008–2009. They might have been remedied with gradual progress toward a deeper economic union. But all that is for the economic historians.We are where we are, and it is not pretty…

The Way Forward — Central Banks with Financial Stability Mandates: The Case of the Eurosystem

• Anne Sibert
• Pages: 433–445

https://doi.org/10.1142/9789814449922_0024

• The political nature of the central bank's financial stability role
• The perceived legitimacy of the Eurosystem as provider of financial stability
• The Eurosystem's output legitimacy
• Input legitimacy through the manner of the ECB's creation
• Accountability and the Eurosystem
• Why macroeconomists are not enough
• Expertise for a financial stability role
• Combining the Financial Stability and Monetary Policy Roles of a Central Bank

BACK MATTER

• Pages: 447–449

https://doi.org/10.1142/9789814449922_bmatter

• Conference Agenda

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What Is a Central Bank, and Does the U.S. Have One?

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What Is a Central Bank?

A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions. Although some are nationalized, many central banks are not government agencies, and so are often touted as being politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

The critical feature of a central bank—distinguishing it from other banks—is its legal monopoly status, which gives it the privilege to issue banknotes and cash. Private commercial banks are only permitted to issue demand liabilities, such as checking deposits .

Key Takeaways

• A central bank is a financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates.
• Central banks enact monetary policy, by easing or tightening the money supply and availability of credit, central banks seek to keep a nation's economy on an even keel.
• A central bank sets requirements for the banking industry, such as the amount of cash reserves banks must maintain vis-à-vis their deposits.
• A central bank can be a lender of last resort to troubled financial institutions and even governments.

Investopedia / Zoe Hansen

Understanding Central Banks

Although their responsibilities range widely, depending on their country, central banks' duties (and the justification for their existence) usually fall into three areas. 

First, central banks control and manipulate the national money supply. They influence the sentiment of markets as they issue currency and set interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country's economy and achieve economic goals, such as full employment .

Most central banks today set interest rates and conduct monetary policy using an inflation target of 2-3% annual inflation.

Second, they regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves .

Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.

Example: The Federal Reserve

Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the central bank is the Federal Reserve System , aka "the Fed". The Federal Reserve Board (FRB), the governing body of the Fed, can affect the national money supply by changing reserve requirements. When the requirement minimums fall, banks can lend more money, and the economy’s money supply climbs. In contrast, raising reserve requirements decreases the money supply. The Federal Reserve was established with the 1913 Federal Reserve Act.

When the Fed lowers the discount rate that banks pay on short-term loans , it also increases liquidity . Lower rates increase the money supply, which in turn boosts economic activity. But decreasing interest rates can fuel inflation, so the Fed must be careful.

And the Fed can conduct open market operations to change the federal funds rate . The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply. The Fed sells securities to move the cash into its pockets and out of the system.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17 th century. The Bank of England was the first to acknowledge the role of lender of last resort . Other early central banks, notably Napoleon’s Bank of France and Germany's Reichsbank, were established to finance expensive government military operations.

It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States' founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country. Despite these objections, the young country did have both official national banks and numerous state-chartered banks for the first decades of its existence, until a “free-banking period” was established between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single U.S. currency , with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907 . In response, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations. The new Fed helped finance World War I and World War II by issuing Treasury bonds .

Between 1870 and 1914, when world  currencies  were pegged to the  gold standard , maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so  inflation  was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing  budget deficits  (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation. After the war, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from any political party or administration.

During the unsettling times of the  Great Depression  in the 1930s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries—a backlash against colonialism. The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.

Central Banks and Deflation

Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its value within a year, deflation became entrenched. The Japanese economy, which had been one of the fastest-growing in the world from the 1960s to the 1980s, slowed dramatically. The '90s became known as Japan's Lost Decade .

The Great Recession  of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers  in September 2008.

The Federal Reserve's Approach

In response, in December 2008, the Federal Open Market Committee (FOMC) , the Federal Reserve's monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, aka quantitative easing (QE) .

The former involved cutting the target federal funds rate essentially to zero and keeping it there at least through mid-2013. But it's the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed's easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation's banks so as to pump liquidity into the economy and drive down long-term interest rates. In this case, it allowed the Fed to purchase riskier assets, including mortgage-backed securities and other non-government debt.

This ripples through to other interest rates across the economy and the broad decline in interest rates stimulate demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their securities holdings.

Other Deflation-Fighting Measures

In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros' worth of bonds, at a monthly pace of 60 billion euros, through to September 2016. The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0% in late-2014 met with only limited success.

While the ECB was the first major central bank to experiment with negative interest rates , a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.

Results of Deflation-Fighting Efforts

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. Meanwhile, the concerted moves to fend off deflation globally have had some strange consequences: 

• QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war .
• European bond yields have turned negative: More than a quarter of debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields . This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in the future.
• Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling balance sheets to record levels. Shrinking these central bank balance sheets may have negative consequences down the road.

In Japan and Europe, the central bank purchases included more than various non-government debt securities. These two banks actively engaged in direct purchases of corporate stock in order to prop up equity markets , making the BoJ the largest equity holder of a number of companies including Kikkoman, the largest soy-sauce producer in the country, indirectly via large positions in exchange-traded funds (ETFs ).

Modern Central Bank Issues

Currently, the Federal Reserve, the European Central Bank, and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree.

Unwinding, or tapering these enormous positions is likely to spook the market since a flood of supply is likely to keep demand at bay. Moreover, in some more illiquid markets, such as the MBS market, central banks became the single largest buyer. In the U.S., for example, with the Fed no longer purchasing and under pressure to sell, it is unclear if there are enough buyers at fair prices to take these assets off the Fed's hands. The fear is that prices will then collapse in these markets, creating more widespread panic. If mortgage bonds fall in value, the other implication is that the interest rates associated with these assets will rise, putting upward pressure on mortgage rates in the market and putting a damper on the long and slow housing recovery.

One strategy that can calm fears is for the central banks to let certain bonds mature and to refrain from buying new ones, rather than outright selling. But even with phasing out purchases, the resilience of markets is unclear, since central banks have been such large and consistent buyers for nearly a decade.

Federal Reserve System. " Federal Reserve Act ."

Federal Reserve System. " Open Market Operations ."

Macrotrends. " Nikkei 225 Index - 67 Year Historical Chart ."

Federal Reserve Bank of St. Louis. " Federal Funds Effective Rate (FEDFUNDS) ."

Federal Reserve System. " Quantitative Easing and the "New Normal" in Monetary Policy ."

European Central Bank. " Annual Report 2016 ."

European Central Bank. " Asset Purchase Programmes ."

European Central Bank. " Going Negative: The ECB’s Experience ."

Bloomberg. " ‘Why Am I Holding This?’ Saying Bye to Europe’s Negative Yields ."

Barron's. " Kikkoman Corp ."

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Study Notes on Central Bank: Meaning, Origin and Functions

After reading this article you will learn about: 1. Meaning of Central Bank 2. Origin of the Central Bank 3. Functions.

Meaning of Central Bank :

It is very difficult to suggest a precise definition of a central bank. However, a central bank can best be defined with reference to its functions.

It can be defined as the bank which stands as the leader of the money market—also called the financial market—issues notes and coins, supervises, controls and regulates the activities of the banking system and acts as the banker of the government. In our pyramidal financial structure, the central bank sits at the top.

A central bank is a bank which constitutes the apex of the monetary and banking structure. It manages the economy in the interest of general public welfare, but not maximization of profit. According to W. A. Shaw, the central bank is the bank which controls credit.

ADVERTISEMENTS:

Samuelson defines central bank “…as a bank of bankers. Its duty is to control the monetary base and through control of this ‘high-powered money’ to control the community’s supply of money.” But as a private citizen, no one—even the Head of the country—either can open a bank account or borrow money from the central bank.

Origin of the Central Bank :

The establishment of a central bank in a modern economy is essential as it is the apex institution of a country’s financial as well as monetary system. Its action affects money supply, the volume of credit, interest rates, etc. All these have direct impacts not only on financial markets but also on national output and inflation (deflation). Thus the central bank plays an important role in any economy.

In fact, every independent country must have a central bank for organizing, running, supervising, regulating and developing the monetary- financial system of the country.

Implemen­tation of the government’s economic policy requires the presence of the central bank which stands as the undisputed leader of the money market. In view of this, some people feel that the central bank is one of the great inventions of modern civilization.

In most countries, the central bank is a nationalized institution. It is the main agent of the government for the purpose of administering its monetary and banking policies. Unlike commercial banks, its aim is not to make profit for its shareholders. So, it does not compete with the commercial banks for ordinary banking business.

The first central bank was established in the 18th century. Though the Riks Bank of Sweden was set up in 1656 and the Bank of England in 1694, the Bank of England started functioning as the central bank of England in 1844. It is said that the Bank of England is the oldest central bank of the world.

In America, Federal Reserve Banks started functioning as the central bank in 1913. The post-World War II period witnessed a phenomenal growth of central banks all over the world. At present, there are more than 150 central banks operating in various countries.

It will not be out of place to mention here that in the USA, there is a federal form of central banking. The USA is the exception in as much as there is not one central bank; there are 12 central banks, called Federal Reserve Banks.

The coordinating central body of these 12 banks is the Federal Reserve Board. One must not call the Federal Reserve Board the central bank. The Reserve Bank of India—the central bank of our country— was set up in 1935. The Bank of Pakistan is the name of the central bank of Pakistan.

On the question of issuing notes, we trace the evolution of central banking. In the 19th century, commercial banks were entrusted to issue notes. But notes issued by them involved difficulties, like lack of uniformity and over-­issue or under-issue of notes.

To avoid these difficulties, the note-issuing power was given to the central bank. The Central Bank of Holland in 1814 and the Bank of England in 1844 were given the monopoly power of note issue. Thus, the central bank is defined as the note-issuing authority.

Functions of Central Bank:

One can find some differences in the style of functioning of a central bank. Its functions in an under­developed country differ from those in a developed country. But the central bank performs the following common but vital functions in every country.

The most important ones are:

(a) Monopoly Power of Note Issue:

In the 19th century, commercial banks in many countries enjoyed the right to issue notes.

As the notes issued by them lacked uniformity, governments could not be prevented from over-issuing (or under-issuing) of notes. In view of these problems, the central bank has been given the monopoly power of note issue. It has been empowered to do so in the interest of uniformity and to bring a balance between demand for money and supply of money (i.e., prevention of over-issue or under-issue of notes).

The notes issued by the central bank are considered as legal tender money of the country and form the cash basis of the credit of commercial banks. Being the sole supplier of money in the economy, the central bank regulates the volume of currency of the country. It has also the power to withdraw worn and torn notes from circulation in exchange for new ones, so that good quality notes and coins circulate in the economy.

(b) Bankers’ Bank:

Commercial banks are required, by law or convention, to keep a certain percentage of their deposits are serves with the central bank. In this way, it acts as a custodian of cash reserves. Banks draw cash balances from the central bank as and when the situation demands.

As a bankers’ bank, it acts as a lender of the last resort. If commercial banks face serious liquidity crisis they approach the central bank and it stretches its lending hand to them—either by discounting bills or buying securities from them. This sort of accommodation makes the central bank a lender of the last resort. This is essential to prevent bank failure.

It gives advice to banks on good/sound banking practice. A central bank usually discusses government policy with them and reports back to the government. Thus, a central bank closely monitors the activity of commercial banks.

(c) Banker, Agent and Adviser to the Government:

The central bank acts as a banker, agent and adviser to any government. As a banker of the government, it has to maintain banking accounts of both central and state governments. It makes and receives payments on behalf of the government as it acts as the agent of the government.

Truly speaking, government (central, state, and union territories) expenditure (say, on road building, hospital construction, etc.,) and revenue (say from income tax, excise duty, etc.,) pass through the central bank. In brief, it performs merchant banking functions for the government.

It also provides short-term loans and advances (known as ways and means advances) to the government to enable the latter to tide over its financial difficulties. It also advises the government on necessary monetary and financial matters such as market borrowing, loan repayment, deficit financing, control of inflation.

(d) Controller of Credit:

The central bank of a country prescribes broad parameters of banking operations within which the country’s banking and finance system operates. In a modern credit-oriented economy, credit is an important component of money supply. Being profit-making institutions, commercial banks may adopt the policy of undue expansion or contraction of credit to suit their needs.

This may lead to inflation or deflation. Neither of the two is desirable. To ensure price stability, credit supply is to be regulated. And, this task has been entrusted with the central bank. The central bank, through its credit control policy, intends to curb the lending potential of commercial banks.

Actually, it keeps the creation of credit within limits. It is accepted that this is its most important function. However, for controlling credit, it uses several official instruments like the bank rate, open market operations, and so on.

(e) Custodian of Foreign Exchange Reserves:

With the aim of facilitating foreign trade and payment and promoting orderly development and maintenance of foreign exchange market, a central bank acts as the manager of foreign exchange. The central bank acts as the sole custodian of gold and foreign currencies for the purpose of issuing notes and for correcting an adverse balance of payments situation.

In this connection, one may note that, by holding gold and foreign currencies, the central bank intends to stabilize foreign exchange rate. Like internal price stability, stability in foreign exchange rate is equally vital. A central bank aims at affecting the foreign exchange rate (i.e., the rate at which one currency is converted into another currency) by buying and selling foreign currencies in the foreign exchange market.

In addition to these functions, the central bank:

I. Acts as a clearing house for the settlement of accounts of commercial banks;

II. Studies different aspects of economic problems, compiles data and informa­tion and publishes reports and periodi­cals, etc.

(f) Promotional and Developmental Functions:

In an underdeveloped economy, a central bank, in addition to the above noted traditional functions, acts as a potential development agency. It is not only a controller and regulator of credit but also a promoter.

Its task in LDCs is:

(i) To develop the money and capital markets

(ii) To strengthen the banking structure

(iii) To meet the genuine financial needs of agriculture and industry, and so on.

It protects the interest of depositors and provides cost-effective banking services to the public. In brief, it corrects the defects and removes the inefficiencies of the country’s monetary- financial system. These activities are called promotional or non-traditional activities of a central bank of LDCs. Thus, the pattern of economic development in low-income countries like India is largely determined by the central bank.

To conclude, it is futile to single out the most important function of a central bank. In fact, all its functions are important from the point of view of developing countries. Further, as far as the objective of growth with stability is concerned, there is no hard and fast rule to delimit the functions of a central bank. Its role and functioning keep on changing with the passage of time.

The preamble of the Reserve Bank of India (being the country’s central bank) describes the basic functions of the RBI as:

“…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”

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Project on Central Bank And Its Functions in INDIA – Class 12

Table of Contents

INTRODUCTION:

A Central Bank, Reserve Bank or Monetary Authority is an institution that manages a State’s Currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their country. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state and usually also prints the national currency, which usually serves as the State’s legal tender. A project on central bank and its functions should be informative for children studying in 11 and 12 class.

The main function of a central bank is to control the Nation’s money supply(monetary policy), through active duties such as managing interest rates, setting the reserve requirement and acting as a lender of last resort to the banking sector during times of bank’s insolvency or financial crisis. Central bank usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior.

Central banks in most developed nations are institutionally designed to be independent of political interference. Still, limited control by the executive and legislative bodies usually exists.

BRIEF HISTORY:

• It was set up on the recommendation of HILTON YOUNG COMMISSION.
• It was started as Share-holders Bank with a paid up capital of Rs.5 Crores.
• It was established on April 1, 1935.
• Initially, it was located in Kolkata.
• It moved to Mumbai in the year 1937.
• Initially, it was privately owned.
• It was the first bank to be nationalized in 1949.
• It has 22 Regional offices, most of these in-state Capitals.
• Since nationalization in 1949, Reserve Bank is fully owned by the Government of India.

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:

“To regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit systems of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth.”

OBJECTIVES OF RBI:

The Objectives of the Central Bank of India are :

• To help ensure the monetary, stability of the country.
• To assist in regulating the financial system of the country.
• To formulate, implement and monitor the monetary policy.
• To maintain liquidity in the country.
• To ensure an adequate flow of credits.
• Prescribes parameters for baking in the country.
• Maintain public confidence in the system.
• To manage the foreign management Act.
• To facilitate external trade.
• Issue and exchange currency.
• Maintain the supply of currency.
• Own and operate the depository and exchange for government bonds.
• Banker to the government.
• To stabilize the internal and external value of rupee.
• To centralize the cash reserves of commercial banks.
• To establish monetary relations with other countries of the world and international financial institutions.

MEANING AND DEFINITION:

“Central Bank is an ‘apex’ body that controls, operate, regulate and direct the entire banking and monetary structure of the country.”

