Traditional central banking emerged in the 19th century during the banking crises in England. The role of the Bank of England as a lender of last resort was first carried out for pragmatic reasons and was then formulated as a theory by British economist and journalist, Walter Bagehot, the founder and first editor of the Economist magazine of London. In his book "Lombard Street" he formulated the role of the Bank of England as a lender of last resort to the bankers in 1873.

During that period currency crises and runs on banks were common and under the Gold Standard which prevailed then, bank runs caused a drain on the gold reserves of the Bank of England. There was then a contraction of credit which made things worse and the Bank of England realized that the opposite should be done and that it should act as a lender of last resort and help to stem the run on the banks by providing additional liquidity. There was the collapse of the Overend Guerney Company in 1866 which caused a run on banks which saw the Bank intervening to provide liquidity.

Our own situation with regard to the Golden Key Credit Card Co. resembles this although our financial crisis was brought on earlier by the exit of short term investors from the bond and stock markets from September onwards. The collapse of Golden Key, Sakvithi, Danduwam Mudalali etc. all undermined public confidence in the finance companies. The Central Bank liberalized lending and provided liquidity to the banks affected by the first factor but has been rather tardy in responding to the second - the run on finance companies. These institutions are equally important since a large number of members of the public have made deposits with them and they are unable to increase their liquidity to cope with the run on them as their asset portfolios cannot be disposed of in a hurry without booking large losses.

The CB arranged for Lankaputra Bank to buy their land and property but only at knock down prices. This will not do. The loans are carried by these companies at their book values even if their assets are not, and if the assets are sold below market the loss will have to be taken into account worsening the Balance Sheets and further undermining public confidence. So the finance companies would prefer not to sell their assets at such unrealistic prices based not on their future returns but on the present liquidity crisis.

Markets always turn upwards as well as downwards. The asset prices will revive sooner or later and these companies, if they can get over their temporary liquidity problems, would be able to sell their assets at much higher prices. The same goes for shares bought earlier at higher prices in the stock market. Investors prefer to hold them and they are able to do so unless they have bought them on margin credit and have to make good margin calls. So the liquidity that should be provided is for the Central Bank (CB) to provide loans against such assets as collateral rather than call upon the affected companies to sell them at knock down prices.

This sort of relief has been provided in other countries.  The US has announced details of a plan to buy up to $1 trillion worth of toxic assets to help repair banks’ balance sheets. Banks there include investment banks. The "Public-Private Investment Program" will purchase the troubled mortgages and securities that have been at the root of the credit crunch. The US Treasury has committed $75bn to $100bn to the program and said the private sector would also contribute. Perhaps Lankaputra Bank can form a Public Private Investment Program to buy up loans which are non-performing at a discounted value.

Valuation of course is a difficult problem for such loans but some ground rules can be established varying on the prospects of the sector in which the borrower operates. The borrowers could be vehicle owners or export firms or construction firms but it is essential to get the flow of credit restarted. It is very necessary to stabilize the financial system and restore the flow of credit which also means the revival of deposit taking by financial institutions.

Officials abroad recognizing these challenges are now seriously considering "non-traditional" policies that combine monetary and fiscal elements. These countries like UK, USA have cut interest rates to (near) zero. It has not been a mistake, but it has been ineffective. The reason, again, is the impaired credit intermediation system. Securitization has almost dried up. Banks are hoarding capital as a cushion against future losses yet to be recognized.  For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector.

The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

The Bank of England is providing liquidity via the rediscounting window on commercial bills and commercial paper. These measures will provide credit more or less directly to the private business sector and help revive trade finance. The high L.C margin deposits imposed by the CB are an unnecessary restrictive control on trade. That’s now being changed.

Urgent Reform proposals

 The Government is raising taxes, particularly indirect taxes like tariffs and cesses, ostensibly to protect local producers but really to collect more tax revenue. But what is more important is to sustain domestic consumption by the people rather than the government which is playing too large a role absorbing 35% of the GDP in a not so productive a manner. If the government tax revenue falls as it is bound to during a downturn, the government should exercise fiscal prudence. The carnival for the government is over and it will have to cut down on either the war or development expenditure. 

The controversy about the Gazette notification tightening the rules regarding the Efficiency Bars for public servants is good news for our public servants who are lotus eaters and constitute a heavy burden on the public. It is very foolish to solve the unemployment problem among university graduates by packing the public service with them. Unproductive work doesn’t create economic value but is more likely subtracting economic value of the services the state provides for excess staff increases inefficiency.

Another change that should be introduced is to overhaul the Labor Laws removing the restrictions on termination of employment by firms introduced by the Marxist Untied Front Government of the 1970s. Similarly the Trade Union Laws must be overhauled and no strike should be considered legal unless there has been a secret ballot held under the auspices of the Labor Department.  Such changes will quicken recovery from the recession. 

There is no room for giving any fiscal stimulus or support packages. Exporters won’t need any if the rupee is allowed to depreciate. What is required is for the CB to play its role as a Lender of Last Resort. The government must reduce its expenditure to the available tax revenue and forget about Capital Expenditure. Our problems are only partly due to the global meltdown. The profligacy of the government and the large budget deficits which funded the growth process was unsustainable and previous growth spurts too had petered off in balance of payments crises. Deficit-spending fiscal boosts programs would not work well and they would have high longer-term costs to be not worth doing. The government, if it stops funding its deficit from borrowing from the banks (printing money), will push up interest rates and pre-empt funds from the private sector. If it prints money it will push up inflation and reduce real incomes of the people.

Additional government borrowing from the markets instead of the banks will push up interest rates, make financing expansion even more expensive for businesses and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.