Bank of England

The Bank of England
The development of the Bank

The Bank of England was established in 1694 with two privileges which the then existing smaller banks did not have. The bank was allowed corporate status and also royal patronage: the latter in response to a loan to the King - William 111 -who needed funds td'-fight a war against France. By corporate status we mean that it was a joint stock company with a large number of shareholders and hence it was able to raise a larger amount of capital than the small private banking busi­nesses which from then on and for 140 уears were not permitted to have more than six partners In this privileged position the Dank of England flourished and gradually predominated more and more over the other banks. It began as an ordinary bank in the sense that it performed the same functions as the private banks, but over the years assumed the functions which we now attribute to a central bank. In view of its special relationship with the monarch, it assumed the role of the government's bank and as the largest issuer of bank notes was allowed even­tually to lake over the note issues of all the other banks as the Bank Charier Act 1844 gradually became fully effective. Apart from relatively small local note issues by me banks in Scotland, the Bank of England is now fully responsible for the note issue in Britain.

Inasmuch as the Bank of England became the main note-issuing bank and that some of the smaller banks elected to use Bank of England notes rather than issue new notes themselves, the private banks became very dependent upon the Bank of England. They had accounts with the Bank, and kept their reserves with it, and when they ran into difficulties because of a lack of confidence as to their ability to 'repay depositors on demand (i.e. a run ion a bank), they relied on whatever support they could get from the Bank of England.

During a crisis in 1825, many banks had to close their doors, and pressure built up in Parliament for something to be done that would enable larger and more stable banking units to be established that could more easily withstand such crises of confidence. The outcome was an Act of Parliament in 1826 (Country Bankers Act), which permitted joint stock banks to be established (and to issue their own notes), outside a radius of 65 miles of London, and at the same time the Bank of England was encouraged to open branches in the provinces. Because the new larger banks could not be established in London, which was very much the main financial and commercial centre, the 1826 Act had little effect in bringing into being the larger and more stable banking units which Parliament wanted. In consequence, the restriction on joint stock banking within London was lifted by a further Act, the Bank of England Act 1833. This permitted joint stock banking in London, provided that the banks did not issue their own notes.

By this time, the practice of paying debts by way of cheque was becoming increasingly recognised as acceptable, and in consequence the restriction in the I833 Act concerning note issues did not have the restrictive effect that was expected. When the new banks advanced money to their customers they did so by giving them overdraft limits, or by crediting their accounts with sums transferred from loan accounts, and encouraging their customers to draw cheques to use the sums advanced. The consequence of the 1833 Act was therefore that the joint stock banks were quickly established from then on and. by a deliberate policy of buying up and absorbing the smaller ban reduced banking in the UK to a rela­tively small number of large banks with networks of branches by the end of the nineteenth century.

Despite the establishment of these large inking units, the dominance of the Bank of England, reinforced by the measure to centralise the note issue in the Bank Charter Act 1844. continued to be strengthened throughout the nineteenth and twentieth centuries by the way that the banks kept accounts with the Bank of England and settled their indebtedness with one another by drawing cheques on 'lie central bank: and also by the fact that. because the Bank's interest rate became the leading rate of interest in the UK. the other banks related their interest rates to it. Furthermore, the importance of the Bank of England as the govern­ment .s bank appreciated as new forms of government securities emerged, and the government's borrowing requirements increased enormously, especially as a consequence of the two world wars.

Because of its importance as both the bankers' bank and the government's bank, the Bank of England has ceased to compete seriously with the other banks in the provision of banking services to industry and commerce. It has some accounts for firms and individuals, but these are relatively small in number. Up to 1946 the Bank of England was privately owned but in that year it was nation­alised, the shareholders being compensated with government stock. The Act nationalising the Bank gave it wide powers of control over the other banks, so that it no longer had to rely on their voluntary co-operation.

In 1979 the Bank of England's control over the other banks was tightened still further by the Banking Act of that year. This Act enforced a system by which all banks in the UK now have to be licensed by the Bank of England and the Bank has also the power to suspend or cancel a licence if it is not satisfied with the way a bank is being operated. This Act was reinforced by the Banking Act 1987 which provided for an even stricter control by the Bank. Under the European Com­munity (EC) rules all banks within member countries must be licensed by the central bank in the country concerned and it is likely that controls over the banks will become even Stricter as the EC gradually evolves.

Another provision of the 1979 Act was the establishment of a Deposit Pro-lection Fund to which all banks must subscribe. The fund exists to protect depositors should a bank fail and in that event each depositor receives compensation to the extent of 75 per cent of his deposit with that bank up to a maximum deposit of £20,000, i.e. a maximum payment of £15.000.

Present-day functions of the Bank

The functions of the Bank of England are very similar to the functions of any central bank and, in fact, many of the central banks throughout the world were modelled on the Bunk of England so that it is not surprising that their functions follow the same lines (see Figure 2.2). These are as follows:

• Operating the government's accounts

• Controlling the issue of notes and coins

• The issue and redemption of govemmeni stocks

• The Treasury bill issue

• Operating the exchange equalisation account

• Carrying out the government's monetary policy

• The Bank's international role

• Operating accounts for the banks

• Lender of last resort

• Supervising the banks

Operating the government's accounts. As the government's bank the Bank of England is responsible for running the accounts of all the government depart­ments, which is a colossal task in view of the sheer volume and total value of transactions carried out by the government.