It is known as the apex (supreme) body as it occupies the topmost position in the monetary and banking system of the country. All the financially developed countries have their own central bank. India’s RBI was established on April 1, 1935, under the Reserve Bank of India Act passes in 1934. Central Bank is known by different names in different countries. In India, it is Reserve Bank of India (RBI), in the UK as Bank of England and in the USA, it is known as Federal Reserve System.

FUNCTIONS OF CENTRAL BANK:

• Issue of currency
• Banker to the Government
• Bankers bank and supervisor
• Money supply and credit control
• Custodian of foreign reserve

As the Central Bank of the country, The Reserve Bank of India performs the following functions:

Currency Issue:

The central bank has the sole authority for the issue of currency in the country. In India, RBI has the sole right of issuing paper currency notes (except one rupee notes and coins, which are issued by Ministry of Finance).

All the currency issued by the Central Bank is its monetary liability i.e. Central Bank is obliged to back the currency with assets of equal value, to enhance the public confidence in paper currency.

Assets usually consist of gold coins, gold bullions, foreign securities, and domestic governments local currency securities.

• Advantages of Sole Authority of Note issue with RBI:
• It leads to uniformity in note circulation.
• It gives the Central Bank power to influence money supply because currency with the public is a part of the money supply.
• It enables the Government to have supervision and control over the Central Bank with respect to the issue of notes.
• It ensures public faith in the currency system.
• It helps in stabilization of internal and external value of the currency.

Central Government is also authorized to borrow money from the Central Bank. Whom government incurs a deficit in its budget, It borrows from Central Bank by selling its treasury bills. When Central Bank acquires these securities, it issues new currency. This is known as ‘monetizing the Govt’s Debt’ or ‘Deficit Financing’.

Banker to the Government:

The Reserve Bank of India acts as a Banker, Agent and a Financial Advisor to the Central Government and all State Governments [except that of Jammu and Kashmir].

As a banker, it carries out all banking business of the Government.

• It maintains a current account for keeping their cash balances.
• It accepts receipts and makes payments for the government and carries out the exchange, remittance and other banking operations.
• It also gives loans and advances to the government for temporary periods. The government borrows money by selling treasury bills to the Central Bank.

As an agent, the Central Bank also has the responsibility of managing the public debt.

As a financial advisor, the Central Bank advises the Government from time to time on economic, financial and monetary matters.

Banker’s Bank and Supervisor:

As the banker to banks, the Central Bank functions in three capacities:

• Custodian of Cash Reserves: Commercial Banks are required to keep a certain proportion of their deposits (known as Cash Reserve Ratio or CRR) with the Central Bank. In this way, Central Bank acts as a custodian of cash reserves of commercial banks.
• Lender of Last Resort: When Commercial Banks fails to meet their financial requirements from other sources, they approach the Central bank to give loans and advances as lender of the last resort. Central Bank assists these banks through discounting of approves securities and bills of exchange .
• Clearing House: All Commercial Banks have their account with the Central Bank. Therefore, The Central Bank can easily settle claims of various economical banks against each other, by making debit and credit entries in their accounts.

As a supervisor, Central Bank regulates and controls the Commercial Banks. The regulation of Banks may be related to their licensing, branch expansion, the liquidity of assets, management, merging, winding up , etc. The control is exercised by periodic inspection of banks and the return filed by them.

The controller of Money Supply and Credit:

Due to economic fluctuations, the Central Bank i.e. RBI controls the money supply and credit in the best interest of the economy as RBI has the sole monopoly in currency issue, it can control credit and supply of money. For this, RBI makes use of the following methods of credit control:

• Repo [Repurchase] Rate: ‘Repo rate is the rate at which the Central Bank of a country lends money to Commercial banks to meet their short-term needs.’ The Central bank advances loans against approved securities or eligible bills of exchange. An increase in repo rate increases the cost of borrowings from the Central Bank. It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans. It reduces the ability of Commercial Banks to create credit. A decrease in the repo rate will have the opposite effect.
• Bank Rate (or Discount Rate): ‘Bank rate is the rate at which the Central Bank of a country lends money to Commercial Banks to meet their long-term needs.’ RBI has been actively using Bank rate to control credit. Bank rate has the same effect as that of Repo rate, i.e. an increase in Bank rate increases the cost of borrowings from the Central bank, which leads to an increase in lending rates by Commercial banks. It discourages borrowers from taking loans, which reduces the ability of Commercial Banks to create credit. Reverse Repo Rate is the exact opposite of the Repo Rate. It is the rate at which RBI borrows from Commercial Banks. RBI makes use of this tool when it feels there is excess money supply in the banking system. An increase in Reverse Repo Rates induces the banks to transfer more funds to RBI due to attractive interest rates.
• Open Market Operations: “Open Market Operations (OMO) refers to buying and selling of Government securities by the Central Bank from/to the public and Commercial Banks.” It does not matter whether the securities are bought or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank.
• Sale of Securities by Central Bank reduces the reserves of Commercial banks. It adversely affects the bank’s ability to create credit and therefore decreases the money supply in the economy.
• Purchase of Securities by Central Bank increases the reserves and raises the Bank’s ability to give credit.
• Legal Reserve Requirements (Variable Reserve Ratio Method): Commercial Banks are required to maintain reserves on two accounts: (i) Cash Reserve Ratio (CRR): ‘It refers to the minimum percentage of net demand and time liabilities, to be kept by Commercial Banks with the Central bank.’ An increase in CRR reduces the excess reserves of Commercial Banks and limits credit creating power. (ii) Statutory Liquidity Ratio (SLR): ‘It refers to the minimum percentage of net demand and time liabilities which Commercial Banks are required to maintain themselves.’ SLR is maintained in the form of designated liquid assets such as excess reserves, and other securities or current account balances with other banks. An increase in SLR reduces the ability of banks to give credit and vice-versa.
• Margin Requirements: ‘Margin is the difference between the amount of loan and market value of the security offered by the borrower against the loan.’ An increase in margin reduces the borrowing capacity and money supply. A fall in margin encourages people to borrow more. RBI may prescribe differed margins for different types of borrowers against Other instruments of credit control are Moral Suasion and Selective Credit Controls. RBI uses the above-mentioned methods to control credit in the economy. The security of the same commodity. The margin is necessary because if a bank gives a loan equal to the full value of the security, the bank will suffer a loss in case fall in the price of the security.

Custodian of Foreign Exchange Reserves:

The Central Bank also acts as the custodian of the country’s stock of gold and reserves of foreign exchange. This function enables the Central bank to exercise reasonable control over foreign exchange. According to regulations of foreign exchange, all foreign exchange transactions must be routed through RBI. The centralization of foreign exchange transactions with RBI serves two objectives:

• It helps the bank in stabilizing the external value of the currency.
• It helps in pursuing a coordinated policy towards the balance of payments situations of the country.

PROMOTIONAL FUNCTIONS OF RBI :

Various promotional functions are performed by the Reserve Bank of India are given below:

• Promotion Of Banking Habit:

The RBI helps in mobilizing the savings of the people for investment. It expanded the banking system throughout institutions like UTI, IDBI, IRCI, NABARD, etc. Thereby it promoted banking habit among the people.

• Providing Refinance for Exports:

The RBI is providing refinance for export promotion. The Export Credit and Guarantee Corporation [ECGC] and Export-Import Bank were established initially by RBI to finance the foreign trade of India.

• Providing Credit to Agriculture:

RBI makes institutional arrangements for rural or agricultural finance. For e.g: the bank has set up special agricultural credit cells. It has promoted regional rural banks with the help of Commercial Banks. It has also promoted NABARD.

• Providing Credit to Small Scale Industrial Unit:

Commercial Banks lend loans to small-scale industrial units as per the directives issued by the RBI time to time. The RBI encourages Commercial Banks to render guarantee services also to the small-scale industrial sector. RBI directed Commercial Banks to open specialized branches to provide adequate financial and technical assistance to small-scale industrial branches.

• Providing Indirect Finance to Cooperative Sector:

The RBI has directed NABARD to give loans to state cooperative Banks, which in turn lend loans to cooperative sector. Hence, the Reserve Bank of India provides indirect finance to cooperative sector in India.

• Exercising Control over Monetary and Banking System of the Country:

The RBI is vested with enormous and extensive powers regarding supervision and control over Commercial Banks, Cooperative Banks and also Non-Banking Institution Institutions receiving deposits. The Banking Regulation Act prescribes extensive requirements reserves, cash reserves, and liquid assets. Every scheduled bank is required to furnish to the Reserve Bank a weekly statement showing the principal items of its liability and assets in India.

ACHIEVEMENTS OF RBI [CENTRAL BANK]:

• Flexible Monetary Policy: The RBI has adopted a flexible monetary policy. It has introduced changes in monetary regulations of the Indian money market. The pressure of seasonal demand has been adequately met.
• Stable Structure of Interest Rates: The interest rate policy of RBI has resulted in a relatively stable structure of interest rates in the economy. The Bank rate remained unchanged at a low level of 3 percent up to 1951.
• Modern Banking and Credit Structure: The Reserve Bank has succeeded in building up a sound modern banking and credit structure. The Bank enjoyed vast supervisory powers which enabled it to guide the development of banking on sound lines. Training of Bank personnel has improved their efficiency. The geographical and fundamental coverage of banking has also increased substantially.
• Cheap Remittance Facilities: The Reserve bank has introduced very cheap remittance facilities. These have been widely used by the Commercial Banks, the Government, and Cooperative Banks.
• Successful Management of Public Debt: The RBI has successfully managed public debt. It has floated loans for the Govt. at low rates of Interest. It has helped in raising the funds for expansion of the public sector in the economy.
• Exchange Stability: The RBI has maintained the exchange value of the rupee at a relatively higher rate than would have prevailed in the market. It has made judicious use of exchange control measures to keep the demand for foreign exchange within the limits of available supplies.
• Enhanced Public Confidence in the Banking Sector: Banks are strictly supervised by Reserve Bank so as to avoid their failures and to enhance public confidence in the banking systems.  The Deposit Insurance System has also been introduced to protect the interests of investors.
• Central Authority Of Indian Money Market: The RBI has functioned as the central authority in the Indian money market. It has supervised and controlled Commercial Banks, Cooperative Banks and Non-banking Financing Companies accepting deposits from the Public.
• Development of Bill Market: The RBI has made serious efforts to develop a sound bill market in India. It has imparted a Substantial degree of elasticity to the credit structure of the country by introducing several Bill Market Schemes.
• Monetary Stability: The Bank has made a rational use of quantitative and qualitative measures of credit control to maintain monetary stability. These controls were generally employed in the direction of greater restraint in the context of persistent imbalances in the economy.
• Contribution to Economic Development: The RBI has played an active role in promoting the economic development of the Indian economy. The Reserve Bank has helped in building up a well-differential structure of financial institutions to cater to the requirements of the different sources of the economy.

FAILURES OF RBI:

• Lack of Adjustment in Money Market: RBI has virtually failed in regulating or controlling the activities of rural money lenders and other indigenous bankers. These bankers just do not come within the scope of the Reserve Bank.
• Lack of Uniformity in the Rate of Interest: Because of the lack of control on different sectors of the money market, different rates of interest continue to prevail outside the organized sector of the money market, ROI is exorbitantly higher than the Bank Rate.
• Lack of Bill Market: RBI prepared a plan for the development of Bill Market in 1952. But to date, there is no Independent and Organised widespread bill market in India.
• Insufficient Availability of Agricultural Credit: Despite the fact that a lot of steps have been initiated by RBI to provide enough agricultural credit, its requirement as it is still being dominated by rural money lenders and other indigenous bankers.
• Insufficient Banking Facility: Most of the banking activity is concentrated in urban areas. People in small villages and sub-urban areas still deprived of the banking facility.
• Instability in the Internal Value of Rupee: It has been the biggest failure of RBI because of ever-increasing circulation of money, prices have been rising almost non-stop.
• Failure of the Banks: RBI has also failed as a Bank of the bankers, its lack of assistance to the Commercial Banks cause their closure. Between 1939 to 1946 nearly 444 Banks failed in the country. Closure of three banks in 1985 is also a notable point.
• Failure in Getting Sufficient Share in Foreign Exchange Business for the Indian Banks: The Reserve Bank has not yet succeeded in getting the Commercial Banks any notable foreign exchange business.
• Share Scam: In 1992-1993, Country witnessed large scale share involving hundreds of crores of rupees. It was a glaring example of the failure of RBI.

CONCLUSION OF CENTRAL BANK:

Banking Systems have been with us for as long as people have been using the money. Banks and Financial Institutions provide security for individuals, businesses, and governments. In general, what banks do is pretty easy to figure out. For the average person, Banks accept deposits, lend loans and provides a safe place for money and valuables and act as a payment agent between merchants and banks.

History has power banks to be vulnerable to many risks, however, including credit, liquidity, market, operating interest rate, and legal risk, many global crises have been resulting of such vulnerabilities and this has led to the strict regulations of state and national banks.

However, Central Bank is the backbone of all Banking sector without which there would be absolutely no banking sector involved. This, Central Bank is an essential part of an economy and helps to grow resources of an economy.

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Banking on interest rates: A playbook for the new era of volatility

The recent accelerated rise in global interest rates, the fastest in decades, brought the curtain down on an extended period of cheap money but provided little clarity on the longer-term outlook. In 2024, competing forces of tepid growth, geopolitical tension, and regional conflict are creating nearly equal chances of higher-for-longer benchmark rates and rapid cuts. In the banking industry, this uncertainty presents both risks and opportunities. But in the absence of recent precedent, many institutions lack the necessary playbook to tackle the challenge.

As rates have risen from their record lows, banks have in general profited from rising net interest margins (NIMs). However, if policy makers switch swiftly into cutting mode, banks may see the opposite effect. For now, futures markets predict the start of that process toward the end of 2024. In that context, the question facing risk managers is how they can retain the benefit of higher rates while preparing for cuts and managing the potential for macroeconomic surprises.

The question facing risk managers is how they can retain the benefit of higher rates while preparing for cuts and managing the potential for macroeconomic surprises.

The volatility playing out in rates markets is reflected in bank deposit trends, with customers more actively managing their cash to make the most of shifting monetary conditions. In Europe, deposits reached 63 percent of available stable funding (ASF) in 2023, compared with 57 percent in 2021. 1 Monitoring of liquidity coverage ratio and net stable funding ratio implementation in the EU – third report, European Banking Authority, June 15, 2023. In the US, conversely, the share of deposits over total liabilities fell over a similar period as money migrated to investments such as money market funds.

In the face of accelerating deposit flows, McKinsey research shows that bank risk management and funding performance has been highly variable. Between 2021 and 2023, the best-performing US and EU banks saw interest rate expenses rise 70 percent less than at the worst-performing banks (Exhibit 1). Among the drivers were better deposit and interest rate management.

Alongside the impacts of deposit flows, funding has come under pressure from other factors, including the steady withdrawal of pandemic-related central bank liquidity facilities. Meanwhile, innovations such as instant payments have motivated customers to make faster and larger transfers. These withdrawals can happen quickly and be fueled by social media, creating a powerful new species of risk.

In the context of a more uncertain environment, regulatory authorities are doubling down on oversight of the potential impacts of rate volatility—for example, by asking banks to mitigate the potential effects of rate normalization, increasing overall scrutiny, and demanding evidence of methodology upgrades. Among European supervisory priorities for 2024–26, banks are advised to sharpen their governance and strategic frameworks to strengthen asset and liability management (ALM) and develop new funding plans and contingency measures for short-term liquidity shocks, including evaluating the adequacy of assumptions supporting some behavioral models. 2 “SSM Supervisory Priorities, 2024-2026,” in Supervisory priorities and assessment of risks and vulnerabilities , European Central Bank, 2023. In the same vein, the Basel Committee on Banking Supervision in 2023 proposed a recalibration of shocks for interest rate risk in the banking book. Banks can achieve this by extending the time series used in model calibration from the current December 2015 standard to December 2022, bringing more volatile rate distributions into the equation.

In a recent McKinsey roundtable, 40 percent of Europe, Middle East, and Africa bank treasurers said the topic that will attract most regulatory attention in the coming period is liquidity risk, followed by capital risk and interest rate risk in the banking book (IRRBB). With these risks in mind, 34 percent of treasurers said their top priorities with respect to rate risk were enhancing models and analytics, revising pricing strategies on loans and deposits, and beefing up ALM governance and monitoring capabilities.

Most participants also expected treasury teams to get more involved in strategic planning and board engagement and to engage business units more closely to define pricing strategies and product innovation (Exhibit 2).

