Central bank

From New World Encyclopedia


Reserve Bank of India in Mumbai, India.

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. Its primary responsibility 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, or bailout, to the private banking sector during times of financial crisis.

A central bank may have supervisory powers to ensure that private banks and other financial institutions do not behave recklessly or fraudulently. A central bank is usually headed by a Governor, President (in the case of the European Central Bank) or Chief Executive (in the case of the Hong Kong Monetary Authority and the Monetary Authority of Singapore).

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 which operates under rules designed to prevent political interference. Examples of independent central banks include the US 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.

Central Bank Responsibilities

Central banks fulfill the duties of primary banker for its Government and private banking branches, and often operate as a monopoly in the issuance of banknotes. Central banks are also responsible for managing its country’s foreign exchange, gold reserves and its Government stock register. In addition to regulating and supervising the general banking industry, central banks are also responsible for setting and implementing the official interest through a variety of policy mechanisms. In turn, the interest rate is used to manage inflation and the national exchange rate.

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 responsibility of a national bank 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 US Federal Reserve, officially do not. This distinction is minimal except when regarding the United States, Europe, and various countries using non-convertible currency including China, Cuba, North Korea, and Vietnam. These exceptions exist 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. The United States is also an exception. Since the collapse of the gold standard in 1931 and the Bretton Woods Agreement in 1944, the US dollar has become a reserve currency. The resulting dollar hegemony means that managing the US dollar affects not only the United States economy, but economies worldwide. As a result, pressures to control US inflation are severe. When the United States experiences a period of inflation, it remains virtually impossible for other countries, which must possess US dollars to purchase commodities of oil, to avoid an economic inflation.

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, a central bank will aim to manage inflation, or the rising of average prices, as well as deflation, or the falling of prices. A central bank will intervene primarily through open market operations in which it achieves its monetary targets by massive buying or selling.

Interest Rate Intervention

A central bank is often responsible for controlling certain types of short-term interest rates. These interest rates also influence the stock and bond markets. The European Central Bank announces its interest rate at the meeting of its Governing Council, while the US Federal Reserve presents theirs before a Board of Governors.

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.

Central Bank Limitations

Despite their authority, central banks have limited powers to put their policies into effect. Even the US Federal Reserve must engage in buying and selling to avoid financial crises and meet its targets. In a notorious case of policy failure, billionaire George Soros arbitraged the pound’s sterling relationship to the European Currency Unit. After making more than $2 billion himself and forcing the UK to spend over $8 billion defending the pound, Soros forced the European Central Bank to abandon its financial policies. Since then, Soros has been a harsh critic of clumsy bank policies and has argued that no one should be able to manipulate the system as he, in fact, did.

The most complex foreign exchange relationships are between the yuan and the US dollar, and the Euro and its neighbors. Financial situations in Cuba are so exceptional as to require the Cuban peso to be dealt with as simply an exception since the US forbids direct trade with Cuba, though US dollars are ubiquitous throughout the Cuban economy.

Policy Instruments

The main instruments of monetary policy available to central banks are open market operations, bank reserve requirements, interest-rate policies, trade policies, 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.

To enable open market operations, a central bank must hold official gold reserves and foreign exchange reserves, often in the form of government bonds. A central bank will also have some influence over any official or mandated exchange rate. Though some exchange rates are managed, some remain market based, or free float. The majority are somewhere in between, referred to as "managed float" or "dirty float".

Capital Requirements

All banks are required to hold a certain percentage of their assets as capital. For international banks, including the 55 central banks comprising the Bank for International Settlements, the threshold is 8%. When at its threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet. 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.

Reserve Requirements

The most fundamental leverage central banks can hold remains their reserve requirements. By requiring that a percentage of liabilities be held as cash, central banks can set absolute limits on the money supply. When a loan is made between two parties, the bank must literally create money. The effects of bank-created money are well controlled by financial economists, though the effects of non-bank-created money are not. Accordingly, financial derivatives like term repurchase agreements are relatively unpredictable, and their increasing use has been a source of concern regarding reserves. In practice, all banks are legally required to delegate a percentage of their deposits as reserves.

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 20th century gold standard and late 20th 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.

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. These promises to pay are circulatory multiples of real money. For general purposes, people perceive money as the amount shown in financial transactions or the amount showing in bank accounts.

