Central Banks and the Credit Crunch of 2007

Apr 18


Sam Vaknin

Sam Vaknin

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The 2007 credit crunch, triggered by the subprime mortgage crisis in the United States, marked a significant transformation in the role of central banks globally. This article delves into the actions taken by central banks during the crisis and examines their evolving functions in the financial system.

The Onset of the 2007 Credit Crunch

The latter half of 2007 saw the global financial system teeter on the brink of collapse,Central Banks and the Credit Crunch of 2007 Articles primarily due to the subprime mortgage crisis in the United States. This period, known as the credit crunch, saw liquidity dry up, as banks became wary of lending to each other amid soaring default risks. On December 12, 2007, a coordinated move by major central banks including the Federal Reserve, the Bank of England, the European Central Bank (ECB), and others, aimed to inject liquidity to ease the global cash squeeze (Federal Reserve).

Strategic Responses to the Crisis

  • Interest Rate Cuts and Auction Facilities: Central banks slashed interest rates and established facilities like the Term Auction Facility (TAF) to provide funds to banks under stress. For instance, the ECB lent €350 million to 390 banks at below-market rates on December 18, 2007.
  • Expansion of Collateral Acceptance: Central banks broadened the range of acceptable collateral, now including prime mortgages, thus taking on more risk and altering their traditional role as lenders of last resort.

Market-Driven Interest Rate Setting

During the crisis, interest rates for lines of credit were often determined through market-driven auctions rather than being directly set by central banks. This approach was intended to prevent central banks from having to directly penalize banks for negligent lending practices.

Evolving Role of Central Banks

Historically, central banks have played a pivotal role in financial systems, but their functions have expanded and transformed significantly over time.

Traditional vs. Contemporary Roles

  • Traditional Roles: Central banks traditionally focused on controlling inflation and managing the national currency and reserves.
  • Contemporary Roles: Today, they are deeply involved in overseeing banking systems, managing interest rates to influence economic activity, and intervening in financial markets during crises.

Influence on Economic Policies

Central banks are influential in shaping economic policies and have a significant impact on financial markets. For instance, decisions by the Federal Reserve can cause immediate reactions in global stock and bond markets.

Supervisory Challenges

The dual role of central banks as both regulators and participants in the banking sector can lead to conflicts of interest, particularly when they are required to supervise banks while potentially critiquing their own prior policies.

Conclusion: A Paradigm Shift

The credit crunch of 2007 highlighted the critical role central banks play in maintaining financial stability during crises. It also led to a paradigm shift in how these institutions perceive their roles, balancing between traditional monetary objectives and the need to act as financial stabilizers.

Central banks now face the challenge of navigating their expanded roles while avoiding conflicts of interest and maintaining transparency and accountability in their operations. The evolution of these institutions continues to be a topic of significant importance in the discourse on global economic stability.

Further Reading