In response to these dynamics, we expect to see many banks revisiting the role of the treasury function in the months ahead. For many, this will mean moving away from approaches designed for the low-rate era and toward those predicated on uncertainty. In this article, we discuss how forward-looking banks are redesigning their treasury functions to obtain deeper insights into probabilities around interest rates and their impacts on pricing, customer behavior, deposits, and liquidity.

Five steps to enhancing the treasury function

To manage volatile interest rates more effectively, leading banks are revisiting practices in the treasury function that evolved during the low-interest-rate period and may no longer be fit for purpose—or at least should be updated for the new environment. Pioneers have taken steps in five broad focus areas: steering and monitoring, risk measurement and capabilities, stress testing, bank funding, and hedging.

Build efficiency and sophistication

A precondition of effective oversight of interest rate business is to ensure decision makers have a clear view of the current state of play. Currently, the standard approach across the industry is somewhat passive, meaning it is based on static or seldom-reviewed pricing and risk management decisions, often taken by relationship managers. Models are fed with low-frequency data, and banks use static fund transfer pricing (FTP) to calculate net interest margins. Monitoring often reflects regulatory timelines rather than the desire to optimize decision making.

Forward-looking banks are tackling these challenges through a more hands-on approach to steering and monitoring, including the following measures:

• dynamic reviews of FTP, reflecting microsegment behaviors and pricing strategies tied to customer lifetime value and the opportunity cost of liquidity
• increased product innovation to boost funding from both corporate and retail clients
• ensuring access to high-quality, frequent, and granular data, with systems equipped to send early warning signals on potential changes in customer behaviors, especially to capture early signs of liquidity shifts
• use of risk limits and targets as active steering mechanisms, bolstered by links to incentives
• automation of reporting and monitoring, so liquidity and other events can be scaled internally much faster, backed by real-time data where possible

Upgrade IRRBB measurement and capabilities

Leading banks are getting a grip on IRRBB risk in areas such as balance sheet management, pricing, and collateral. Many have assembled dedicated teams to help them make more effective decisions. Given the threat to deposits, some are making greater use of scenario-based frameworks, bringing together liquidity and interest rate risk management. They are using real-time data to inform funding and pricing decisions.

To ensure they consider all aspects of rate risk, leading banks employ a cascade of models, feeding the outputs into steering and stress-testing frameworks, and capturing behavioral indicators that can inform balance sheet planning and hedging activities. Some banks are employing behavioral models to forecast loan acceptance rates and credit line drawings. Best practice involves using statistical grids differentiated by type of customer, product, and process phase.

When it comes to loans, some banks are leveraging AI to predict prepayments and their impacts on balance sheets and hedging requirements. Best practice in prepayments modeling is to move away from linear models and toward machine learning algorithms such as random forests to consider nonlinear relationships (for instance, between prepayments and interest rate variation) and loan features (for example, embedded options), as well as behavioral factors. We see five key steps:

• Customer segmentation . Banks can use AI to achieve granulated segmentation—for example, incorporating behavioral factors.
• Prepayment behavior . Banks can quantify constant prepayments and prepayments subject to criteria including interest rate levels, prepayment penalties, age of mortgage, and borrower characteristics. Leading banks establish a parent model and leverage customer segmentation to derive dedicated prepayment functions, taking into account customer protections such as statutory payment holidays.
• Interest rate scenarios . Banks can employ Monte Carlo simulations and other models to analyze a range of scenarios, including extreme and regulatory scenarios, and simulate potential prepayment behaviors for each scenario.
• Hedging ratios and strategy . Decision makers should evaluate the value of mortgages under different interest scenarios and derive sensitivities to economic value and P&L. They can then select hedging instruments with the aim of neutralizing scenario impacts.
• Pricing . Mortgage pricing can be adjusted based on maturity and potential prepayment behavior. Banks can use fund transfer pricing, with risks handled by a dedicated team in the treasury function.

Another important focus area is deposit decay. Many banks still prioritize moving-average approaches segmented by maturity and backed by expert judgment. A best practice would be to identify a core balance through a combined expert and statistical approach, looking at trends across customer segmentation, core balance modeling, deposit volume modeling, deposit beta and pass-through rates, and replicating portfolio/hedge strategies. This would mean leveraging AI and high-frequency data relating to transactions, to estimate each account’s non-operational liquidity, which customers may be more likely to move elsewhere (see sidebar “Case study: Deposit modeling to limit deposit erosion”). Some banks also use survival models to gauge non-linearities in deposit behaviors.

Case study: Deposit modeling to limit deposit erosion

One bank achieved an equivalent of €150 million to €200 million positive P&L impact on €30 billion of deposits by using AI techniques for repricing. The tool provided transparency on the following measures:

• the amount of liquidity at risk for each client—that is, the excess liquidity the client could potentially invest or move freely to other banks
• the churn probability for each client, or the probability the client would move the liquidity if the bank took no action, based on client sophistication, the quality and intensity of the client’s relationship with the bank, and the level of market competition
• the customer value at risk, an estimate of future revenues that would be at risk if the client moved the liquidity elsewhere (for example, including not only the opportunity cost of funding, but also revenues from related services)

Armed with this transparency, the bank was able to formulate client-specific strategies for repricing actions and product offerings (for example, investment products and transaction banking services), optimizing both its funding sources and profitability. New capabilities to support the effort included a deposits command center, producing a real-time dashboard for monitoring, including early warning triggers, sales team mobilization, and new product offering, especially for cash-rich corporate clients.

In the context of IRRBB strategy, leading banks are keeping a close eye on both deposit beta and pass-through rates (the portion of a change in the benchmark rate that is passed on to the deposit rate). They back their judgments with views on client stickiness, which they traditionally arrive at through expert judgment and market research. A more advanced approach is to derive regime-based elasticities, capturing data from historical economic cycles.

Better modeling enables more resilience: One bank’s story

A European global bank wanted to improve its forecasting in a rising-interest-rate context. Managers decided to focus more on customer behavior. They moved away from expert-judgment buffers to AI and stochastic modeling and a more focused approach to model calibration. They also updated scenario planning based on regulatory guidelines and best-in-class approaches, such as an interest rate risk in the banking book (IRRBB) dynamic balance sheet methodology. Through these changes, the bank was able to estimate its duration gap (between assets and liabilities) more accurately and thereby reduce delta economic value of equity (EVE). As a result, the bank recorded a 70-basis-point uplift in return on equity, resulting from capital savings on interest rate risk and a direct P&L impact from reduced hedging.

Finally, risks need to be optimally matched with hedges. The recent trend is to use stochastic models to support hedging decisions, enabling banks to gauge non-linearities. Forward-looking banks increasingly integrate deposit, prepayment, and pipeline modeling directly into their hedging strategies. They also ensure model risk is closely monitored, with models recalibrated frequently to reduce reliance on expert input (see sidebar “Better modeling enables more resilience: One bank’s story”).

Improve stress testing

Several players are integrating interest rate risk, credit spread risk, liquidity risk, and funding concentration risk in both regulatory and internal stress tests. Indeed, the IRRBB, liquidity risk, and market risk (credit spread risk in the banking book, or CSRBB) highlight the trade-off between capital and liquidity regulations. In short, higher capital requirements may reduce the need for excessive liquidity, and vice versa, for a bank with stable funding—a situation that remains a challenge to current regulatory frameworks.

Stress testing to measure interest rate risk is also evolving, with some banks adopting reverse stress testing (see sidebar “Enhancing Basel's interest rate risk measures: Exploring the efficacy of reverse stress testing and VAR”).

Enhancing Basel’s interest rate risk measures: Exploring the efficacy of reverse stress testing and VAR

Research conducted by a group of bank risk managers suggests that the current supervisory outlier tests for interest rate risk in the banking book (IRRBB) may not adequately address all significant risk scenarios. Specifically, the scenarios outlined in the BCBS 368 guidelines for stress-testing economic value of equity (EVE) and net interest income (NII) may fall short in identifying substantial IRRBB risks. This oversight could make it more difficult for banks to recognize material risks of loss, especially if they have complex or unconventional portfolios.

To identify more material risks, experts are recommending a shift in approach. Instead of focusing solely on extreme and plausible scenarios, they are advised to consider all possible scenarios and integrate reverse stress testing. This would involve simulating thousands of historical and hypothetical scenarios, covering almost the entire spectrum of possible yield curves. After computing NII and EVE, attention would be directed to the scenarios that could have the most adverse impact on the bank’s balance sheet.

In alignment with this proposed methodology, Australian banks will be mandated from 2025 to calculate IRRBB capital using measures of expected shortfall rather than value at risk (VAR). The change is intended to incorporate tail risk, with the new methodology utilizing data from the past seven years, coupled with a distinct one-year stress period.

In upgrading their stress-testing frameworks and interest rate strategies, banks need to balance net interest income (NII) and economic value of equity (EVE) risks that may materialize as a function of rate volatility. On NII, banks can productively apply scenario-based yield curve analysis across regulatory, market, and bank-specific variables and weigh these in the context of overall balance sheet exposures, hedges, and factors including deposits, prepayments, and committed credit lines. Additional economic risks include basis risk, option risk, and credit spread risk, which also should be measured.

Tailor planning

Bank funding plans are often generic, periodic, and spread across different frameworks and methodologies, including funding plans, capital plans, internal capital adequacy assessment processes (ICAAP), and internal liquidity adequacy assessment processes (ILAAP). They are often designed for a range of purposes and audiences and updated only when prompted by regulatory requirements. In future, banks will need dynamic, diversified, and granular funding plans—for example, tailored to products and regions. The plans should reflect flexible and contingent funding sources, central bank policies, and the trade-off between risks and costs.

Embrace dynamic hedging strategies

In the era of low rates, hedging of interest rate risk was a less prominent activity. Banks often employed simple, static, short-term, or isolated strategies, mostly aimed at protecting P&L. Few banks paid a great deal of attention to collateral management.

Now, in a more volatile rate environment, the potential for losses is much higher, suggesting banks need more sophisticated, agile, and frequent hedging to respond to shifts in interest rates, credit spreads, and customer deposit behaviors (Exhibit 3). Indeed, in 2023, the traded volume of euro-denominated interest rate derivatives increased by 3.4 times compared with 2020, according to the International Swaps and Derivatives Association. 3 “Interest rate derivatives US: Transaction data,” ISDA.

Hedging strategies are evolving to be dynamic, horizontally integrated across the organization, and wedded to risk appetite frameworks, so banks can balance P&L priorities and reductions in tail risk. On the ground, banks will likely need to recalibrate their strategies frequently, ideally leveraging a comprehensive scenario-based approach to reflect changes in the external environment. Many, for example, have already revisited hedging to reflect higher rates, but as rates fall, they will need to assess factors such as the impact of convexity on short positions. The objective of these exercises would ideally extend beyond risk mitigation to the optimization of NII (see sidebar “Replication and hedging: The upsides of NIM optimization”).

Replication and hedging: The upsides of NIM optimization

Broadly, banks may consider four approaches to replication and hedging, each of which offers benefits that will vary according to the bank’s unique asset base.

Static replication is a widely applied and robust approach that involves derivation and adjustment of cash flows from deposit volume models for deposit rate elasticity and pass-through rates. The remainder of cash flows are replicated with bonds, interest rate swaps, or loans. Future deposit growth can be incorporated if desired.

Dynamic hedging of present value of net interest margin (NIM) treats the deposit portfolio like a structured product. Banks calculate the present value of NIM arising from deposits, enabling derivation of present value sensitivity to changes in interest rates. The method supports dynamic hedging and can take into account negative convexity.

Static NIM optimization provides the recommended trade-off between granularity and sophistication on the one hand and usability on the other, and it is our preferred approach. It involves design of the fixed-income portfolio to replicate deposit balance dynamics over a sample period. The analyst then selects the portfolio yielding the most stable margin, represented by minimization of margin standard deviation of the spread between the portfolio return and deposit rate. The approach enables NIM maximization, with the caveat that shorter tenors tend to be preferred in periods of low benchmark rates.

Dynamic NIM optimization permits banks to model future interest rates with NIM and investment strategy optimized for a future horizon. Again, NIM can be maximized, but the approach requires assumptions on volume growth, and the optimization horizon may not extend to the full rate cycle.

A key principle of best-in-class hedging strategy is that a proactive, forward-looking approach tends to work best and will enable banks to hedge more points on the yield curve. And with forward-looking scenario analysis, they should be able to anticipate risks more effectively. Consider the case of a bank that was exposed to falling interest rates and did not meet the regulatory threshold for outliers under the new IRRBB rules for changes in NII. Through analysis of potential client migrations to other products and a push to help clients make those transfers, combined with a new multi-billion-dollar derivative hedging strategy, the bank brought itself within the threshold.

Banks should not view hedging as a stand-alone activity but rather as integrated with risk management, backed by investment in talent and education to ensure teams choose the right hedges for the right situation. These may be traditional interest rate derivatives but equally could be options or swaptions to bring more flexibility to the hedging strategy. AI will be table stakes to support decision making and identify risks before they materialize. A more automated approach to data analytics will likely be required. And collateral management should be a core element of hedging frameworks, with analytics employed to forecast collateral valuations and needs, optimize liquidity reserves, and mitigate margin call risk.

Next steps: Making change happen

To effectively implement change across the activities highlighted here, best practice would be to bring together modeling capabilities under a dedicated data strategy. The target state should be comprehensive capabilities, a unified and actionable scenario-based framework, and routine use of AI techniques and behavioral data for decisions around pricing and collateral. Most likely, a talent strategy also will be required to support capability building across analytics, trading, finance, pricing, and risk management.

Banks must marshal a broad range of market data to support effective modeling. The data will include all credit lines, including both on–balance sheet and off–balance sheet items, deposit lines, fixed-income assets and liabilities, capital items, and other items on the banking book. Ideally, banks would assemble 15 to 20 years of data, which would take in the previous period of rising interest rates from 2004 to 2007. Alongside these basic resources, banks need information on historical residual balances, amortization plans, optionality, currencies, indexing, counterparty information, behavioral insights, and a full set of macro data. Some cutting-edge models incorporate about 150 different features.

Armed with comprehensive data, banks can build behavioral models (for example, prepayments, deposits) to estimate parameters and infer behavioral effects in different scenarios. They can then integrate behavioral outputs into stress-testing simulations, alongside expert-based insights. Once macroeconomic data has been inputted, banks should be able to compute delta NII and EVE for three years. Visualization tools and hedging replica analysis can help teams clarify their insights and test their hedging strategies across risk factors.

Banks that have embraced the levers discussed here have set themselves on a course to more proactive and effective interest rate risk management. Through a sharper focus on high-quality data and the use of AI and scenario-based frameworks, banks have shown they can make better decisions, upgrade their hedging capabilities, optimize the cost of funding, and ensure they stay within regulatory thresholds. In short, they will be equipped to respond faster and more flexibly as interest rates enter a new era of volatility.

Andreas Bohn is a partner in McKinsey’s Frankfurt office, Sebastian Schneider is a senior partner in the Munich office, Enrique Briega is a knowledge expert in the Madrid office, and Mario Nargi is an associate partner in the Milan office.

The authors wish to thank Gonzalo Oliveira and Stefano Terra for their contributions to this article.

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• Open access
• Published: 18 June 2024

Engaging a community to focus on upper limb function in people with multiple sclerosis: the ThinkHand campaign case study

• Alison Thomson 1 ,
• Rachel Horne 2 ,
• Christine Chapman 2 ,
• Trishna Bharadia 2 ,
• Patrick Burke 2 ,
• Elizabeth Colwell 2 ,
• Mark Harrington 2 ,
• Bonnie Boskovic 2 ,
• Andrea Stennett 1 , 4 ,
• David Baker 3 ,
• Gavin Giovannoni 1 , 3 , 4 &
• Klaus Schmierer 3 , 4  

Research Involvement and Engagement volume  10 , Article number:  62 ( 2024 ) Cite this article

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Background: Solving complex research challenges requires innovative thinking and alternative approaches to traditional methods. One such example is the problem of arm and hand, or upper limb function in multiple sclerosis (MS), a neurological condition affecting approximately 2.9 million people worldwide and more than 150,000 in the United Kingdom. Historically, clinical trials and research have focused on mobility and walking ability. This excludes a large number of patients who are wheelchair users, limiting their quality of life and restricting access to possibly helpful medications. To address this issue, the ThinkHand campaign was launched in 2016, aiming to raise awareness about the importance of upper limb function in MS and develop alternative ways to measure, record, and account for hand and arm function changes.

