Economics, 3rd Edition

The Role of Central Banks

As the financial crisis unravelled, focus centred on the response of central banks around the world. The role 

of monetary policy in helping to alleviate the worst effects of the financial crisis and the resulting recession 

is seen as important and has since come under scrutiny with regard to the effectiveness of the action 

of key policy makers. The markets were looking for three key aspects of policy response from central 

banks: speed of intervention, innovation and coordination. There were aspects of each of these that have 

occurred since the crisis developed but there are also important differences in the degree to which each 

of the main central banks responded, partly because of the different levels of flexibility that each enjoyed.

The early signs of crisis emerged in 2007 when rumours of rising levels of default from sub-prime mort-

gages began to increase. In July, Standard & Poors and Moody’s downgraded ratings on bonds backed by 

sub-prime mortgages. In late July a German bank, IKB, said that it was in financial trouble as a result of 

its exposure to sub-prime and was swiftly taken over by German government-owned bank, KfW (Kredit-

anstalt für Wiederaufbau). By early August the ramifications of the downgrading of funds related to sub-

prime were starting to unravel and, on 3 August, Bear Stearns had to contact its shareholders following 

the collapse of two hedge funds that it managed and the subsequent fall in its share price. On 9 August, 

French bank BNP Paribas announced that it was ceasing trading three of its funds and with that credit mar-

kets effectively froze. Interbank lending ground to a halt as banks began to recognize that their exposure 

to sub-prime could be extensive.

The freezing of credit markets effectively marked the start of intervention by central banks around the 

world. The ECB was one of the first to react on 9 August with the then President, Jean-Claude Trichet, 

authorizing an injection of 

€95 billion into the financial markets to help ease overnight liquidity problems. 

On the following day a further 

€61 billion was authorized. Soon after the ECB move the Fed announced 

that it would inject 

$38 billion to help ease liquidity; the Bank of England, however, did not follow suit. On 

10 August, the Bank was involved in the growing problems at Northern Rock which had expanded rapidly 

in previous years but now found its expansion based on leverage unsustainable and, as credit markets 

froze, it was struggling to continue. In the coming weeks the extent of the problems at Northern Rock 

became public and a run on the bank ensued. Queues formed outside Northern Rock branches as worried 

account holders looked to withdraw their money. Moves to calm the situation did not seem to have too 

much effect and on 17 September the government, in consultation with the Bank, agreed to guarantee all 

existing Northern Rock deposits.

As banks around the world began to falter over the coming months; the question of which bank should be 

rescued and which left to fail had to be considered by central bank leaders. The Bank of England had issued 

warnings that it was concerned investors were not pricing risk appropriately. In the US, Ben Bernanke had 

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  791

made a number of statements attempting to calm the fears over the extent to which sub-prime would 

affect the real economy. In May 2007 he had given a speech at a conference in Chicago and said:

We believe the effect of the troubles in the subprime sector on the broader housing market will likely be 

limited, and we do not expect significant spillovers from the subprime market to the rest of the economy 

or to the financial system. (http://www.federalreserve.gov/newsevents/speech/bernanke20070517a 

.htm accessed 27 October 2009)

He reiterated this view a month later when he said:

At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the 

broader economy or the financial system. (http://www.federalreserve.gov/newsevents/speech 

/Bernanke20070605a.htm accessed 27 October 2009)

Whether this was an attempt to exert some psychological influence over decision-makers or a lack of 

information or understanding of the situation is open to debate. In hindsight, it is easy to isolate quotes 

and point fingers at central banks. The reluctance of the Bank of England to inject funds into the markets 

was partly seen as the concern with moral hazard but also the subjugating of financial stability to a lesser 

role. However, the Bank of England, at that time, had limited tools available to it to deal with the events 

that were unfolding in comparison to other central banks. It was not until the passing of the Banking Act in 

2009 that the Bank of England was given additional powers and responsibilities that enabled it to improve 

its control of financial stability.

In the event, the Bank of England eventually announced that it would provide financial help to institu-

tions that needed overnight funds but that any such borrowing would incur a penalty rate. By April 2008 it 

had gained the authority to lend to banks against mortgage debt – something that the ECB could do which 

the Bank could not. The Bank was given authority to issue short-dated UK government bonds in exchange 

for mortgage securities. However, at the end of August 2007 it emerged that Barclays had asked the Bank 

for a loan of 

£1.6 billion and the news, which would not normally have made front page headlines, was 

interpreted as being another sign that a major bank was in trouble. Barclays needed the funds because 

of a malfunction in computer systems related to clearing and had tried borrowing from the wholesale 

markets. The Bank then removed the penalty rate, since it seemed that far from calming nerves it merely 

served to increase the sense of panic.

As the crisis began to gather momentum, monetary policy around the world was eased. The Fed cut 

the repo rate by 0.75 per cent in January 2008; the ECB held its rate at 4.0 per cent. The Bank had cut 

rates by a quarter-point in February and April 2008 but by May that year the Fed had cut rates seven times 

in eight months with the Fed Funds Rate standing at 2.0 per cent. As 2008 progressed the  financial situ-

ation did show clear signs that it was ‘spilling over’ to the economy and output levels began to  contract 

in  economies across the globe. The problems were such that, in October, seven major economies, the 

UK, US, China, the EU, Canada, United Arab Emirates (UAE) and Sweden, announced a coordinated 

0.5 per cent cut in interest rates. By then end of October the Fed cut again to 1 per cent.

In the US, discussions were taking place to set up the Troubled Asset Relief Plan (TARP), a 

$700 billion 

plan to support the banking system. In November the Fed announced a further 

$800 billion support fund. 

In that same month the Bank reduced rates by 1.5 per cent – the largest single change in rates since it 

was given independence in 1997. By March 2009 the MPC had cut interest rates in the UK to 0.5 per cent, 

the lowest since the Bank of England was established in 1694. The Fed cut its rates to a target of between 

0 and 0.25 per cent and the ECB had cut rates to 1 per cent.

The scale of the intervention by central banks and the various fiscal stimulus programmes announced 

by governments made it clear that the crisis was serious. The ‘contagion’ from the sub-prime fall-out and 

the collapse of banks around the world accompanied by the alarming declines in output meant that global 

recession was now the real threat and not the prospects for inflation, which remained stubbornly high in 

countries like the UK.

There are those who believe that, given the circumstances, central banks acted according to the three 

key aspects of policy response outlined above. The speed with which central banks intervened and the 

extent of these interventions did differ, largely because of technical as well as ideological differences, but 

many see their role as having been decisive in exceptional circumstances. When inflationary pressures 

eased then central banks did relax monetary policy and acted in a coordinated way in October 2008 to 

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bring down interest rates. Central banks have had to be flexible and innovative in dealing with the issues 

that were highly unusual. As with the Bank of England, central banks have expanded their roles and 

assumed new powers and responsibilities and introduced new tools and instruments. Two such examples 

have been the growth of bilateral swap agreements between central banks of different countries where 

local currencies can be swapped against the US dollar to enable trade to be financed and liquidity to be 

eased and the use of quantitative easing.