The Swiss National Bank in Bern, Switzerland. Source: iStock/Thinkstock.
Did the Swiss National Bank unpeg its currency, and thereby unleash mayhem in currency markets, because its privately owned shareholders were concerned about incurring losses from the recent depreciation of the euro?
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That's the argument Cullen Roche, author of the Pragmatic Capitalism blog, made last week in a post titled: "The SNB is 48% Privately Owned ... No Wonder They De-Pegged":
This an elegant theory but it's also both entirely conjecture and inconsistent with past precedent -- namely, the historical behavior of the once-private Bank of England, which, it's worth pointing out, is recognized as a model for central banks around the world.
Walter Bagehot wrote at length on this in Lombard Street: A Description of the Money Market, the "bible of central banking" published in 1873. At the time, the Bank of England wasn't only privately owned; its directors would "scarcely acknowledge" that they had an elevated duty to be particularly prudent when it came to managing the United Kingdom's bank reserves -- that is, all of them.
Not to overstate the point, but had the Bank of England failed at doing so, the economies of not only England, Scotland, and Ireland would be ruined, but virtually every banker and merchant on the European continent would have been threatened with failure as well. As Bagehot noted:
Keep in mind that the Bank of England also held the reserves for most continental European banks, as deposit-taking (which necessitates the holding of reserves) had yet to take hold outside of England.
The question, in turn, is this: How did the directors of the Bank of England behave? Did they act according to the profit-maximizing dictates of a private bank? Or did they, despite refusing to acknowledge their public duty, operate in the more responsible manner that one would expect from an institution entrusted to uphold the public's trust?
The answer is that the bank acted as one would expect a central bank to act -- that is, by subordinating its duty to private shareholders in favor of maintaining a fortress-like balance of liquid reserves. "As anyone can see by the published figures," Bagehot wrote, "the Bank of England keeps as a great reserve in bank notes and coin between 30% and 50% of its liabilities, and the other banks only keep in bank notes and coin the bare minimum they need to open shop with."
This may not seem notable to a person unversed in the profit levers of banking, but to a banker, keeping such a considerable reserve is nothing short of blasphemy. A bank is nothing more than a highly leveraged fund. It borrows money from depositors and other types of institutional lenders and then reinvests the proceeds into interest-earning assets. The difference between a bank's cost of funds and its earnings on assets is where much of its profit derives from.
It's axiomatic, in other words, that the strategy of a privately owned bank is to safely maximize the yield on its asset portfolio. This can only be done by investing in illiquid assets -- namely, loans. By contrast, this can't be done by leaving money in a highly liquid form, such as cash or government securities. "The more money lying idle, the less, cteris paribus, is the dividend; the less money lying idle, the greater is the dividend," explained Bagehot. Thus, by keeping between a third and a half of its funds essentially in cash, the Bank of England was in no way behaving like a private bank.
To further drive this point home, Bagehot compared the Bank of England's philosophy toward reserves to that of another widely respected private bank, the London and Westminster Bank (emphasis added):
My point is that people can argue all day long about the theoretical incentives of a quasi-privately owned central bank like the Swiss National Bank. But history speaks clearly on the point that this alone doesn't mean that such a structure will subordinate the bank's public duties to its private desires to earn a substantial profit. And this is particularly the case in a country like Switzerland, which profits greatly from its long and storied reputation of prudent financial management.
Thus, Roche might be right. Or he might be wrong. But either way, the evidence cited by him neither supports nor refutes his underlying point. Indeed, far more likely, albeit less conspiratorial, is the simple fact that the Bank of Switzerland abandoned the franc-to-euro peg because it became imprudent from a public perspective to maintain the exchange rate in the face of a rapidly depreciating euro.
The article Did the Swiss National Bank Unleash Mayhem in Currency Markets to Protect Its Private Shareholders? originally appeared on Fool.com.
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