Main body: The campaign utilised innovative strategies at scientific conferences and online surveys to engage people affected by MS, healthcare professionals, charities, and researchers in discussing the importance of preserving upper limb function. Through co-design and interdisciplinary collaboration, the campaign developed new tools like the low-cost cardboard version of the Nine-Hole Peg Test, facilitating remote monitoring of hand function. Additionally, the campaign co-created the “Under & Over” rehabilitation tool, allowing individuals with advanced MS to participate in a remote rehabilitation program.

The impact of the ThinkHand campaign has been significant, helping to shift the focus of both academic and industry-supported trials, including the O’HAND and ChariotMS trials, both using upper limb function as their primary end point. The campaign’s patient-centred approach highlighted the importance of recognising patients’ perspectives in research and challenged established assumptions and practices. It demonstrated the effectiveness of interdisciplinary collaboration, systems thinking, and co-creation with stakeholders in tackling complex problems.

Conclusion: The ThinkHand campaign provides valuable insights for health research practices. By involving patients at all stages, researchers can gain a deeper understanding of the impact of disease on their lives, identify gaps and focus research on their needs. Experimentation and iteration can lead to innovative solutions, and openness to unconventional methods can drive widespread change. The ThinkHand campaign exemplifies the potential of patient-centred approaches to address complex research challenges and revolutionise the field of MS research and management. Embracing such approaches will contribute to more inclusive and impactful research in the future.

Plain English Summary

Solving complex research challenges requires creative thinking and new ways of doing things. One such challenge is understanding the problems with arm and hand function in multiple sclerosis (MS), a neurological condition that affects more than 150,000 in the United Kingdom. In the past, research focused mainly on walking ability, leaving out many people who use wheelchairs.

To tackle this issue, we created the ThinkHand campaign in 2016. Its goal was to raise awareness about the importance of hand and arm function for people with MS (pwMS) and find better ways to measure changes in these functions such that they can become outcomes in clinical trials. This could provide a pathway to better treatments for pwMS who cannot walk.

The campaign used various methods, including surveys, social media posts, exhibitions and music to involve pwMS, healthcare professionals, charities, and researchers in discussions about the issues. Working together, they created tools to support pwMS, particularly those at an advanced stage of the disease (pwAMS), to take part in research and measure their hand and arm function. Through our collaborative approach focusing on patients’ perspectives, the campaign challenged old ideas and deeply embedded practices. It showed that collaboration between different areas of expertise involving pwMS at all stages of research can help solve complex problems. This campaign teaches us valuable lessons for health research. When researchers listen to patients and try new things, they can better understand how a disease affects people’s lives and develop better solutions.

In conclusion, we show how embracing a patient-centred approach can address complex research challenges and improve how we study and manage MS and other conditions in the future.

Peer Review reports

Solving complex research challenges requires innovative thinking and alternative approaches to traditional methods. One such example is the problem of arm and hand, or upper limb function, in multiple sclerosis (MS), a neurological condition affecting approximately 2.9 million people worldwide and more than 150,000 in the United Kingdom (UK) [ 1 , 2 ]. The historical focus on mobility and walking ability, dominated by lower limb function, in clinical trials and research, has potentially negative implications on the quality of life of some individuals with MS, particularly in the more advanced stages. Indeed, there is also evidence to suggest that some newly diagnosed people with MS (pwMS) present with upper limb impairment which increases in severity over time [ 3 , 4 ]. Yet, the focus on lower limb function has meant that, historically, the vast majority of trials have excluded patients who are wheelchair users [ 5 ]. The main reason for this understanding was that treatment would not be beneficial given the nature of the condition in these individuals since its usefulness was being measured by improvement in lower limb function [ 6 ]. This means that to date, MS disease-modifying treatments (DMTs) had only been licensed if they improve walking ability. To address this problem, our group launched the ThinkHand campaign in 2016. The key aims were set out and made public to raise awareness about the importance of upper limb function in MS, the socioeconomic costs of losing upper limb function and to develop alternative ways to measure, record, and account for the change in hand and arm function in the everyday lives of people with MS.

The early and innovative contribution of people with MS in this project and the creative methods used, enabled the ThinkHand campaign to successfully bring this “wicked problem” to the fore, while having a long-lasting impact on the field of MS research and management. “Wicked” because of its (i) bias and exclusion of a large number of pwMS from MS research participation opportunities and (ii) complexity and interrelated causes and consequences. “Wicked problems”, a term coined by Rittel and Webber [ 7 ] describes complex social problems that are difficult to solve due to their interrelated causes and consequences, the lack of a clear problem definition, the presence of multiple stakeholders with conflicting values and goals, and the unpredictable nature of their evolution. These problems often defy traditional problem-solving approaches and require novel, innovative, and collaborative solutions that address the underlying systemic issues. In the case of the ThinkHand campaign, it also required pathophysiological underpinning, which was achieved through hypothesis-generating and supporting, preliminary evidence [ 8 , 9 , 10 ]. The multi-faceted and unpredictable nature of MS and its impact on upper limb function makes it difficult to measure and track effectively. This issue is also interconnected with other factors such as walking ability, cognition, quality of life, employability, and daily living activities, adding to its complexity. The lack of consensus among stakeholders, including patients, healthcare providers, researchers, and policymakers, on the most effective ways to measure and track upper limb function in MS also makes it challenging to find a comprehensive solution.

The aim of this case study is to document the impact of the ThinkHand campaign and demonstrate the potential for patient-centred approaches to address complex issues in health research. The article highlights the importance of recognising that traditional methods of knowledge dissemination and mobilisation within science and academia have limited reach and impact, and that alternative methods from disciplines such as art and design can open up a topic for debate, invite people with lived experience of MS to challenge assumptions and ultimately change clinical and research practice. The article also highlights the importance of actively involving patients, their families, and members of the public in the design, conduct, and dissemination of research activities, which is now considered best practice in the UK. This can take many forms, such as patient advisory groups, patient representatives on research teams, and patient-led research projects. The goal of patient and public involvement (PPI) in research is to ensure that the needs, concerns, and perspectives of patients and the public are taken into account in the research process. ThinkHand demonstrates how through involving patients and the public, researchers can gain a deeper understanding of the impact of disease on their lives and where they want research to focus. Further, it demonstrates how engaging people living with the conditions can help tackle “wicked problems” and in turn change a field of research.

The problem within the field

The decision to raise awareness about the importance of hand and arm function in MS stemmed from the realisation that clinical trials had shown that DMTs in individuals with advanced stages of MS can still delay the worsening of disability in hand function, despite having little to no impact on leg function. The effect on hand function was observed in trials where it had been employed as a secondary endpoint. This is a problem if the only outcome measure is around walking ability, as measured by the Expanded Disability Status Scale (EDSS) [ 11 , 12 ]. This observation has been reported in neurology literature dating back to the early 1990s but has not been acted on by the MS community. In light of this, the research team at QMUL and Barts Health NHS Trust revisited a model previously – and ironically – suggested by John Kurtzke [ 13 ], the inventor of the EDSS, to describe progressive MS as a “length-dependent central nervous system axonopathy” [ 8 ]. This model suggests that the longer the nerve fibres, the more likely they are affected to a functionally relevant degree by MS lesions and, ultimately, die off. This is why progressive MS symptoms are often seen first in the legs, as the nerve fibres supplying the legs are longer than those to the arms. This concept is key to testing whether people with advanced MS using wheelchairs can still expect improvements in hand and arm function.

Through responsive and meaningful patient involvement, the ThinkHand campaign aimed to raise awareness and initiate discussions among people with MS, clinicians, charities, pharmaceutical companies, and regulators about the importance of preserving upper limb function for people with more advanced MS. The campaign outlined specific goals to impact [ 1 ] trials in more advanced MS to include wheelchair users [ 2 ], regulators to accept the Nine-Hole Peg Test (9HPT) as a primary outcome measure for phase 3 trials [ 3 ], treatments for people with more advanced MS (wheelchair users) to protect arm and hand function and [ 4 ] evidence-based stopping criteria for DMTs.

How we addressed the issue

The method used in the campaign, shown in Fig.  1 , was a multi-pronged approach that involved online surveys, disruptive strategies at scientific conferences, awareness events, and co-design of outcome measurement and rehabilitation tools. The following provides further details of the methods used:

Online Surveys : Online surveys were conducted through The MS Research blog [ 14 ] to gather data on the importance of hand and arm function in daily life for individuals with advanced MS and the attitudes of healthcare professionals towards including such individuals in research studies.

Social Media : explanatory videos documenting the pathway to ChariotMS trial [ 15 ].

Innovative Strategies : To disseminate the knowledge obtained from the online surveys and encourage discussion around the issue, unconventional activities were employed at the European Committee for Treatment and Research in Multiple Sclerosis (ECTRIMS) conference in 2016. These included researchers constructing their research poster out of cardboard using their own hands emphasising the importance of hand function and inviting people with MS to contribute to a “Burning Debate” session on the inclusion of wheelchair users in MS clinical trials.

Awareness Event : The campaign organised a ThinkHand awareness event in London, which celebrated the hand function of artists, musicians, and a renowned jewellery maker, all living with MS. The aim of the event was to highlight the impact of hand and arm function on self-expression, livelihood, creativity, and independence.

Low-Cost Assessment Tool : The 9HPT is an outcome measure used to measure finger dexterity and arm function and is considered the gold standard for assessing upper limb function in people with MS in clinical trials. Because the commercial apparatus, made of plastic, is quite expensive (around GBP105), we created a low-cost (GBP9.99), environmentally friendly version for people to use at home so they could monitor their arm and hand function themselves. The cardboard tool was exhibited at ECTRIMS 2017 and an academic publication detailing its validation was produced [ 16 ].

Co-Design of Rehabilitation Tool : The focus on patient-generated knowledge in the campaign led to the co-design of a hand rehabilitation tool “Under & Over” with individuals living with MS. A randomised controlled study was conducted to assess the delivery of a remote rehabilitation program to individuals with advanced MS [ 17 ].

Workflow diagram of the stages of the campaign

Role of patient engagement

The MS Research group at QMUL has a long-standing PPI group and a track record of engaging people at all stages of research development [ 18 , 19 , 20 , 21 ]. Clinical academics and researchers within the group successfully use a range of social media platforms within their PPI and engagement work, which became crucial in this campaign. The established PPI group, along with a number of other people with MS (co-authors on this paper and listed in the acknowledgements) contributed to the formulation of how to tackle the wicked problem, contributing their personal experiences and personal insights of the issue. For example, people were sharing experiences such as, “Now that I’m in a wheelchair, my hands have become my legs.”

Online survey

This led to the campaign initiating a series of online surveys [ 6 ]. These were conducted through The MS Research Blog, which had a daily readership of 9,000 individuals. The surveys invited people with advanced MS to share the importance of hand and arm function in their daily lives and healthcare professionals to share their attitudes towards including individuals with advanced MS in research studies. 360 people with MS and 43 MS Neurologists responded to the surveys. The findings revealed that 92% of respondents (321/349) placed greater importance on their upper limb function compared to lower limb function, and 95% (332/350) felt that pwMS using wheelchairs should not be excluded from DMT trials. At the same time, 75% of UK MS Neurologists (32/43) said that they regularly stop prescribing DMTs in pwMS who need a wheelchair, even though 61% (26/43) felt that currently available DMTs were likely still effective even at this stage of the disease. The results of these surveys focused the ThinkHand campaign efforts on changing perceptions of the problem. The team needed to go beyond traditional methods of communication and knowledge dissemination to illustrate the impact of these issues on a larger scale.

Innovative strategies and social media

The cardboard poster presented at ECTRIMS conference 2017, being made by poster authors by hand

To do this, they employed disruptive strategies at a clinical academic conference in 2017 to draw attention to the survey results and the wider issue. ECTRIMS is the largest worldwide conference dedicated to understanding and treating MS and is attended by thousands of MS specialist healthcare professionals, researchers, and pharmaceutical companies. The survey results were created by hand by the authors into a poster made of cardboard to emphasise the importance of hand function in daily life (Fig.  2 ). The team also hosted a “Burning Debate” on the inclusion of wheelchair users in clinical trials, utilising the survey data and with a backdrop of inflatable numbers (see Fig.  3 ) to support the argument. The balloons displayed the number “95%,” representing the data and indicating the percentage of survey respondents who believe that people with MS using wheelchairs should not be excluded from progressive trials. People with MS were invited to the conference debate through Twitter (now X), where they contributed comments on the discussion (see Fig.  3 ). These activities brought attention to the issue with conference participants engaging in these activities and reflecting on their own assumptions and approaches about managing and researching upper limb function for the people they research and treat. Unconventional elements such as balloons and handmade posters were used to creatively emphasise critical issues at the academic conference, disrupting traditional approaches. Additionally, involving people with MS in the debate through social media challenged assumptions and brought a fresh perspective to the discussion.

Professor Klaus Schmierer taking part in the Burning Debate and Twitter commentary from patients

Awareness event

The ThinkHand exhibition was crucial to raising awareness about the impact of hand and arm function on key aspects of life such as self-expression, livelihood, and creativity. The exhibition showcased work of artists, musicians, and a renowned jewellery maker who have MS. The aim was to communicate the human aspect of upper limb function and its link to one’s identity. It was held in London on February 22nd 2018 and engaged funders, regulators, and researchers to reflect on this issue. It was covered by the Evening Standard [ 22 ] and various multimedia channels within the MS community [ 23 , 24 , 25 , 26 ].

Low-cost assessment tool

The cardboard 9 Hole Peg Test. Image credit: The Agency of Design

The 9HPT is a widely used tool for evaluating upper limb function and is a standard method in MS clinical trials [ 27 , 28 ]. However, the standard 9HPT apparatus made of plastic is costly and the test usually administered by a clinician, limiting its access for patients to monitor their upper limb function themselves. To address these limitations, the ThinkHand campaign developed a low-cost cardboard version of the test (Fig.  4 ). This innovative measure was designed and produced by the campaign team, in collaboration with a design consultancy The Agency of Design, and was validated through an academic publication [ 16 ]. This low-cost and easily accessible cardboard 9HPT provides an alternative measure for upper limb function, making it more widely available to researchers and clinicians working in the field of MS. It was distributed to 12,000 delegates at the ECTRIMS conference and quickly became a success, receiving requests from around the world for its use in remote monitoring of hand function in patients and clinical and research teams.

Co-design of a rehabilitation tool

After the international distribution and use of the cardboard 9HPT, the team received feedback that patients were using the tool more regularly than intended. Some were using it multiple times a week to see if they could improve on their time, ultimately using it like a rehabilitation tool. This supported other patient feedback the team had received from earlier qualitative work, where people with MS used everyday activities and objects to monitor changes in their hand and arm function at home. Anecdotes of using the ability to scrape a yoghurt pot clean every morning at breakfast to varying degrees of success would tell one person what their hand and arm function was like that day. This became a design-led exploration of alternative ways to measure, record and account for people’s experiences of change in hand and arm function in everyday life. Key to this design process was reviewing existing upper limb rehabilitation tools for both MS and other conditions, then including insights from patients about how they engaged with the c9HPT tool at home (Fig.  5 ).

A photograph of the Under and Over rehabilitation tool. Image credit: The Agency of Design

The resulting tool, Under & Over, is a plastic board with two strings that people can thread to create a range of patterns. This tool was formally assessed in a remote study with a 12-week rehabilitation programme. The study found that a small, engaged, and motivated group of individuals with advanced MS were able to complete a remote rehabilitation program [ 17 ]. The study was the first fully remote study examining the effect of a targeted upper limb rehabilitation tool and demonstrates the feasibility and acceptability of delivering a remote program to individuals with advanced MS.

Campaign success

The ThinkHand campaign contributed to several notable outcomes in the field of MS research and management. The campaign received financial support from private donors, commercial and government agencies which allocated resources towards the study of upper limb function in people with MS. Our activities contributed to the development of two clinical trials with emphasis on people with more advanced MS with upper limb function measured using the nine-hole-peg test as their primary outcome measures. (i) An international trial to assess ocrelizumab in people with primary progressive MS (O’HAND Study, NCT04035005), of which one of the co-authors (Giovannoni) became the principal investigator. (ii) A UK-wide trial called ChariotMS (NCT04695080), which focusses entirely on pwMS who are wheelchair users. From its inception, ChariotMS has been co-created and managed with PPIE input. The trial, testing cladribine tablets in pwMS with an EDSS between 6.5 and 8.5 is being supported by three charities (MS Society UK, National MS Society US, Barts Charity), the National Institute for Health and Care Research (NIHR) EME-Programme, and an industry partner (Merck Healthcare). If successful, both ChariotMS and O’HAND could lead to the first MS drug(s) licensed to protect upper limb function, including in pwMS who have so far been completely excluded from participating in MS DMT trials. With two trials underway that were facilitated by our campaign, the team won in 2019 the Influence Award in the public engagement award ceremony of the QMUL Centre for Public Engagement.