Bank accounts, however, record both financial credits and debits that cancel each other out. After aggregate settlement, the remaining central-bank money, or final money, can take only one of two forms: central-bank money, or physical cash, though cash is rarely used in wholesale financial markets. The currency component of the money supply is far smaller than the deposit component. Currency and bank reserves together make up the monetary base, called M1 and M2.

Examples of Use

The People's Bank of China has been forced into particularly aggressive tactics by the extreme complexity and rapid expansion of the Chinese economy. In 2003, the People’s Bank imposed a variety of lending restrictions to specific industries, and required more reserves from urban banks than rural ones. The United States has used similar tactics. Historically, the US has maintained a wide range of reserve requirements between its smaller branches. Domestic development is thought to be optimized mostly by reserve requirements rather than by capital adequacy methods, since they can be more finely tuned and regionally varied.

Open Market Operations

Small economies with little control over users of their currency, and the US which due to the use of its currency worldwide also has little control, and the EU which can't easily control policies of all national banks, tend to employ open market operations rather than Chinese-style reserve rulings.

Through open market operations, a central bank influences the money supply in an economy directly. Each time it buys securities, exchanging money for the security, it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.

The main open market operations are:

  • Temporary lending of money for collateral securities ("Reverse Operations"). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned off.
  • Buying or selling securities ("Direct Operations") on ad-hoc basis.
  • Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the People's Bank of China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus the Renminbi and the Yen.

Interest rates

By far the most visible and obvious power of the central bank is to set interest rates unilaterally.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." - Henry C K Liu, in an Asia Times article explaining modern central bank function in detail He explains further that "the US central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market.... a fiat money system set by command of the central bank. The Fed is the head of the central-bank snake because the US dollar is the key reserve currency for international trade. The global money market is a US dollar market. All other currencies markets revolve around the US dollar market." Accordingly the US situation isn't typical of central banks in general.

However even despite dollar hegemony, a typical central bank has several interest rates it can set to influence markets.

  • Marginal Lending Rate (currently 3.75% in the Eurozone) A fixed rate for institutions to borrow money from the CB.
  • Main Refinancing Rate (2.75% in the Eurozone) This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans (In the US this is called the Discount rate).
  • Deposit Rate (1.75% in the Eurozone) The rate parties receive for deposits at the CB.

These rates directly affect the rates in the money market, the market for short term loans.

Banking supervision and other activities

In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as The UK Ministry of Finance, or an independent government agency (eg UK's Financial Services Authority). It examines the banks' balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Any cartel of banks is particularly closely watched and controlled. Most countries control bank mergers and are wary of concentration in this industry due to the danger of groupthink and runaway lending bubbles based on a single point of failure, the credit culture of the few large banks. In finance generally, diversification reduces financial risk, including diversity of point of view.

"Independence"

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust"), as politicians may be tempted to boost economic activity in advance of an election, to the detriment of the long-term health of the economy and the country.

In addition, it is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect. Even the People's Bank of China has been accorded great latitude due to the difficulty of problems it faces, though in China the official role of the bank remains that of a national bank rather than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under pressure". PBoC independence can thus be read more as independence from the US which rules the financial markets, not from the Communist Party of China which rules the country. The fact that the CPoC is not elected also relieves the pressure to please people, increasing its independence.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U.S., and his choice must be confirmed by the Congress.

The powers of such appointed positions are usually highly limited. The main decisions on monetary policy, to name but one example, are made by privately appointed figures independently of any elected political powers. Such is the case with the Monetary Policy Committee of the Bank of England. Where the majority power is elected by and given to members of private corporations.

History

In Europe prior to the 17th century most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The medieval European Knights Templar ran probably the best known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having laid the basis for the modern banking system. At about the same time, Kublai Khan introduced fiat currency to China, which was imposed by force by the confiscation of specie. However, it was colonialism and the introduction of a large global commodity market, mostly managed by the British Empire with its vast sea power - the Royal Navy.

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

The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms in that country, and this accelerated in 1989 when the country took a generally capitalist approach to developing at least its export economy. By 2000 the PBoC was in all senses a modern central bank, and emerged as such partly in response to the European Central Bank. This is the most modern bank model and was introduced with the Euro to coordinate the European national banks, which continue to separately manage their respective economies.


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