Central bank

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A central bank, reserve bank, or monetary authority, is an entity responsible for the monetary policy of its country or of its group of member states. In most countries, the central bank is state-owned and has a minimal degree of autonomy to allow for the possibility of government intervention in monetary policy. An "independent central bank" is one that operates under rules designed to prevent political interference. Examples of independent central banks include the U.S. Federal Reserve, the Bank of England, the Reserve Bank of India, the Bank of Japan, the Deutsche Bundesbank, the Bank of Canada, the Reserve Bank of Australia, and the European Central Bank. The primary responsibility of the central bank is to maintain the stability of the national currency and money supply, though more active duties include controlling subsidized loan interest rates, and acting as the lender of last resort to the private banking sector during times of financial crisis.

A central bank may also have supervisory powers to ensure that private banks and other financial institutions do not behave recklessly or fraudulently. Thus, the central bank's function is to maintain economic stability by storing and regulating the flow of money in its country, or larger area of responsibility, much as various organs in the human body regulate the production and flow of blood, including the production and flow of red and white blood cells, to support the health of the body as a whole. Historically, the body of human society has suffered ill-health, as has its economic system, including the collapse of several banking systems. As humankind develops greater maturity and a peaceful world of harmony and co-prosperity is established, the economic system, including the banking system, will enjoy greater health and the central bank will be able to develop effective policies and implement them successfully.

Contents

History

Reserve Bank of India in Mumbai, India.

Prior to seventeenth-century Europe, money was typically in the form of gold or silver commodity money. The reliance on promises to pay, however, was accepted as value at least five centuries earlier throughout parts of Europe and Asia. The earliest prototype of a central banking system was developed by the medieval European Knights Templar. Many believe their activities as having laid the basis for the modern system of banking, as their promises to pay were widely regarded and upheld. China’s Kublai Khan introduced fiat currency to Asia soon after. Today’s international system of banking, however, most resembles facets of colonialism and its introduction of a large, global, commodity market mostly managed by the British Empire and controlled by its vast sea power.

The oldest central bank in the world is the Bank of Sweden, which was opened in 1668 with help from Dutch businessmen. The Bank of England followed in 1694, created by Scottish businessman, William Paterson, at the request of the English government to finance a war. The Federal Reserve System would follow much later, created by the U.S. Congress through the passing of the Glass-Owen Bill and signed by President Woodrow Wilson on December 23, 1913.

With the introduction of Chinese market reforms, the People’s Bank of China evolved its role as a central bank in 1979. This accelerated in 1989, when the country took a capitalist approach to developing its export economy. By 2000, the People’s Bank of China was in all senses a modern central bank, emerging as such in response to the European Central Bank, the most modern of international bank models. The European Central Bank was introduced with the euro to coordinate the European national banks, which continue to separately manage their respective economies.

Central Bank Responsibilities

Central banks often serve as a nation’s principle monetary authority and maintain a list of fiscal responsibilities. These institutions regulate their nation’s money supply and credit, and are responsible for issuing currency, managing the foreign exchange rate, and administering monetary policies to regulate economic conditions. Central banks also manage their government’s stock register and gold reserves, and hold deposits representing the reserves of other banks. These institutions also conduct business appropriate to the protection of public interest.

A central bank acts as the fiscal agent of its government and is responsible for the supervision of commercial banks. Central banks fulfill the duties of primary banker for their government and private banking branches, and often operate as a monopoly in the issuance of banknotes. In its use of monetary policy, a central bank can change its nation’s money supply by adjusting the interest rate. In turn, the interest rate is used to manage inflation and the national exchange rate. A central bank can also influence commercial bank borrowing by setting the interest rate at an encouraging or discouraging level. In this way, a central bank maintains direct control over its nation’s economy.

In addition to fulfilling its range of responsibilities, a central bank will aim to maintain high levels of employment, efficient productivity, and stable market prices. Above all, central banks seek to monitor and foster their nation’s economic growth.

The Central Bank vs. National Banks

A central bank's main responsibility is the management of monetary policy to ensure a stable national currency. This is distinct from the national bank’s responsibility to ensure a stable domestic economy. Though some central banks, like the People's Bank of China, explicitly declare themselves a national bank, others, including the U.S. Federal Reserve, officially do not.

This distinction is generally subtle but significant. Most day to day functions of a central or national bank are the same. A central or national bank can act as a lender of last resort to assist other banks in cases of financial distress. Unlike a national bank, though, a central bank will aim to manage inflation, as well as deflation, or the falling of prices, through monetary policies designed to maintain stability of currency and money supply.