While the ThinkHand campaign aimed to address an important unmet need in the MS community, some pwMS expressed resistance to being regularly reminded of the limitations imposed by their condition. Similarly, some researchers and professionals in the field of MS found the campaign’s approach to be challenging to established perspectives and dogmas. This type of resistance to new ideas and perspectives is not uncommon in any field of research, as new ideas often challenge established views and can take time to gain acceptance [ 29 ]. Despite the slightly mixed reception, the ThinkHand campaign has had a lasting impact on the field of MS research and management and has provided patients with an innovative and independent method for monitoring their upper limb function.

Learnings for practice

Through the experience of working with people with MS in creative practices of engagement and involvement, valuable insights emerge, offering significant learnings for practice that enable researchers to effectively tackle complex problems within clinical and research settings in new ways.

Interdisciplinary collaboration

The campaign was an interdisciplinary collaboration, harnessing the collective expertise of multiple fields to tackle the complex and multifaceted nature of the so-called wicked problem. For example, the project involved collaboration between experts in areas such as lived experience, medicine, clinical research, design research, and social sciences to address the challenge at hand. This interdisciplinary approach not only facilitated a holistic understanding of the issue but also promoted innovative and creative exploration. Unlike approaches confined to a single field, the campaign benefited from a range of accountabilities and was not bound by the constraints of any singular research methodology. This flexibility allowed the project to employ diverse methods from various disciplines, enabling a more creative and responsive process.

Systems thinking

The project used systems thinking to understand the interconnectedness of different components of the problem and how they influence each other. This approach was used to identify the root causes of lack of change in the field and design interventions that address these holistically. The impact of this has long lasting benefits for people with MS. For example, the cardboard 9HPT tool addressed health access issues brought about during the Covid-19 pandemic where the Neurology service at The Royal London Hospital used it as a remote test to monitor patients when they were unable to see them in person [ 30 , 31 ].

Co-creation with multiple stakeholders

The project involved co-creation with stakeholders, including people with MS, funders, charities, regulators, health care professionals and researchers to ensure that interventions were relevant and feasible. The project used participatory methods, such as co-design, to gather input and build engagement from these stakeholders. For example, the project engaged with people with advanced MS to understand exactly how they generate information on their hand function at home and used this to develop the Under & Over tool that could align with their needs and values.

Experimentation and iteration

The project used an experimental and iterative approach, testing and refining interventions based on reflections and feedback from multiple audiences. This approach allowed the project to learn from failures, improve upon successful ideas and approaches, and continuously adapt to changing circumstances. For example, the team kept a commentary of the campaign on the MS Research Blog, engaging readers on the development of the campaign and sharing problems, challenges and developments, such as the ChariotMS trial. The project did not follow a traditional research process. The team had a practical understanding of the problem that guided activities while responding to iterative feedback from people with MS. In this way, it was not restricted to a predetermined process that could have limited aspects of its responsiveness.

In summary, we have described the innovative approach undertaken by our team in the ThinkHand campaign, addressing the complex issue of upper limb function in pwMS. By actively involving patients in the process, the campaign not only raised awareness about the importance of upper limb function in MS but also contributed to the development of innovative ways to measure, record, and account for the change in hand and arm function in the everyday lives of people with MS. This has had a long-lasting influence on the field of MS research and management.

Moreover, the campaign underscores the immense potential of a patient-centred approach when grappling with complex issues in health research. By fostering openness, transparency, and honest discussions, patients were empowered to contribute and influence the trajectory of the project actively. This powerful impact of sustained patient engagement and involvement practices cannot be overstated.

The campaign’s realisation that traditional methods of communication and knowledge dissemination are inadequate for driving widespread change further emphasises the crucial lessons learned from involvement and engagement. Through these lessons, we recognise the necessity of working with more dynamic, engaging, and creative methods to comprehend the significance of this issue truly.

Data availability

No datasets were generated or analysed during the current study.

Abbreviations

Queen Mary University of London

patient public involvement

disease-modifying treatments

• Multiple Sclerosis

Nine-Hole Peg Test

Cardboard Nine-Hole Peg Test

European Committee for Treatment and Research in Multiple Sclerosis

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Acknowledgements

We sincerely thank all PPI co-authors for their enthusiastic and invaluable contributions to this project and in shaping the manuscript with their valuable insights. Thank you to the Barts MS Patient Advisory Group members and The MS Research Blog readers for enriching our understanding through their shared experiences and thoughts. We greatly thank Christine Chapman for her exceptional dedication to the ChariotMS study and related activities.

We express our gratitude to Ondrej Rypacek, Kishon Khan, and Romilly Saumarez Smith for their active participation in the exhibition, significantly enhancing its impact. Finally, our sincere appreciation to go to the study participants in the Measurement on Our Terms, Under & Over and ChariotMS studies and the online survey respondents for their indispensable contributions to the campaign’s success.

The ThinkHand campaign and new upper limb patient-related outcome measure was funded by the Horne Family Foundation. The c9HPT and associated ECTRIMS 2016 stand was funded by Biogen. The Under & Over study, O’HAND study (NCT04035005) and the ECTRIMS 2018 booth were funded by Roche. ChariotMS (NCT04695080) is funded by the Efficacy and Mechanism Evaluation (EME) Programme, an MRC and NIHR partnership (project reference 17/145/09). The views expressed in this publication are those of the author(s) and not necessarily those of the MRC, NIHR or the Department of Health and Social Care. ChariotMS receives further support from the MS Society UK, US National MS Society, Barts Charity and Merck Healthcare. We are also grateful for support from the Morris-Saady Charitable Trust and Lipomed GmbH during the preparation stage of ChariotMS.

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Centre for Preventive Neurology, Wolfson Institute of Population Health, Queen Mary University of London, London, UK

Alison Thomson, Andrea Stennett & Gavin Giovannoni

Patient Author, Barts MS Advisory Group, Queen Mary University of London, London, UK

Rachel Horne, Christine Chapman, Trishna Bharadia, Patrick Burke, Elizabeth Colwell, Mark Harrington & Bonnie Boskovic

The Blizard Institute, Centre for Neuroscience, Surgery and Trauma, Queen Mary University of London, London, UK

David Baker, Gavin Giovannoni & Klaus Schmierer

Clinical Board Medicine (Neuroscience), Barts Health NHS Trust, The Royal London Hospital, London, UK

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Contributions

The project’s concept and design were developed collaboratively by AT, KS, DB, GG, and the PPI co-authors. The manuscript was primarily drafted by AT who actively incorporated valuable insights from PPI co-authors. Early drafts were reviewed and commented on by AS, KS, DB, and GG. PB, EC, MH, CC, TB, and RH played pivotal roles in reviewing and providing an overview of the lived experience aspect of the project. All authors contributed to and approved the manuscript in its present form.

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Correspondence to Alison Thomson .

Ethics declarations

Ethical approval and consent to participate.

Online survey respondents received a link to the online survey, which informed them that completion of the electronic questionnaire implied that they had consented to participate in the survey.

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Not applicable.

Competing interests

AT: AT has received research support from The UK MS Society, Roche and honoraria from Novartis and Merck. RH: RH is part of the Horne Family Foundation. CC: None.TB: None.PB: None.EC: None.MH: None.BB: None.AS: None.DB: DB has received honoraria for consultancy from Merck, Novartis, Teva and Sandoz.KS: KS has received research support, through Queen Mary University of London, from Biogen, Merck KGaA, and Novartis, Roche and Sanofi-Genzyme, speaking honoraria from, and/or served in an advisory role for, Biogen, EMD Serono, IGES UK, Merck KGaA, Novartis, Roche, and Sanofi-Genzyme and Teva; and remuneration for teaching activities from AcadeMe, Medscape and the Neurology Academy.GG: In the last two years, GG has received compensation for serving as a consultant or speaker for or has received research support from Aurinia Pharmaceuticals, Biogen, BMS-Celgene, GlaxoSmithKline, Janssens/J&J, Japanese Tobacco, Merck KGaA/EMD Serono, Moderna, Novartis, Sandoz, Sanofi and Roche/Genentech.

AT is a design researcher and Senior Lecturer in PPIE at Queen Mary University of London. AT established and leads the Barts MS Patient Advisory Group and was the PI of the Under & Over study.

TB is an MS patient advocate and thought leader who provided ongoing support and advice as an ambassador for the ThinkHand campaign, particularly around engagement with the MS community.

CC lives with MS and is an Honorary Research Fellow (clinical trials patient communications) at the Blizard Institute.

RH, PB, MH, EC and BB live with MS and contributed as members of the Barts MS Patient Advisory Group to the development of ThinkHand activities and writing of this manuscript.

AS is a research neuro-physiotherapist at Barts Health NHS Trust and Honorary Clinical Lecturer at Queen Mary University of London and was involved in the Under & Over study.

KS is a Professor of Neurology and consultant neurologist. He is a Deputy Director of Clinical Research at QMUL & Barts Health NHS Trust, the Neurology Research lead, and the clinical lead of BartsMS. KS is the chief investigator of ChariotMS.

DB is a Professor of Immunology at Queen Mary University of London and is a frequent author of The MS Research Blog.

GG is a Professor of Neurology and MS consultant neurologist and runs the MS Selfie website.

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Thomson, A., Horne, R., Chapman, C. et al. Engaging a community to focus on upper limb function in people with multiple sclerosis: the ThinkHand campaign case study. Res Involv Engagem 10 , 62 (2024). https://doi.org/10.1186/s40900-024-00586-y

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DOI : https://doi.org/10.1186/s40900-024-00586-y

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Most people with Long COVID experience symptoms days after first learning they had COVID-19, but some people who later develop Long COVID do not know when they were infected. People can be reinfected with SARS-CoV-2 multiple times. Each time a person is infected with SARS-CoV-2, they have a risk of developing Long COVID. Long COVID symptoms and conditions can emerge, persist, resolve, and reemerge over weeks and months. These symptoms and conditions can range from mild to severe, may require comprehensive care, and can even result in a disability .

While rates of new cases of Long COVID have decreased since the beginning of the COVID-19 pandemic, it remains a serious public health concern as millions of U.S. adults and children have been affected by Long COVID.

Signs and symptoms

People with Long COVID can have a wide variety of symptoms that can range from mild to severe and may be similar to symptoms from other illnesses. Symptoms can last weeks, months, or years after COVID-19 illness and can emerge, persist, resolve, and reemerge over different lengths of time. Long COVID may not affect everyone the same way. Some people can experience health problems from different types and combinations of symptoms that may:

• Be difficult to recognize or diagnose
• Require comprehensive care
• Result in disability

Fatigue, brain fog, and post-exertional malaise (PEM) are commonly reported symptoms, but more than 200 Long COVID symptoms have been identified.

General symptoms 

• Tiredness or fatigue that interferes with daily life
• Symptoms that get worse after physical or mental effort

  Respiratory and heart symptoms

• Difficulty breathing or shortness of breath
• Fast-beating or pounding heart (also known as heart palpitations)

  Neurological symptoms

• Difficulty thinking or concentrating (sometimes referred to as “brain fog”)
• Sleep problems
• Dizziness when you stand up (lightheadedness)
• Pins-and-needles feelings
• Change in smell or taste
• Depression or anxiety

  Digestive symptoms

• Stomach pain
• Constipation

  Other symptoms

• Joint or muscle pain
• Changes in menstrual cycles

Symptoms that are hard to explain and manage

Some people with Long COVID have symptoms that are hard to explain or difficult to manage. There is no laboratory test that can determine if your unexplained symptoms are due to Long COVID. People with these unexplained symptoms may sometimes even be misunderstood or experience stigma. This can result in a delay in diagnosis and receiving the appropriate care or treatment. Long COVID treatment is focused on managing symptoms, reducing their impact on daily activities, and improving your quality of life.

Talk to your healthcare provider if you are experiencing symptoms that are hard to explain or that persist, or if you think you or your child has Long COVID.

Complications

Some people, especially those who had severe COVID-19, may experience multi-organ effects or autoimmune conditions lasting weeks, months, or even years after COVID-19 illness. Multi-organ effects can involve many body systems, including the heart, lungs, kidneys, skin, and brain. Symptoms for many of these multi-organ complications are similar to commonly reported Long COVID symptoms. As a result of these effects, people who have had COVID-19 may be more likely to develop new or worsening of health conditions such as:

• Heart conditions
• Blood clots
• Neurological conditions

Who is at risk

While anyone who gets COVID-19 can develop Long COVID, studies have shown that some groups of people are more likely to develop Long COVID than others, including (not a comprehensive list):

• Hispanic and Latino people
• People who have experienced more severe COVID-19 illness, especially those who were hospitalized or needed intensive care
• People with underlying health conditions and adults who are 65 or older
• People who did not get a COVID-19 vaccine

Health inequities affect populations at risk for Long COVID

Health inequities from disability , economic, geographic, and other social factors disproportionately affect some groups of people. These inequities can increase the risk of negative health outcomes and impact from Long COVID.

CDC emphasizes core strategies  to lower health risks from COVID-19, including severe outcomes such as hospitalization and death. Preventing severe outcomes from COVID-19 illness helps prevent Long COVID. Steps you can take to protect yourself and others include:

• Staying up to date on COVID-19 vaccination .
• Practicing good hygiene  (practices like handwashing that improve cleanliness)
• Taking steps for cleaner air
• Use precautions to prevent spread
• Seek healthcare promptly for testing and/or treatment if you have risk factors for severe illness ; treatment  may help lower your risk of severe illness

Research shows COVID-19 vaccination  is the best available tool to prevent Long COVID.

Testing and diagnosis

Long COVID is not one illness. There is no laboratory test that can determine if your symptoms or conditions are due to Long COVID. A positive SARS-CoV-2 test is not required for a Long COVID diagnosis. Your healthcare provider considers a diagnosis of Long COVID based on:

• Your health history
• If you had a diagnosis of COVID-19 by a positive test, symptoms, or exposure
• A health examination

Clinical evaluations and results of routine blood tests, chest X-rays, and electrocardiograms may be normal in someone with Long COVID. People experiencing Long COVID should seek care from a healthcare provider to create a personal medical management plan and improve their symptoms and quality of life. Talk to your healthcare provider if you think you or your child has Long COVID.

Similar conditions

Some people experiencing Long COVID symptoms have symptoms similar to those reported by people with myalgic encephalomyelitis/chronic fatigue syndrome (ME/CFS)  and other poorly understood chronic illnesses that may occur after other infections. These unexplained symptoms or conditions may be misunderstood by healthcare providers, which can result in a delay in diagnosis and people receiving the appropriate care or treatment.

What CDC is doing

CDC is working with other federal agencies to better understand and address the long-term impacts of Long COVID , who gets Long COVID, and why. CDC supports these goals by:

• Partnering with state and local jurisdictions
• Supporting healthcare providers
• Promoting and conducting research

Studies are in progress to learn more about Long COVID and identify further measures to help prevent Long COVID. CDC and partners use multiple approaches to support and conduct research that estimates:

• How many people experience Long COVID and why
• Which groups of people are disproportionately impacted by Long COVID
• How new variants may affect Long COVID
• The role that COVID-19 vaccination plays in preventing Long COVID

Each approach helps CDC and its partners better understand Long COVID and how healthcare providers can treat or support patients living with these long-term effects. CDC posts data on Long COVID and provides analyses. The most recent CDC data and analyses on Long COVID can be found on the  U.S. Census Bureau’s Household Pulse Survey . CDC will continue to share information with healthcare providers to help them evaluate and manage these conditions.

