Have you ever wondered why every time a commercial bank fails, the government rushes the central bank to rescue the situation?
Why is a central bank always called upon whenever inflation rises and interest rates surge?
The role of central banks in containing crises in the markets can hardly be understated.
A central bank is the primary financial institution of a country or a group of countries that overlooks the monetary policy of the region.
As the main authority on economic policy, a central bank issues the national or regional currency, regulates the banking sector of the region, and enforces policies to combat illegal practices such as money laundering.
In India, the Reserve Bank of India (RBI) acts as the central bank of the country. Similarly, the European Central Bank (ECB) is the central bank of the countries which make up the European Union.
Central banks such as the RBI and the ECB have played a significant role in managing economic crises on several occasions in the past and continue to do so.
In simple words, a domino effect is the cumulative effect in one market generated as a result of another event somewhere else and it goes on until it is controlled.
For instance, the Wall Street crisis in 2008 due to the collapse of the Lehman Brothers led to a terrible domino effect. It led to a global financial crisis for the next 2-3 years which hit the economies in countries as far as India.
One such common phenomenon in the global markets is the domino effect that central banks often have to manage.
In such a scenario, a spiralling chain of negative events can adversely affect the economy of a country and even the world. To manage such a crisis, central banks act in a coordinated manner so that they serve both the national economic interest and stabilise the global economy.
This was a rather exceptional example. But there are more.
Another domino effect began when a rise in bond yields in Greece during 2012-14 led to a debt crisis across Europe. It took years for the Greek economy and the broader Eurozone economy to recover. The role of central banks such as the European Central Bank (ECB) and International Monetary Fund (IMF) via bailout loans to Greece was crucial in managing this domino effect.
One common domino effect is a regular phenomenon in the global market. Whenever there is a political crisis in the Gulf countries, the price of the crude oil goes up instantly.
You might wonder why a political crisis in one part of the world is affecting the price action of a crucial natural resource globally.
But this is exactly what a domino effect does, and this is why it’s so critical to nip it in the bud.
It happens because the Gulf is a provider of crude oil to large parts of the world. A political crisis there affects the supply chain of the resources and leads to a surge in the price of the crude oil.
Managing such crises is necessary for any central bank so that a country’s economy is well functioning.
Such interventions of the central banks in recent years such as during the 2008 Wall Street crisis and the COVID-19 pandemic have been noteworthy and deserve our attention.
During such episodes of domino effect, price disarray and difference between buyers and sellers are impaired and markets exhibit unstable dynamics.
Central banks have an enormous interest in the well-functioning of markets, especially those at the heart of the financial system.
A crisis in the markets due to a domino effect has a direct impact on different aspects of a central bank’s policy, such as:
The domino effect in financial markets can potentially disrupt the flow of credit into the economy, impacting market activity and price stability. Therefore, the central bank in any country assumes the primary role in addressing these concerns.
Central banks have employed two primary kinds of tools to remedy the domino effect in the markets:
Lending activities can be beneficial in addressing core market disarray caused by liquidity concerns which often lead to market spirals. They may be put in place using existing counterparties.
Asset purchases can be more effective than lending loans in containing the domino effect in the markets caused by a range of factors. Purchases not only provide liquidity but directly impact the markets. These actions contribute to handling price discovery breakdowns caused by information disarray.
Asset purchases can also resolve dysfunction caused by balance sheet limits because they eliminate risks from market members’ balance sheets. Furthermore, they might be more tailored to specific market sectors.
Actions of the central bank to resolve dysfunction in the markets are expensive and may make the economic and financial systems, central banks, and government resources vulnerable to a variety of risks. An -dependence on the central bank has the potential to distort market mechanisms. Too much help on the part of the central bank may potentially sabotage central bank capital and taxpayer funds.
Independence of the central bank, on the other hand, maybe jeopardised, particularly in emerging market economies. Actions such as the purchase or lending against government debt often lead to speculations that a central bank’s policy decisions are unduly influenced by the government’s financing requirements. All these risks are generally higher for asset purchases than for lending operations.
To reduce the impact of the domino effect on the markets, central banks may be inclined to use their authority to grow their balance sheets and supply liquidity.
However, such activities must not be a substitute for the primary responsibilities of market participants to manage their own risks, which should be reinforced by appropriate monetary regulation.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.