Exceptions to this distinction include the United States, Europe, and various countries using non-convertible currency including China, Cuba, North Korea, and Vietnam. The latter four are exceptions because of their use of a county-specific currency, and managing the nation’s currency means managing the national economy.

The European Union is an exception, as its nations share a general currency but do not share a single common economy. There, many historically separate national banks cooperate with the newer, single central bank, the European Central Bank. The United States is also an exception. Since the collapse of the gold standard in 1931 and the Bretton Woods Agreement in 1944, the U.S. dollar has become a reserve currency, with the result that managing the U.S. dollar affects not only the United States economy, but economies worldwide. As a result, pressures to control U.S. inflation are severe. When the United States experiences a period of inflation, it remains virtually impossible for many other countries, which must possess U.S. dollars to purchase certain commodities, to avoid economic inflation.

Monetary Policy

The main instruments of monetary policy available to central banks are open market operations, interest rate intervention, reserve requirements, re-lending, and re-discounting. Capital adequacy, a measure of financial strength, is also considered instrumental, but is strictly regulated by the Bank for International Settlements.

Open Market Operations

Through open market operations, a central bank can directly influence a nation’s money supply. By purchasing securities with money, a central bank will increase the amount of money in its economy’s circulation, and therefore increase its nation’s money supply. Conversely, the selling of securities will lower the money supply and reduce the amount of money in economic circulation. Main open market operations include reverse operations, or the temporary lending of money for collateral securities, direct operations, or the buying and selling of securities, and foreign exchange operations.

Smaller economies, with limited control over the users of their currency, often employ open market operations as a means of monetary policy. Open market operations are also used by the United States, as the U.S. dollar is used worldwide, and used by the European Union, which holds limited authority over their national banking policies.

To enable open market operations, a central bank must hold official gold reserves and foreign exchange reserves, often in the form of government bonds. Open market operations can also influence the foreign exchange market and foreign exchange rate. On occasion, the People's Bank of China and the Bank of Japan have purchased large amounts of U.S. treasuries to stop the decline of the U.S. dollar versus China’s renminbi and Japan’s yen.

Interest Rate Intervention

One of the most important responsibilities of the central bank is the unilateral determination of its economy’s interest rate, or the rate at which the central bank will lend money. The U.S. Federal Reserve sets a lending rate known as the "Federal funds rate," a targeted fund rate that its Open Market Committee aims to match through active borrowing or lending.

A typical central bank has several interest rates it can set to influence markets. These rates include the marginal lending rate, the main refinancing rate, and the deposit rate. The marginal interest rate is a fixed rate set for institutions when borrowing from a central bank. The main refinancing rate, minimum bid rate, or discount rate, is the interest rate announced by the central bank to the public. The deposit rate marks the rate parties receive for deposits at the central bank. These rates directly affect the money market and the market for short-term loans.

A central bank is often responsible for controlling certain types of short-term interest rates that can also influence the stock and bond markets. Both the Federal Reserve and the European Central Bank are composed of one or more central bodies that are responsible for any decision regarding interest rates and the size and type of open market operations. These banks also employ several smaller branches to execute its determined policies. In the United States, these branches are known as the local Federal Reserve Banks, throughout Europe they are the National Central Banks.

Reserve Requirements

The most fundamental leverage of central banks is the establishment of reserve requirements. By requiring that a percentage of liabilities be held as cash, central banks can set absolute limits on their nation's money supply.

Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks to overextend themselves and suffer from reserve depletions. As the early twentieth-century gold standard and late twentieth-century dollar hegemony evolved, banks proliferated and engaged in more complex transactions, profiting from global dealings. These practices became mandatory, if only to ensure that there was some limit on the swelling of the money supply. However, such limits are difficult to enforce. The People's Bank of China, for example, retains more powers over reserves due to the fact that the yuan is a non-convertible currency.

If reserves were not a legal requirement, prudence would still advise banks to hold a certain percentage of their assets in the form of cash reserves. Commercial banks are often viewed as passive receivers of deposits from their customers. For many purposes, this is an accurate view. However, the passivity of bank activity becomes misleading when determining the nation's money supply and credit. Banks loan activities play a fundamental role in determining a nation’s money supply. The amount of real money in the banking system is defined by the amount of money deposited by commercial banks at the central bank. Other versions of money are merely promises to pay real money.

Capital Requirements

All banks are required to hold a certain percentage of their assets as capital. When at its threshold, a bank cannot extend another loan without acquiring further capital. Due to concerns regarding asset inflation, term repurchasing agreements, and difficulties in accurately measuring liability, capital requirements are often considered more effective than deposit or reserve requirements in preventing indefinite lending.