• The Office of Long COVID Research and Practice (OLC) (HHS)
• Long COVID (Veterans Affairs)
• Coronavirus Resources (Department of Labor)
• RECOVER COVID Initiative

Long COVID Reports

• A Long COVID Definition: A Chronic, Systemic Disease State with Profound Consequences | The National Academies Press
• Long-Term Health Effects of COVID-19: Disability and Function Following SARS-CoV-2 Infection | The National Academies Press
• Implementation of the Government-wide Response to Long COVID (HHS)
• National Research Action Plan (covid.gov)
• Services and Supports for Longer-Term Impacts of COVID-19
• Health+ Long Covid Human-Centered Design Report (HHS)
• Whole Health System Approach to Long COVID (Veterans Affairs)

To receive email updates about COVID-19, enter your email address:

Exit Notification / Disclaimer Policy

• The Centers for Disease Control and Prevention (CDC) cannot attest to the accuracy of a non-federal website.
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In recent years, bank failure has become a growth industry. Banking crisis around the world has become so pervasive that many central bankers are likely to have some personal experience of one financial crisis or other in the last five years. As banks around the world begin to feel the onset of recession, with rising loan losses arising from property and share price falls in Japan, the United States, and the United Kingdom, and as banks in highly indebted countries still suffer the effects of major structural adjustment programs, an unprecedented global shake-up in the financial sector is likely to occur in the early 1990s. If so, central bankers must be prepared to deal with banking crises as they arise, or better still prevent crises from happening. This paper looks specifically at the role of the central bank in domestic banking crises.1

In recent years, bank failure has become a growth industry. Banking crisis around the world has become so pervasive that many central bankers are likely to have some personal experience of one financial crisis or other in the last five years. As banks around the world begin to feel the onset of recession, with rising loan losses arising from property and share price falls in Japan, the United States, and the United Kingdom, and as banks in highly indebted countries still suffer the effects of major structural adjustment programs, an unprecedented global shake-up in the financial sector is likely to occur in the early 1990s. If so, central bankers must be prepared to deal with banking crises as they arise, or better still prevent crises from happening. This paper looks specifically at the role of the central bank in domestic banking crises. 1

The decade of the 1980s has taught central bankers around the world quite a lot about banking crises, although controversy still exists about the exact causes and cures. The landmark bank failures of the 1970s, Herstatt and Franklin National, appear today small-fry compared with the losses of the savings and loan debacle in the United States, and the banking crises in Spain, Latin America, Africa, and Asia in the 1980s, A number of these cases have become fairly well documented in the International Monetary Fund and the World Bank. This paper attempts to synthesize broadly the practical lessons drawn from these cases, based upon a research project in the Bank on bank restructuring in developing countries. It begins with the definitions of banking crises, then looks at the contractual nature of banking and the macroeconomic and microeconomic origins of crises. Various country cases are then grouped into various types of crises and the methodology of crisis resolution is then examined. Finally, a case study is presented on the management of banking crisis from the vantage point of the central bank, based upon the experience of the Malaysian banking crisis of 1985–87.

• Definitions

In this paper, the terms banking crisis and financial crisis are interchangeable. Most definitions of a financial crisis would be close to that offered by Goldsmith (1982) :

a sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators—short-term interest rates, asset prices (stock, real estate, land prices), commercial insolvencies and failures of financial institutions.

In the narrow sense, the actual crisis (such as a large bank failure that sparks off a large run that spreads to a number of banks) is a decisive event that marks the turning point in the business cycle. However, real and financial conditions deteriorate—managements behave speculatively, structures become fragile, supervision becomes lax, depositors become nervous—over a fairly long time horizon. Moreover, the resolution of a banking crisis, particularly where the root causes are structural, takes not less than three to five years. The U.S. thrift crisis took about a decade to unfold: from the first technical insolvencies caused by high interest rates in the beginning of the 1980s to government action in 1989 to restructure the regulatory, supervisory, and liquidation agencies to handle the large number of thrift failures.

Banking crises typically occur when financial distress prevails. Distress is defined as the condition when the banking system as a whole has negative capital and current profits are insufficient to cover losses to such an extent that the banking system is unable to generate internally positive capital ( Hinds (1988) ). There are, however, different degrees of severity of crises. Mr. Corrigan (1989/90) , of the Federal Reserve Bank of New York, has recently differentiated between “financial disruptions” and “financial crises,” the latter being episodes that cause clear and significant damage to the real economy. Under this definition, major bank failures or market crashes in the postwar period would certainly count only as “disruptions.” For example, stock and land prices fell sharply in Taiwan Province of China and Japan in 1990, but these factors do not appear to have caused significant changes in real economic growth, changes in the balance of payments, or foreign exchange reserves—factors common in a number of financial crises. In strong economies, some banks may be hurt and peripheral financial institutions may fail, but real economic activity need not be severely affected.

This definition of financial disruption is similar to what Anna Schwartz (1985) calls pseudofinancial crises, that is, declines in asset prices of equity stock, real estate, commodities; depreciation of the exchange rate; financial distress of large firms, financial industry or sovereign debtors. In her view, real financial crises occur when the stability of the banking system is threatened.

• Nature and Origins of Banking Crises

There are a number of schools of thought on the causes of banking crises. Schwartz and others in the monetarist school consider that financial crises are not triggered by financial distress but by the failure of authorities to respond correctly to financial distress and that they are aggravated by the private sector’s uncertainty about the correct policy responses. On the other hand, the Minsky and Kindleberger school has evolved a theory of financial fragility, which is defined broadly as a long period of economic growth that leads to euphoric behavior by economic entities. The financial fragility of players (governments, enterprises, banks, and households) increases over the growth cycle as capital cushions deteriorate, leverage increases, and the economy becomes more vulnerable to economic shocks. Political events, external shocks, local or sectoral problems all create doubts over the sustainability of such euphoria, and the speculative bubble bursts when asset prices fall. The forced debt liquidation accentuates declining asset values, tightening liquidity, and precipitating insolvencies of debtors, thus triggering bank failures. 2

Controversy also exists over whether banking crises have macroeconomic or microeconomic origins. The macroeconomic school blames structural imbalances, inappropriate economic policies and external shocks, or a combination of such factors. Typical factors include large fiscal and balance of payments deficits, overvalued exchange rates, negative real interest rates, high external debt, inflation, and fundamentally inefficient domestic industries. These factors, plus flaws in the financial structure, make the economy (and hence the banking system) highly vulnerable to external shocks, sudden relative price changes, or major policy shifts.

Changes in the macroeconomic environment are not the only factors accounting for ailing banks. Many financial systems have not been designed to withstand shocks. The monetary sector of the financial system is usually highly regulated and protected by the central bank, but other components, such as rural savings institutions, deposit-taking cooperatives, stock markets, and informal curb markets are usually self-regulated or very loosely regulated. These secondary or fringe financial institutions do not have lender of last resort facilities, nor effective supervision to ensure that public savings with them are adequately protected from fraud and management abuses. Failure in these unregulated subsectors often spill over to the monetary sector. In addition, the duplication of supervision or gaps in supervision (particularly where there are lacunae in the law) do not allow the authorities to act flexibly and quickly in response to problems in any particular sector.

Macroeconomic and structural issues aside, experienced bank supervisors invariably have no hesitation in pinpointing microeconomic roots in bank failures—bad bank management, supervisory inadequacies, poor accounting standards, and weak legal framework ( U.S. Treasury (1988) and Sinkey (1979) ). Aristobulo de Juan’s dictum (1987) on how good bankers become bad bankers through the stages of technical mismanagement, cosmetic mismanagement, desperate management, and, finally, fraudulent management is now well-known. Temptations to steal in banking are so large that elements of fraud or conflict of interests are found in almost all cases of bank failure. In Malaysia, there is a saying that “you don’t let monkeys look after bananas.” Strong and effective bank supervision can play a major role to detect bank problems, but as can be seen later, cannot wholly prevent bank failure.

In practice, there is often a macro-micro negative feedback mechanism. Macroeconomic maladjustments, such as an overvalued exchange rate, large fiscal deficits, heavily protected industries, corruption, and excessive domestic speculation lead ultimately to losses incurred by borrowers. These losses show up as nonperforming loans in the banking system. Banks initially may be able to absorb such losses, so long as nonperforming loans remain a small proportion of their total loan portfolio. The costs of loan-loss provisions are usually absorbed through higher spreads, such costs being borne by depositors and performing borrowers. If loan-losses persist, however, and erode the banks’ solvency, the management may seek to hide their losses through cosmetic accounting, or through “evergreening” loans to keep large borrowers alive, bidding up deposit rates to maintain their liquidity. Perverse incentives occur. Distressed borrowers have no hesitation in paying excessive real interest rates to have access to new credit in order to maintain the illusion of solvency. On the other hand, distressed asset sales drive down asset prices and erode further the collateral base of the banks. Faced with uncertainty and large losses, banks contract credit and raise real interest rates, thus dampening investment and growth.

At this point, doubts over the soundness of a particular financial institution, whether true or unfounded, could lead to a bank run, inducing flight to quality, or in more serious cases of contagion, a flight to currency. If the contagion is not stopped quickly, nervousness about the soundness of the banking system would create capital flight. As experience shows, central bank lending to banks during capital flight only adds fuel to the fire and is self-defeating, as it entails immediate loss in foreign exchange reserves. The resultant depreciation of the exchange rate could cause more panic. Raising interest rates to stem capital flight would contract economic activity further, sending the economy into a deflationary spiral. Consequently, few central banks dare to treat potential problems of banks lightly. Because of the constant threat of contagion, it is impossible to tell ex ante whether a bank problem is a financial disruption, or what ex post turns out to be a full blown financial crisis. It is the fear of systemic risks (discussed later) that drives central bank intervention in problem banking situations.

The role of the central bank at this stage is crucial. The central bank is required fundamentally to maintain financial stability. This involves not only maintaining the internal and external value of the currency, but also the stability of the banking system. But, what does “maintenance of the stability of the banking system” mean in practical terms? Providing liquidity to a solvent banking system to ease sporadic shortage of funds and maintaining integrity of the payments mechanism is generally accepted doctrine. The provision of central bank funds to an insolvent financial system to maintain stability, however, has quasifiscal implications and is much more controversial and less well understood.

Is a central bank obliged as guardian of the system to provide not only liquidity but also to safeguard system solvency? Indeed, under conditions of crisis and uncertainty, it is extremely difficult to distinguish between a liquidity need and a solvency need. My personal experience is that when bankers come to the central bank for liquidity help (after they are not able to obtain help from other institutions), it is no longer liquidity assistance, but a question of solvency. This dilemma was considered by Bagehot (1978) , whose view of the proper role of the lender of last resort was succinctly restated by Summers (1989) as central banks should adopt, announce, and follow a policy of lending freely and aggressively but at a penalty rate to all sound but no unsound borrowers in time of crisis.

There are three good reasons behind this advice. First, provision of liquidity to good borrowers would assure the smooth and stable functioning of the payments system, thus heading off problems of confidence in the ability of even good borrowers to meet their commitments. Second, by lending only at penalty rates against good security, the central bank deters moral hazard behavior of distressed borrowers and protects its own solvency at the same time. Third, in a crisis, the central bank may be the only available buyer of good securities. Its presence in the market could check the free fall of the price of bonds or quality commercial paper, the forced debt liquidation of which may make even normally sound borrowers insolvent.

Central bank intervention in banking crisis has wide monetary and fiscal implications. Central bank lending to problem banks is expansionary on money supply. Central bank’s losses through measures to subsidize ailing banks, assumption of foreign exchange losses of banks or enterprises, or takeover of bad assets of insolvent banks are all quasi-fiscal deficits in nature. If these losses are monetized, the result could be higher inflation. In an open economy, there is always the danger that if the public perceives that the central bank is itself “insolvent” by absorbing too much loss, then capital flight would ensue. At the worst stage, a central bank with net foreign exchange liabilities would be caught in a downward spiral in which it tries to buy foreign exchange to service its debt only at higher and higher rates, thus losing monetary control and depreciating at the same time. The devaluation worsens the foreign exchange losses of the central bank, and the central bank itself becomes the source of monetary inflation.

There are tempting reasons for governments to use central banks not only as the lender of last resort but also as equity provider of last resort to help rescue banks. Central banks are, after all, institutionally created to act quickly to deal with financial crises. It may not be possible for the government to appropriate funds from the budget quickly enough to help stem a crisis. In times of crises, when there is a shortage of risk capital in both the private and public sectors, there may be no alternative to the central bank putting its funds at risk; however, the central bank can do this if, and only if, the losses on the assets it acquires are less than its income from other assets, otherwise the central bank’s own solvency is affected. As the case studies described later will show, experience suggests that it would be perilous for governments to tinker with a central bank’s solvency, since that damages the public’s confidence in the stability of the domestic currency. The capacity of a central bank to absorb losses of the banking system is a theme to which I shall return.

• The Contractual Nature of Banking

The periodic instability of financial systems has its roots in the contractual nature of banking. As financial intermediaries, banks essentially straddle two sets of contracts in the economy, a bundle of deposit contracts with savers and various loan contracts with borrowers. Bank failure is fundamentally the breakdown of contractual obligations between banks and their borrowers to the point that banks have to break their contracts with depositors. All markets, other than barter markets, are markets in contracts. Economic entities (principals and agents) trade products, or rather contractual obligations, under a written or unwritten set of regulations that protect and enforce the property rights of the market participants. All markets operate under conditions of uncertainty and risk. Implicitly, the Basle Committee on Banking Supervision (1990) in its recent work on credit concentrations has conceptually acknowledged the contractual nature of banking by categorizing banking risks into two broad categories: counterparty risks (credit risks, sectoral concentration exposures) and market risks (foreign exchange, interest rate, equity, and asset price fluctuation risks).

All financial products are by definition different forms of contracts that allocate risks and obligations between the various parties involved. Holders of obligations can only eliminate counterparty risks (such as credit risk) by final settlement in cash. In the meantime, both parties are subject to market risks, such as changes in interest rates, exchange rates, prices, or general market conditions that may affect the liquidity or solvency of the counterparty to deliver on the due date. What is not normally understood is that while contracts protect rights and obligations when both parties are solvent, the minute one party becomes insolvent, the holders of the insolvent party’s obligations immediately assume losses. In other words, rational self-preservation behavior calls for an insolvent institution to borrow as much as possible, since contractually it passes losses to all holders of its obligations. Eventually, it reaches the stage of “too big to fail” and the creditors are obliged to bail out that institution in their own self-interest. Hence, the fundamental truth of the anecdote that if you owe the bank $1,000, you are in trouble; if you owe the bank $100 million, the bank is in trouble.

In a world of volatile prices, no transparency in accounting disclosure, and general uncertainty, holders of contracts are never sure when the counterparty becomes insolvent or engages in cheating behavior, such as reneging on the contract. Market participants deal with each other on the basis of past experience or reputation. Confidence is generated through repeated successful conclusion of contracts. When a contract fails, confidence is eroded. Thus, banks are able to generate public confidence through their ability to meet deposit withdrawals on demand. Banks are therefore also subject to reputational risks. Contagion occurs when the public perceives, rightly or wrongly, that banks (or their subsidiaries or affiliates) may not be able to meet their obligations. Reputational risks occur when creditors (including depositors) associate problems of one economic entity with another related entity. The withdrawal of credit from one entity to entities of the same group typically creates a liquidity crisis for the group as a whole. Hence, bank supervisors tend to supervise financial institutions on a group or consolidated basis. Experience suggests that reputational risks can quickly destroy large groups of companies, particularly where these have been weakened by connected lending and excessive reliance on funding from associated financial institutions.

Systemic risks are in a sense an extension of reputational risks from individual institutions or groups to the financial system as a whole. A closer examination of systemic risks suggests that such risks occur mainly at the payment system level. Failure of one participant in the payment system triggers a chain reaction in nonpayment by other participants, particularly when the affected parties are unable to raise liquidity themselves in time to fulfil their own contractual obligations. The inability of (reputationally) first-rate institutions to meet their obligations creates uncertainty and can lead to panic self-protective measures by depositors, such as a run. Consequently, the central bank as lender of last resort has to step in quickly before problems spread throughout the system.

One can extend this argument to the economy as a whole. All financial contracts are measured and based on the currency contract, money being the measure and store of value, as well as the means of final settlement. When the central bank, as the issuer of domestic currency, is unable to maintain the stability of the value of the currency internally and externally, depositor and borrower behavior changes, and the crisis is worsened by inflation and currency flight. The reputation of the central bank is destroyed, as its credibility to defend the currency or the stability of the financial system itself is questioned. At that point, perhaps the worst type of financial crisis, the central bank may itself be a party to the crisis of confidence.

In sum, financial crises arise when real losses in the economy occur. These real losses ultimately are reflected in the banking system, through the breakdown of borrower and depositor contracts. A crisis occurs when the existing financial system (the institutions as well as the legal and regulatory framework) is unable to withstand external shocks to the system through sudden relative price changes or through internal corrosion, such as fraud and mismanagement (or a combination of both). A liquidity crisis when solvency is not at stake is a financial disruption. A solvency crisis, in which large parts of the financial system are insolvent, is a genuine financial crisis. The central bank may be able to address short-run crises of confidence through the temporary provision of liquidity, but ultimately it must also address the questions of insolvency of financial institutions and loss allocation. If depositors are to be protected from losses, then the losses are borne ultimately by other sectors of the economy, through inflation, taxation, or levies on the banking system. All these are in the realm of political economy, as the following case studies show.