Controlling the issue of notes and coins. In conjunction with the Treasury (the government's finance department), the Bank is responsible for printing bank notes. It determines the size of the note issue, which must be increased to meet seasonal needs and in the longer term to meet the needs of an economy which, hopefully, is growing, and in which therefore the number and value of transac­tions is increasing. Coins are minted by the Royal Mint, which is a separate entity from the Bank of England, but it is the Bank's responsibility to ensure that adequate coins of each denomination are minted to meet the needs of the com­munity. Similarly, it must print an appropriate quantity of each bank note and ensure that torn and dirty notes arc replaced.

Issue and redemption of government stocks. The Bank is registrar for most of the government's issues of Stocks. A Stock is a loan to the government against which a stock certificate is issued. Each certificate indicates the name of the corporate body or individual who owns the stock and the amount that is registered in its (his) name. As registrar the Bank issues and redeems stocks, records their ownership and pays the interest when it is due. These securities represent the main part of the National Debt (i.e. the amount owed by the nation as a whole to companies, institutions and individuals in the community), and their sale and redemption provide an important means whereby the Bank of England can manipulate the amount of funds and the level interest rates in the money market.

The Treasury hill issuer These are a special type of bill of exchange issued by «he Treasury and the/represent short-term loans to the government whereas gov­ernment blocks arc long-term loans. In the wording of the bill the Treasury undertakes to pay the face value of the bill 91 days alter the date of issue. This payment is in fad the repayment of money lent to the Treasury on the day of issue plus interest at the rate determined on that day. The majority of Treasury bills are tender bills in that they are bid for by institutions in the money market bid them for. If an institution tenders at a price of say £97.50 (per £l00) and that offer is taken up, it will in effect receive an annual rate of interest of around 10 per cent on the money because the money is being lent for approximately a quarter of a year (£2.50 x 4 per £100). The Treasury bill rate (of interest) is watched very carefully in the money market as an indicator as to how the level of interest rates generally is likely to move. The Trea­sury bill tender, like the issue and redemption of other government securities, is important in the context of carrying out the government’s monetary policy.

Operating the exchange equalisation account By operating this account the Bank is able to influence the value of sterling and other currencies in the foreign exchange market.

The account holds all of the UK reserves of gold and foreign currencies. When sterling is weak (i.e. it has become less valuable in terms of other currencies in the foreign exchange market), the Bank of England will sell some foreign cur­rency, maybe US dollars, in exchange for sterling. This reduces the supply of sterling in the foreign exchange market and increases the supply of the foreign currency: this tends to increase the value of sterling and to reduce the value of the foreign currency and to bring about a state of equilibrium in the market. When sterling is particularly strong the bank must operate the account in the opposite direction - sell sterling in exchange for dollars - in order to keep down the value of the pound and to increase the value of the dollar.

Carrying out the government's monetary policy It is vital that the government controls the total of the money supply if it is to succeed in maintaining constant, or fairly constant, prices: in oilier words if it (s to avoid inflation. As we saw in Chapter I, the majority of the money supply, whichever way it is measured, is made up of bank deposits, and therefore any attempt to control the money supply must involve influencing or determining the size of bank deposits. The main determinants of the size of deposits" are the level of interest rates and sale and purchase of government securities, which are both within the control of the Bank of England, though ultimately it is the government, which dictates how the Bank, as its agent, must use these devices.

The Bank's international role The Governor of the Bank of England is respons­ible not only for carrying out the government’s monetary policy, but also for meeting with other central bank governors to discuss international monetary problems, and to decide upon joint action to deal with them.

Accounts of the banks Each of the other British banks keeps, accounts, with the Bank of England, and through these they are able to settle transactions with one another, i.e. id draw cheques on the Bank.

The Bank of England maintains accounts for overseas banks as well as the British banks, and these include the central banks' accounts through which it is possible lo carry out transactions relating to loans between countries and through such institutions as the International Monetary Fund (IMF). The Bank of England also holds accounts for the IMF and other international institutions.

The balances of the British banks' accounts with the Bank of England form part of their cash reserves in that they can draw upon them at any time, and they arc maintained at the minimum amount it is reckoned they need for the day-to-day transactions that arc settled through the accounts.'

Lender of last resort It is vital that a central bank should act as lender of last resort to the banking system. If the banks are short |of funds and are unable to acquire additional funds from other sources, then they must have the support of the central bank. but the central bank is able to determine, the price that has to be paid for that support, i.e. the rate of interest charged. In the UK the Bank of England gives this support indirectly in that h is the London discount houses and not the banks that are forced to obtain funds from the Bank of England if they are short. If the supply of funds in the London money market is insufficient, then the banks call in some of the call money from the discount houses» forcing them to seek assist­ance. This assistance may be given by the Bank directly buying bills or. alter­natively. the Bank may choose to give indirect assistance by buying bills, from the bunks, enabling them to restore their call money loans to the discount houses or. rarely these days. lending to them. Acting as lender of last resort provides the central bank with a weapon to use as part of the government's monetary policy.

Supervision of the banks Under the Banking Acts'1979 and 1987 the Bank of England is able lo demand very detailed statistical returns from the other banks in order to ensure that the banks are being operated on safe and prudent! it lines. If the Bunk is not satisfied with a particular bank's returns it is able to insist that measures are taken to put matters right. For instance, the Bank might insist that the offending bank build up its liquid assets and run down its holdings of longerterm assets in order lo maintain a more satisfactory liquidity ratio. If a bank fails to follow the guidelines given by the Bank of England the ultimate sanction of withdrawing that bank's licence to accept deposits could be used.