Central Bank Limitations

Despite their authority, central banks have limited powers to put their policies into effect. Even the U.S. Federal Reserve must engage in buying and selling to avoid financial crises and meet its targets.

Supervision

Some central banks, through their subsidiaries, can control and monitor the banking sector. However most often, banking supervision is carried out by a government department like the United Kingdom’s Ministry of Finance, or an independent government agency like the UK’s Financial Services Authority. These agencies examine the banking behaviors, balance sheets, and customer policy, as well as the transferring of funds, bank notes, coins, and foreign currency.

Independence

Advocates of central bank independence argue that a bank that is too susceptible to political pressures may contribute to cycles of economic instability. Politicians may be tempted to boost economic activity in advance of an election, causing deterioration of the long-term health of the general economy. The aim of central bank independence is primarily to prevent this type of short-term interference.

Other advocates believe that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Thus, the Bank of England and the European Central Bank as independent institutions follow a set of published inflation targets so that markets know what to expect.

Governments generally maintain some degree of influence over independent central banks. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the United States, then confirmed by Congress. However, the powers of such appointed positions are usually highly limited. Ultimate decisions regarding monetary policy are made by privately appointed figures that are independent of elected political powers. With the Bank of England’s Monetary Policy Committee, the majority power is elected by, and given to, members of private corporations.

Examples of Central Banks

There are more than 150 central banks throughout the world, including the U.S. Federal Reserve System and the Bank of England. The Bank of Sweden, the European Central Bank, the Bank of Japan, and the People’s Bank of China are briefly detailed below.

The U.S. Federal Reserve System

The U.S. Federal Reserve System is the central banking system of the United States. It was created via the Federal Reserve Act of December 23, 1913, which required all national banks to join the system. This legislation also allowed for the creation of Federal Reserve notes to maintain an elastic supply of currency. The Reserve Banks were integrated into the system one year later in 1914. The system involves some government regulation and is comprised of the Board of Governors, a Federal Open Market Committee, twelve regional Federal Reserve banks, and four private banks owning stock in regional branches.

According to the Board of Governors, the main tasks of the Federal Reserve System are:

  1. conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
  2. supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
  3. maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
  4. providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

The Bank of England

The Bank of England

The Bank of England is the central bank of the United Kingdom, known as "The Old Lady of Threadneedle Street."

The bank was founded in 1694 by the Scotsman, William Paterson, who was delegated to act as the English government's banker by Royal Charter. The bank was originally constructed above London’s Temple of Mithras, the god of contracts. In 1734, the bank moved to its current location on Threadneedle Street, slowly acquiring the land to create the edifice seen today.

During the eighteenth century, by accordance of the Royal Charter, the bank was to keep enough gold in stock to pay its notes on demand into 1797. The government then prohibited the bank from payments of gold until 1821, as war had significantly diminished England’s gold reserves.

The 1844 Bank Charter Act allowed the bank sole rights to the issuance of banknotes. Some private banks, which had previously retained that right, continued to issue their own notes, until the last of them were taken over in the 1930s. However, the private Scottish and Northern Irish banks have continued to retain that right.

The Swedish National Bank

The Swedish National Bank, Bank of Sweden, or Sveriges Riksbank, is the world's oldest central bank, beginning its operations in 1668. Before this time, the bank was known as the Stockholms Banco or Bank of Palmstruch, founded by Johan Palmstruch in 1656 and controlled by the king.

Stockholms Banco, the world's oldest note-issuing bank, collapsed in the mid-seventeenth century as a result of issuing bank notes without necessary collateral. Palmstruch, considered responsible for the bank's losses, was condemned to death, but later received clemency. In 1668, the king-appointed privilege to operate as a national bank was transferred to the Riksens Ständers Bank, or the Bank of the Estates of the Realm, and was run by parliament. When a new Riksdag was instituted in 1866, the name of the bank was changed to Sveriges Riksbank.

The Riksbank was not permitted to issue bank notes, but in 1701 began to issue similar credit notes. In the middle of the eighteenth century, however, counterfeit notes began to circulate and the Riksbank began producing its own paper for bank notes at their personal paper mill.

Soon after, Sweden’s first commercial banks were founded and permitted to issue bank notes. The bank notes represented a claim to the bank without interest paid, and became a considerable source of income to the banks. Nonetheless, security in the form of a deposit at the Riksbank was required to cover the value of all notes issued.

During the nineteenth century, the Riksbank maintained a dominant position as a credit institution and issuer of bank notes. The bank also managed national trade transactions and provided credit to the general public. In 1897, the first Riksbank Act was passed allowing the Riksbank the exclusive right to issue bank notes and establishing the institution as an official central bank.