• Types of Financial Crises

Before proceeding to a survey of the different types of banking crises encountered in recent years, it may be useful to make a general observation about banking developments in the 1980s. The catch-phrases globalization, securitization, innovation, and deregulation that arose from the “big bang” are an appropriate starting point. 3 The world is becoming one big financial market through liberalization of exchange controls, freeing of exchange rates, and improvements in telecommunications and bank processing technology. In their search for profits and through competition, banks have introduced a number of innovations, particularly new financial products (contracts), such as swaps, options, securitized paper, and off-balance sheet obligations, for which the risks and regulatory framework are by no means clear. National governments have helped the process of innovation and competition through deregulation, although the process of deregulation varies considerably from country to country.

On the other hand, periodic financial disruptions, such as the problems of Continental Illinois or Johnson Matthey, have evolved an illusion of a banking safety net that the central banks will always step in to protect banks that are too big to fail, or whose failure would disrupt the payments or market-clearing mechanisms. This was justified on the basis that the direct costs of rescuing a bank would be lower than the social costs of disruptions to the payments system and the confidence in the banking system as a whole. Implicitly through central bank action or explicitly through deposit insurance schemes, governments around the world have de facto if not de jure guaranteed the nominal value of the liability side of the banking system’s balance sheet, while having relatively little control over the asset side.

Indeed, through innovation, deregulation, and greater volatility of prices, interest rates, and exchange rates, the asset side of banking systems around the world has become much more vulnerable to shocks, at a time when competition and the search for profits have tended to erode the banking system’s capital base. The Basle Committee’s work has helped considerably to stem this erosion, but in a world where share prices can rise and fall 15 percent in one day, and when banks are heavily exposed to property and highly indebted countries well in excess of their capital base, it is not surprising that the public is concerned over the safety and soundness of the banking system. The size of these asset losses are not always transparent to the public, due to the poor state of accounting standards in many countries, inadequate bank supervision, and general unwillingness in a number of countries to deal with such complex problems. These issues become more evident from the following brief survey of country experiences. 4

Recent experience of financial crises can be grouped broadly into four country groups: the developed economies with advanced financial systems and reasonably strong supervision; the small, open-market-oriented developing economies that suffered shocks and bank fraud or mismanagement; the centrally planned economies with de facto nationalized banking systems; and finally, the hyperinflation economies that are still undergoing various stages of financial crises and structural adjustment.

The classification of these case studies remains fundamentally qualitative and judgmental, as the quantitative research and analysis is still going on. 5 The basis for classification is intuitively simple: solvent authorities (including central banks under this category), defined as those with large reserves, low debt, or the capacity to borrow or tax without affecting significantly monetary and price stability, have generally been able to solve banking crises with relative ease. At the other extreme, governments with large fiscal deficits and heavy external debt may themselves be the fundamental cause of financial crises, and inappropriate measures to deal with crises without maintaining fiscal and monetary discipline only worsen the situation.

Developed Country Experience

Financial disruptions in the advanced economies have so far proved to be relatively easy to solve, because of their sophisticated financial structure—sound contracts, good legal systems, established laws and enforcement agencies, availability of bank management skills, relatively high standards of bank ethics, and reasonably adequate bank supervision that could respond fairly quickly to detect and solve problems. Problems in these economies came mainly from either macroeconomic policy mistakes or flaws in the banking structure that were not corrected in time.

For example, the problems of the U.S. thrifts originated in their flawed funding structure. Their portfolio of long-term fixed interest housing loans were funded from short-term deposits, and many thrifts became technically insolvent when tight monetary policy in 1980–81 raised domestic interest rates. Instead of addressing the capital shortfall directly, the authorities made a number of policy errors: they allowed the thrifts to try to outgrow their problems by liberalizing their asset portfolio (without corresponding improvement in supervision), and they allowed the thrifts to finance the asset expansion through a raised limit ($100,000) on the deposit insurance scheme. Over the last decade, inadequate supervision, plus the moral hazard raised by the high deposit insurance scheme, allowed thrift management to incur large losses in junk bonds, real estate, and other areas where they had traditionally no expertise ( Silverberg (1989) ). The U.S. savings and loans saga, plus the present problems in the banking industry, came partly from the structural flaws of highly segmented banking markets, regulatory constraints on nation-wide branch banking, and difficulties of coordinating supervision. The saga is still unfolding.

The English secondary banking crisis of 1973–75 was mainly the result of overborrowing on the part of real estate and securities firms that suffered from the collapse of property and share prices following tight monetary policy in the wake of the 1973 oil crisis. While the large clearing banks were not affected, the smaller secondary banks, which were highly exposed to real estate and securities sectors, became both illiquid and insolvent, creating a situation of instability at a time when the economy was adjusting from a balance of payments crisis. The decisive action by the Bank of England to organize a “lifeboat fund” amounting to £1.2 billion (equivalent to 40 percent of the capital base of the English and Scottish clearing banks) jointly with the strong clearing banks, contained the problem. Twenty-six deposit-taking institutions received help from the fund, and eight were eventually liquidated ( Bank of England (1978) ).

The Spanish banking crisis of 1978–83 was partly the result of structural adjustment in the economy following the oil crisis of 1973 and 1979 and too many new banks as a consequence of financial liberalization. Fifty-one banks out of 110 were affected, involving nearly 20 percent of total deposits. Nearly 90 percent of the problem banks were relatively new institutions (Larrain and Montes-Negret ( 1986 )) and bank mismanagement and fraud was much to blame ( de Juan (1985) ). Again, decisive action by the Bank of Spain to establish the Spanish Guarantee Fund (jointly with the banks) helped to stem the crisis. The Spanish Guarantee Fund was a model for bank restructuring in a number of other countries.

An interesting case of bank crisis in a largely self-regulated and free market banking environment was the failure of a number of smaller banks in Hong Kong in 1985-86, caused mainly by fraud and mismanagement and lack of effective supervision. The failures were exposed in the wake of the decline in share and property prices following uncertainty over the political future of Hong Kong during negotiations between China and the United Kingdom in 1983–84. In the absence of a central bank, the Hong Kong Government used reserves from the Exchange Fund to finance the liquidity as well as share acquisition support for the affected banks. The Hong Kong case suggests that even in a much vaunted free market environment, financial markets are not very efficient in self-regulation and some effective government supervision is necessary to check fraud and mismanagement.

Developing Country Experience

The second group of small-to-middle-income developing countries that experienced financial crises or distress of relative degrees that are so far documented include Thailand, Malaysia, the Philippines, Colombia, Ghana, and Guinea. These economies with mixed (large public sector banks, operating with private, as well as foreign banks) banking systems suffered a variety of problems, ranging from the effects of structural adjustments in the economy; commingled with extensive fraud and mismanagement, brought about partly because of inadequate supervision, inadequate legal powers to deal with bank problems, and, in some cases, political interference.

The “purest” case of bank failure that could be attributed almost exclusively to fraud and mismanagement without any apparent macroeconomic origins is the case of Guinea-Conakry ( Tenconi (1989) ). The authorities closed down six state-owned banks, which accounted for 95 percent of the assets of the banking system, after it was found that fictitious assets and accounts accounted for 76 percent of total assets. The Government bore the brunt of its losses from the budget.

For the middle-income countries of Thailand, the Philippines, Malaysia, and Colombia, banking problems demonstrated partly the vulnerability of small economies dependent on a narrow range of export commodities. Overexuberant lending at the height of a commodity boom, followed by strong measures to tackle macroeconomic imbalances in the wake of a sharp decline in commodity prices, had the usual effects of deflation that affected overborrowed enterprises. In Colombia, problems also came from overseas branches of domestic banks, which were used to bypass domestic credit restrictions ( Montes-Negret (1990) ). In the Philippines, political interference in the government-owned banks’ credit process was a major cause of losses for the two largest banks ( Lamberte (1989) ). In all these countries, losses were evident in banks that had loan concentrations to large groups, or specific economic sectors, such as real estate. For Thailand and Malaysia, strong corrective measures on the macroeconomic front and tighter bank supervision helped to overcome the distress, and the banking systems recovered rapidly, as these economies enjoyed high growth rates in the last three years. In both cases, the central banks played critical roles in dealing with the crisis, with liquidity or financial support coming mainly from the central banks.

The Malaysian case had remarkable similarities with the Norwegian banking crisis ( Solheim (1990) ) and the U.S. Texas banking problems, all three economies being oil producers with a high degree of commodity concentration. The Malaysian economy suffered a classic case of Dutch disease in the second half of the 1970s, as high oil income on top of rising commodity prices generated an economic boom, and led to an overvaluation of the currency. This caused a large shift towards nontradables, particularly speculation in real estate. Large fiscal and external account imbalances emerged by 1981–82, with a fiscal deficit as high as 18 percent of gross domestic product (GDP) and a current account deficit of 14 percent of GDP in 1982. With a collapse of oil prices coming on top of the slide in commodity prices in the early 1980s, the authorities cut back on fiscal expenditure, and the resulting deflation brought about massive collapse of share and property prices. The central bank had to step in to resolve 35 deposit-taking cooperatives that failed, 4 badly affected banks, and a number of small finance companies.

Generally, the lessons from this group of case studies appear to be that those countries that successfully tackled their macroeconomic imbalances managed to resolve their banking crises, but not before major restructuring of their financial systems by changing laws, tightening supervision, and improving bank management.

State-Owned Financial Systems

Centrally planned economies with almost wholly nationalized or state-owned banking systems are perhaps the most interesting group of case studies. Theoretically, there should be no runs against state-owned banks, since the banking system carries a blanket state guarantee; however, crises in the financial systems of centrally planned economies emerge as currency flights and monetary overhangs that threaten to explode into hyperinflations. State-owned banking systems have a large capacity to hide losses, because of price distortions in the economy, directed and subsidized credit to loss-making and inefficient enterprises or borrowers, or weak and inefficient bank management. Soviet-style accounting used widely by enterprises and banks in those economies, from China to Eastern Europe, is designed to report compliance with central plan targets and not the viability and solvency of borrowers or banks. In other words, the real losses or inefficiency of borrowers are hidden largely in the books of the banking system, and since the system is a monopoly on public savings (with a state guarantee), such losses can be carried for a long time without erupting into periodic financial crises.

On the other hand, state-owned banks operating in environments with limited private sector enterprises also tend to suffer from fraud and corruption as lowly paid bureaucrats and bank managers can easily succumb to bribes to give loans to enterprises, since all loan losses are borne by the state. Central banks in these environments have great difficulty in supervising state-owned banks because their management are either bureaucrats of the same or equivalent rank or, in many cases, are politically appointed and not accountable to the central bank.

Banking crises in centrally planned economies have a special feature in that all losses of the banking system are effectively quasi-fiscal deficits. 6 The typical monobank or recently divested two-tier stateowned banking system carries on its liability side a large deposit liability, partly denominated in foreign currency and the external debt, against which there is very little hard currency reserves. On the asset side, the banking system carries large loans to state-owned enterprises or public sector investments, many of which would not be viable under international prices. Where the currency has undergone devaluation in recent years, it is often not surprising to see large revaluation losses on the asset side of the balance sheet. Where the external debt is vested in the books of the central bank, the central bank suffers large revaluation losses when the domestic currency is devalued. Usually, the cost of financing these losses and servicing the external debt is so large that the central bank loses monetary control. In the Yugoslav case, 80 percent of the National Bank’s revenues at one stage was used to finance interest payments on foreign debt ( Gaspari (1989) ). The capital losses were as large as 11.8 percent of social product in 1986. When the central bank is called upon to refinance loss-making enterprises on top of monetization of its own revaluation losses, stabilization of the economy through monetary policy is almost impossible.

Given the shortage of convertible currency, some banking systems in these economies allowed banks to accept foreign currency deposits from residents, and the proceeds were surrendered to the central bank in exchange for domestic currency. This placed a large internal debt, denominated in foreign currency, on the central bank. The large net foreign currency liability to residents was a source of monetary instability in Yugoslavia and a number of other Eastern European countries, as residents could quickly shift in and out of domestic currency as a hedge against inflation or impending devaluation. This structural flaw, found in a number of centrally planned economies and other economies, threatens to break out periodically as capital flight whenever political crises occur, thus exacerbating the fragility of the economic system.

High-Inflation Economies

The last group of case studies comprises the economies that suffered extremely severe financial distress, and some are still going through various stages of crises. The most severe case recorded is that of Argentina, which had two bouts of hyperinflation in as many years and appears in the last decade or so to be in a prolonged state of financial crisis. The overhang of excessive external debt and large fiscal deficits were primary causes of financial instability. With external funding shut off as a result of the international debt crisis, attempts to correct the balance of payments deficit through devaluation caused large foreign exchange losses in enterprises, which were transferred to the central bank under an exchange rate guarantee scheme. Large fiscal deficits, caused partly by loans to loss-making state enterprises, were funded through central bank rediscounts, which were in turn financed through high reserve requirements and forced investments on the banking system. Central bank monetization of the large fiscal and quasi-fiscal deficits was a major cause of the hyperinflation. The system was subject to disintermediation from the banking system and periodic bouts of capital flight, held back only by excessively high real interest rates. Bouts of crises were arrested by drastic austerity measures and attempts to curb the fiscal deficit, which were eroded over time by public pressure to increase nominal wages and subsidies to loss-making public enterprises.

These types of crises demonstrate the complexity and extremity of distress when central bank financing of large fiscal (and quasi-fiscal) deficits are at the root of the crisis. The inequities caused by the breakage of the currency contract create complex political problems, which make the financial crises more difficult to solve. Rich savers have the knowledge and skill to benefit from speculative behavior during high inflation and to avoid direct taxation or even the inflation tax through capital flight. The small saver is forced to hold currency for basic transactionary purposes and therefore bears the brunt of the inflation tax.

Probably the most successful case of a turnaround in the banking crises in a high inflation economy was the Chilean banking crisis of 1981–83. Problem banks that were liquidated or intervened by the Government represented 60 percent of the banking system’s portfolio (Larrain and Montes-Negret ( 1986 )). The immediate causes of bank failure were the macroeconomic adjustments to control inflation and correction of balance of payments and fiscal deficits, which sent the economy into a recession and caused extensive borrower defaults. This came, however, on top of a weakened banking structure after the extensive denationalization of the banks in the early 1970s, when the abolishment of legislation against concentration of ownership meant that banking became controlled by large private groups with interlocking interests in industry, commerce, and banking. The Chileans used two major techniques: an across-the-board debt rescheduling for borrowers and coverage against foreign exchange losses and a “carve-out” of bad loans from the banks by the central bank in exchange for central bank promissory notes, to be repurchased over time. Once the macroeconomic situation was stabilized and inflation brought under control, the banking system gradually returned to profitability.

• Crisis Resolution

The exact techniques of crisis resolution are dealt with in Chapter 14 , by Brian Quinn. This section will deal with the four key stages of resolution of banking crisis, namely, diagnostics, damage control, loss allocation, and rebuilding profitability.

The diagnostic stage in crisis resolution is critical to the identification of the problems and central bank understanding of the depth and scope of the crisis. De Juan calls this “getting out of the dark.” A timely, accurate, and reliable central bank off-site surveillance reporting system, plus other information sources, such as market talk, consumer feedback, research studies, industry surveys, and bank consultations all help to piece together a reliable composite picture of market performance. Having good bank-accounting standards, particularly loan classification and income accrual standards, are critical to an appreciation of the extent of nonperforming loans and to assess whether an ailing institution is only illiquid or in reality insolvent. The reporting system should be able to detect potential problem areas, such as loan concentrations, connected lending, high exposures to market risks, noncompliance with prudential regulations, and any unusual behavior. The off-site surveillance system should be complemented by a team of on-site bank inspectors or external auditors, which can move quickly to assess first-hand the extent of the damage, when a financial institution begins to display signs of failing. Moreover, an alert supervisor would be able to detect structural flaws in the system, which call for major legal and institutional reforms.

Two lessons from experience deserve mentioning in the diagnostic stage: the-sooner-the-better and the-problems-are-always-worse-than-expected. The first dictum requires prompt action—hesitation and procrastination in dealing with a crisis situation have inevitably proved costly. This advice is closely related to the second dictum: bankers have a tendency to sit on a problem until it becomes too big to handle. De Juan relates how the Spanish experience suggested that loan-loss provisions by external auditors tend to be double those made by bank management. Bank examiners would double the provisions made by the auditors, and in a liquidation situation, loan losses would turn out to be double those estimated by the bank examiners. Once a bank moves into negative capital, the losses are effectively passed either to the depositors or de facto to the central bank or deposit insurance fund. As lenders of last resort, central banks would bear the ultimate risks unless such loans are fully secured.

