Revisiting role of a central bank: For monetary stability or financial stability or both?

Nice overview Speech by Sabine Lautenschläger of ECB:

….going back in time, the relationship between the different functions of central banks have generated quasi-existential questions.

What a central bank is, can be defined by what it does.1 And the “what it does” part mostly revolves around the question of whether a central bank cares about two types of stability.

The first is monetary stability: the creation of a monetary regime that can ensure price stability. The second is financial stability which, when central banking was born, was essentially the same as “bank stability”. So, throughout history, the most popular definitions of “central bank” have revolved around their role in ensuring monetary stability, financial stability or both.

One of the founding ECB board members, Tommaso Padoa Schioppa, believed that both aspects mattered. To him, a central bank was defined by its role in safeguarding both price stability and financial stability.

As for financial stability, he argued that historically, a central bank’s role in this realm was rooted in its DNA. First, the central bank was a bank. It was also monopolist in the provision of ultimate liquidity. And last but not least, it was a bankers’ bank. It played a role in settling payments between banks.2 And a well-functioning interbank market plays an important role for financial stability.

And he was of course not the only one to see the role that central banks played in financial stability as essential. From Walter Bagehot’s book “Lombard Street” all the way to the work of Charles Goodhart, one function has been singled out to identify central banks: their role as lenders of last resort.

Take the Bank of England as an example. Even after becoming a monopolistic issuer of notes, it still operated as a profit-maximizing bank. Charles Goodhart argues that it did not become a true central bank until the second half of the 19th century, once it let go of profit-maximizing and took on the role of lender of last resort.3

And there is a similar story about the emergence of central banks on the other side of the Atlantic. This story roughly starts with the Panic of 1907: a series of bank runs and bank failures that devastated the US economy. In the absence of a public lender of last resort, a private citizen stepped in: JP Morgan. He called on a group of fellow bankers, and together they stopped the panic by providing loans to troubled banks. This episode eventually led to the creation of the Federal Reserve System as a public lender of last resort.

So, there it is: historically, some scholars saw financial stability as a central aspect of central banks’ work. But of course, history can be seen from different angles. And that is also true for the history of central banks.

In fact, in explaining how modern central banks emerged, others have focused on monetary stability rather than financial stability. Their story starts with the introduction of paper money. Unlike commodity money, paper money does not have an intrinsic value; after all, it’s just a piece of paper. So when commodity money gave way to paper money, a need arose for institutions that could guarantee a stable value of money.

It was central banks, of course, that could do so. They could issue a national currency and ensure its stability.4 And here again, the Bank of England is seen as the first modern central bank.5

So what is it now that makes a central bank so special? What is it that sets it apart from other banks? Is it the ability to maintain monetary stability, the ability to maintain financial stability, or both?

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