The European Central Bank

The ECB building in Frankfurt, Germany

Established on June 1, 1998, the European Central Bank (ECB) is centrally located in Frankfurt am Main, Germany. The ECB is among the world's largest central banks and is responsible for enacting monetary policy throughout the European Union. It is also responsible for maintaining control over the euro, the Union’s official currency used by more than 300 million people. The ECU is structured after Germany’s Central Bank, the Deutsche Bundesbank, and was designed as an independent institution to operate without political intervention.

The ECB is headed by a single president, governed by a board of directors, and directed by a board of governors that include representatives of central banks of the European System of Central Banks (ESCB). The ESCB’s Executive Board consists of six members that collaborate on the strategies used by the European Central Bank. Four of these six seats are reserved for representatives of the Union’s largest central banks: the Banks of France, Italy, Spain, and Germany’s Deutsche Bundesbank.

The Bank of Japan

The Bank of Japan has its headquarters in this building in Tokyo.

The Bank of Japan is headquartered in Nihonbashi, Tokyo on the site of a former gold mint. The building is located near the famous Ginza district, named after the former silver mint established there. The institution also maintains a branch in Osaka.

The central bank, established after the Meiji Restoration, was originally designed as a monopoly to control Japan’s fluctuating money supply. Before the founding of Japan’s central bank, both the central government and its national bank branches were responsible for issuing Japan’s newly established currency, the yen. As both institutions retained the right to print money, Japan battled cycles of economic instability until the founding of the Bank of Japan in 1882.

The Bank of Japan suffered a brief hiatus after World War II, when the occupying Allies issued a military currency and restructured Japan’s central bank into a more independent entity. In 1997, major revisions were made to the Bank of Japan Law to allow the central bank more independence, although it is not yet listed as an independent institution.

The People's Bank of China

The People’s Bank of China (PBC) is the central bank of the People's Republic of China and remains a separate entity from the Bank of China and the Central Bank of China. The PBC regulates financial institutions and controls monetary policy throughout mainland China. The bank is structured after the United States Federal Reserve.

The PBC was founded in 1948. After the establishment of the People’s Republic, all banks were nationalized and incorporated into the PBC. PBC headquarters were first located in Shijiazhuang, Hebei, but later moved to Beijing, in 1949. For nearly thirty years the PBC remained the sole bank of the People’s Republic and was responsible for both central banking and commercial banking operations. In the 1980s, the PBC was restructured to retain only the functions of a central bank, and later, in 1998, nine regional branches were established to reduce local political influences on PBC policy making.

The Future of Central Banks

Throughout history, the main objective of a central bank has remained the maintenance of a national currency. Fostering financial stability and economic growth has also been delegated to a nation’s banking body.

In recent years, economists have highlighted the difficulties central banking institutions face, and the hardships they endure in their day to day decision making. Some have argued that the historical reliance of central banks on the gold standard continues to compromise price stability. These theorists also believe the central bank faces continuous tension to fulfill its duties of currency maintenance, while functioning as the banker to its central government. Economists also argue that the power entrusted to certain central banks is significantly restricted as government agencies have the ultimate say.

There are major policy dilemmas that face central banking institutions worldwide. These include persistent short-term fluctuations between periods of inflation and growth, the choosing of inflation targets, and general operations. Modern central banks make use of other agencies to regulate financial stability including finance ministries, financial regulators, and financial supervisors.

Central banks worldwide have undergone histories of development regarding changing ideas, theories, and perceptions about the proper role a centralized bank should play. In this era of globalization, determining the role of central banks has become even more critical. In some areas, such as the European Union, a new central bank (the European Central Bank) emerged, designed to operate independently of political intervention. On the other hand, the free banking school of thought has argued that the existence of central banking institutions is unnecessary, citing historical instabilities that have resulted from monetary and financial error.

Financial difficulties surrounding the Indonesian, South Korean, Thai, and Russian economies, and the 1930 banking collapse of the United States and the United Kingdom, have allowed modern central banks certain insight. By understanding the components of past phenomena, current economies can ensure that similar mistakes are not made. In this way, central banks continue in their constant quest to improve all facets of monetary and financial policies.

References

  • Britannica Concise Encyclopedia. Central Bank. Copyright © 1994-2006 Encyclopædia Britannica, Inc. All rights reserved.
  • Cappie, Forest. 1995. The Future of Central Banking: The Tercentenary Symposium of the Bank of England. Cambridge, England: Cambridge University Press. ISBN 0521496349.

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