The next stage of damage control (sometimes conducted almost simultaneously with diagnostics) is to stop or minimize losses. This involves an immediate change in management of the problem institutions, if incompetence or fraud is suspected, or at least the placement of competent advisers who can institute effective internal controls and measures to prevent further losses from speculation, continued lending to bad borrowers, and wasteful expenditure. On the part of the central bank, an effective monitoring system has to be established quickly to ensure that the losses and financial condition of the ailing institutions are monitored and reported constantly. Where existing tax measures, regulations, and bad practices have been causes of bank losses, remedies should be taken as soon as possible. On the whole, bank supervision and examination staff should be strengthened, and power for the central bank to act promptly should be provided.

The loss-allocation process is in practice the most difficult stage of crisis resolution, as loss allocation is not always defined in the law, and may have to be done arbitrarily. There are numerous interest groups in the loss-allocation process: the borrowers, bank shareholders, employees, other creditors, depositors, the central bank, and the government. According to present Western convention, defined partly in company and banking law, the bank losses should be borne first by the borrowers, then the shareholders, then other creditors, including employees, and thereafter by the depositors or the government through the deposit insurance fund. In practice, the process of loss allocation depends on the power of individual interest groups. For example, in a number of Latin American cases, foreign exchange losses of the enterprises and borrowers were passed to the central bank. In one African case, the powerful shareholders of failed banks received some compensation from the government. Bank unions can also ask for large compensations. Part of the reason why governments favor deposit insurance funds as liquidators of banks is the sheer complicated process of unwinding thousands of deposit and loan contracts, on top of employment contracts of failed banks, which can easily be disrupted by legal suits.

Thus, more often than not, it becomes politically expedient to absorb bank losses directly into the budget or off-budget in the books of the central bank. The point to remember is that losses absorbed by either the government or the central bank is a fiscal or quasi-fiscal deficit that has to be financed by taxation, borrowing, sale of government assets, or through inflationary financing. Periods of financial crises and structural adjustments are not always the appropriate time to raise taxes. Hence, it is always tempting to political decision makers to request the central bank to absorb the losses. When the central bank has large reserves relative to the size of losses, the problems can be resolved; however, when the degree of losses exceeds even the capital and reserves of the central bank, then the net losses of the central bank tend to become monetized and the loss burden is distributed in the economy through the inflation tax.

Consequently, a critical issue of banking crisis is how the losses are ultimately distributed or borne in the economy. Since the central bank is part of the government, the government may initially take responsibility for the losses, but it is eventually passed on to the population in the form of higher taxes, borrowing, or through the inflation tax. Experience shows that measures that affect the solvency of the central bank is self-defeating and may prove highly costly in the long run. The government has to deal with the loss directly through the budget, and become the “equity provider of last resort.” How the bank losses are ultimately distributed to the system would depend on the combination of techniques adopted.

For example, the government need not bear the full brunt of the losses. In a number of cases, losses were borne partly by the depositors. In Malaysia, the depositors of the failed deposit-taking cooperatives received 50 percent of their deposits in the form of equity in a licensed finance company that took over the assets of the failed cooperatives, while the balance of 50 percent was repaid over a three-year period at a low rate of interest. In Thailand, depositors of failed finance companies received only the principal portion of their deposits in ten equal installments over ten years, interest free. This represented roughly a 50 percent loss in real terms when deposit rates were around 10 percent a year. This technique of cofinancing by depositors was also recently adopted in an Australian failed building society. Another way to recover costs is through ex post levies on the banking system, which would pass the costs back to the consumer through higher bank spreads.

Finally, the root cause of bank losses must be addressed. Often these can be found either in distortions in the enterprise sector, fiscal imbalances, or structural imbalances in the economy that require major policy changes. In addition to laying down a sound and competitive framework for banks to operate in, under which they can rebuild profitability, it is essential that a sound and stable macroeconomic environment is built for the real sector, with appropriate policies that encourage competition and efficiency. Dealing with bank crisis without tackling real sector distortions will invite a repeat crisis in the near future.

• Crisis Management by Central Banks

Much has been written about banking crises, but relatively little about how one manages institutionally during the crisis. References on how to handle a financial crisis are few. The only helpful practical advice remains variations on Bagehot’s dictum for the central bank to lend liberally in a financial crisis against good security. The academic literature has been sparse on the practicalities of dealing with crises.

How one deals with crises depends on the circumstances of each case, such as the legal framework, institutional structure, and often the capabilities of the crisis management team. Since central banks are directly responsible for the stability of the financial system, it is often assumed that central bank management knows how to handle crises. The case study of Malaysia illustrates this point. The Central Bank of Malaysia’s capacity to deal with bank problems was shaped by its early history. Following runs on a large domestic bank in the mid-1960s, the Malaysian central bank, Bank Negara, began to build up its bank supervision and examination capacity. It developed, early on, teams of inspectors with the capacity to identify quickly bank problems, especially in the credit portfolio, and to assess the quality of bank management. At the same time, an off-site surveillance system was installed with a comprehensive bank data base. In the early 1980s, as banks began to “herd” into lending to finance the property sector, the Bank put into place close monitors on lending to property and shares.

The Bank also led the way in installing a sophisticated dealing room with good telecommunications to help develop the domestic money and foreign exchange markets. Under a flexible exchange rate regime since 1973, the Bank soon built up its own skills in managing the interbank money and foreign exchange markets and relied heavily on the dealing room to monitor market trends.

In 1983–84, the Bank was closely involved with the Ministry of Finance and the Economic Planning Unit of the Prime Minister’s Department to address the large twin deficits in the budget and the balance of payments. It realized that the self-imposed structural adjustment program, calling for very large budgetary cutbacks in the face of declining commodity prices, would have a massive deflationary impact on the economy, and hence on the banking system. Early signs of the impending recession came when the stock market crashed first in 1983, recovered for a short while, and then crashed again in December 1985, when the Kuala Lumpur stock exchange was closed for a few days.

In preparation for potential banking problems, the banking law was changed to allow the Bank to acquire shares in ailing banks. No deposit insurance scheme was envisaged as the stronger banks were not willing to finance the failure of weaker institutions. By coincidence, emergency legislation was drafted as a contingency plan to deal with illegal deposit-taking corporations that sprung up during the period of tight liquidity. This piece of legislation was a powerful tool for the Bank in dealing with the collapse of 24 cooperatives, involving more than half a million depositors in July and August 1986. The suspension of payments by the cooperatives (not supervised by the Bank) caused immediate runs against a number of the weaker licensed finance companies, which the Bank had to deal with.

A clear issue in dealing with financial crises was which agency should deal with the day-to-day problems, and how could the problems be managed from an issue and policy point of view. How could that agency, for example, be accountable for financial and other decisions that have budgetary and political implications? These issues fortunately were spelt out in the Malaysian emergency legislation. The central bank was vested with the responsibility and power to deal with the crisis. It could not, however, carry out its wide powers, such as investigate or “freeze” bank accounts of cooperatives or bank management suspected of fraud, without clearing it through an advisory panel, comprising the governor as chairman, the secretary-general of the treasury, the attorney general, the chairman of the Association of Banks and a private sector member. This panel de facto became the policy-making body that oversaw the handling of the crisis, summoning as and when needed advice from the Cooperative Department, police, or other government departments. The secretariat of the panel was vested in the Bank Regulation Department of the Bank, which prepared regular position and policy papers for decision by the panel. The panel met sometimes daily but at least once a week to decide on important issues. Administrative costs for managing the crisis were borne by the central bank.

To manage the 17 firms of auditors plus numerous teams of bank examiners that had to investigate the 600 odd branches of the cooperatives, the Bank established an Operations Room, continually manned to monitor, coordinate, and direct operations. This served as the center in which all information sources were concentrated and digested. For example, reports came in from newspaper articles, public tip-offs, calls from banks or finance companies, examiners returning from onsite inspections, and other sources about the occurrence of bank runs or any incidence affecting the banks, finance companies, or licensed finance companies. When a bank run occurred, the Operations Room would be able to register the incident, determine the cash requirements, obtain authority from the head office of the branch concerned to provide the Bank with collateral or funding, and promptly authorize the nearest central bank branch to issue cash against such collateral. The Bank used the opportunity to obtain from the bank or finance company management or shareholders maximum cooperation for assistance. In a number of instances, the Bank was able to effect required changes in management or commitments to increase capital, before additional funding was approved. The policy of the Bank in bank runs was to supply as much cash as required to meet the deposit withdrawal, until depositors realized that it was pointless to run against a bank or finance company behind which the central bank stood as lender of last resort. Prompt press releases were made to give assurances to the public that the central bank was providing liquidity support. Hesitation in meeting deposit withdrawals always worsened bank runs.

The Operations Room was critical as an information and decision center. It had current information on the financial conditions of each licensed institution and was able to refer quickly to senior staff for decisions. It coordinated information received from all sources, including the dealing room, which monitored behavior in the money and foreign exchange markets. Information gaps and monitoring deficiencies were quickly corrected. For example, the Bank’s information on bank exposure to shares prior to 1986 was subject to considerable lag. This was quickly corrected, since it became apparent that a number of smaller finance companies had been lending considerably to finance shares and were vulnerable to further declines in share prices. By the October 1987 stock-market crash, the Bank had current information on the exposure of each bank to each stockbroker. The Operations Room was a useful adaptation of a military innovation that helped to deal with immediate problems without losing sight of the overall strategic directions. It played a key role to keep the central bank management, other government departments, and the political decision makers constantly informed of developments, policy issues, implications, and options for decisions. Once decisions were made, the Operations Room implemented the decisions, issued necessary press releases to keep the public informed to allay problems of public uncertainty, and maintained the pace of reforms and measures necessary to deal with the crisis.

The lesson of the Malaysian banking crisis of 1986–88 in the management aspect is perhaps that it was critical to have political backing and intragovernmental consensus and cooperation to deal with the crisis. Once it was decided that the central bank should be the lead organization to handle the crisis, an administrative decision-making mechanism and structure was quickly built to cope with the crisis as it unfolded. Timely, reliable, and accurate information was critical, and the Bank used external auditors to supplement its own examination teams to verify the information. The information received was quickly digested and analyzed, and policy recommendations evolved from the advisory panel decision. Having the legal powers to act quickly and effectively under the emergency legislation was important. Keeping the public informed and winning the confidence of the public in the tough action taken against bank mismanagement and fraud was equally critical. It was quite clear, however, that without the correction of the macroimbalances, specifically cutting the fiscal deficit and turning around the balance of payments current account to a surplus, the banking crisis could not have been solved so quickly.

• Conclusions

In sum, the nature of financial crisis is complex, with economic, political, institutional, and legal implications. There are immense difficulties and complex conditions under which different central banks work in dealing with financial crises. Each central bank has to work with different resource constraints, financial as well as manpower, under disparate cultural, national, political, and bureaucratic environments.

It is too easy to say that prevention is better than the cure. Certainly, the avoidance of macroeconomic imbalances, the existence of efficient and competitive banking systems under strictly enforced bank supervision to prevent fraud and mismanagement, and an underlying strong real sector all help to prevent crises, or at worst the minimization of financial disruptions.

Central bankers have to deal, however, with the real world, where such imbalances and crises exist. Central bankers have an institutional role to maintain the integrity of the currency contract—that is, the stability of the internal and external value of the currency. This implies above all financial discipline on banks, enterprises, and governments, particularly fiscal discipline. It is when the currency contract is broken, when the public loses confidence, when the banking system and ultimately the government will not protect their savings that crises break out. The solvency of the central bank, that is, its net capital and reserves, only helps to bolster that confidence. In the last analysis, it is the professional competence, integrity, and independent judgement of the central banks that can steer policy in the right way or the wrong way. Without financial discipline, banking crises are historical inevitabilities.

• Bibliography

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Baliño , Tomas J. T. , “The Argentine Banking Crisis of 1980,” IMF Working Paper, No. 87/77 ( unpublished , Washington : International Monetary Fund , 1987 ).

Bank of England , “The Secondary Banking Crisis and the Bank of England’s Support Operations,” Quarterly Bulletin , Bank of England ( April 1978 ).

Basle Committee on Banking Supervision , “Measuring and Controlling Large Credit Exposures” ( unpublished , Basle , March 1990 ).

Bordo , Michael D. , “Some Historical Evidence 1870–1933 on the Impact and International Transmission of Financial Crises” NBER Working Paper, No. 1606 ( Cambridge, Massachusetts : National Bureau of Economic Research , April 1985 ).

Corrigan , E. Gerald , “A Perspective on Recent Financial Disruptions,” Quarterly Review , Federal Reserve Bank of New York ( Winter 1989/90 ).

de Juan , Aristobulo , “Dealing with Problem Banks: The Case of Spain,” paper presented at the third Central Banking Seminar , International Monetary Fund , July 1985 , Washington.

de Juan , Aristobulo , “From Good Bankers to Bad Bankers: Ineffective Supervision as Major Elements in Banking Crises” ( unpublished , Washington : World Bank , 1987 ).

Gaspari , Mitja , “Balance of Payments Adjustment and Financial Crisis in Yugoslavia,” in Financial Reform in Socialist Economies , ed. by Christine Kessides , Timothy King , Mario Nuti , and Catherine Sokil ( Washington : World Bank , 1989 ), 214 – 29 .

Goldsmith , Raymond , “Comment” in Financial Crises: Theory, History, and Policy , ed. by Charles P. Kindleberger and Jean-Pierre Laffargue ( Cambridge; New York : Cambridge University Press , 1982 ), pp. 41 – 43 .

Hinds , Manuel , “Economic Effects of Financial Crises,” Policy, Planning, and Research Working Paper, No. 104 ( Washington : World Bank , October 1988 ).

Krugman , Paul , “International Financial Crises,” paper presented at an NBER conference on Reducing the Risk of Economic Crises ( Cambridge, Massachusetts : National Bureau of Economic Research , October 1989 ).

Lamberte , Mario , “Assessment of the Problems of the Financial System: The Philippines Case” ( unpublished , Washington : World Bank , August 1989 ).

Larrain , Mauricio , and Fernando Montes-Negret , “The Spanish Guarantee Fund” ( unpublished , Washington : World Bank , 1986 ).

Montes-Negret , Fernando , “An Overview of Colombia’s Banking Crisis, 1982–1988” ( unpublished , Washington : World Bank , 1990 ).

Schwartz , Anna J. , “Real and Pseudo-Financial Crises,” in Financial Crises and the World Banking System , ed. by Forrest Capie and Geoffrey E. Wood ( New York : St. Martin’s Press , 1985 ), pp. 11 – 31 .

Sheng , Andrew , “The Art of Bank Restructuring: Issues and Techniques,” paper presented at an Economic Development Institute senior policy seminar on Financial Systems and Development in Africa, Nairobi, January 29–February 1, 1990 ( mimeo , Washington : World Bank , January 1990 ).

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Solheim , Jon A. , “The Banking Crisis in Norway,” paper presented at an Economic Development Institute Seminar on Financial Sector Liberalization and Regulation, Cambridge, June 10–15, 1990 ( unpublished , Washington : World Bank , 1990 ).

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The author is a Senior Financial Specialist, Financial Policy and Systems Division, World Bank, on leave from his position as Advisor, Bank Regulation, Bank Negara Malaysia. All views and opinions expressed in this paper are entirely those of the author and do not represent those of the World Bank or Bank Negara Malaysia.

The subject of dealing with international financial crises is outside the scope of this paper, although many international crises have national origins. For a survey of the issues involved in international banking crisis, see Krugman (1989) .

Excellent surveys of the literature on financial crises are found in Bordo (1985) and Sundararajan(1988) .

The “big bang” is the term usually applied to the liberalization of the U.K. securities markets in 1986 and is generally extended to the financial liberalization efforts of the 1980s.

This brief survey cannot do full justice to the complex origins and factors involved in each case. For detailed discussions of cases mentioned, please refer to references cited.

An excellent analysis of seven cases—Argentina, Chile, Uruguay, Thailand, the Philippines, Spain and Malaysia—was presented in Sundararajan (1988) . For short summaries of individual cases, see Sheng (1990) .

By definition, when there is an implicit or explicit government guarantee on bank deposits of a banking system, and the government would not allow any bank to fail, all losses of the banking system (after deducting capital and reserves) are quasi-fiscal deficits.

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Table of Contents

Ahmed , A.K.N. , “Role of Central Bank in Economic Development—Financing of Public and Private Sectors,” Commerce ( Bombay ), Vol. 154 ( January 10 , 1987 ), pp. 14 – 23 .

Albers , Norman , “Electronic Fund Transfers und die Geldpolitik,” Zeitschrift fur das Gesamte Kreditwesen , Vol. 41 ( May 1 , 1988 ), pp. 366 – 72 .

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