Central bank

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A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. It is a bank that can lend money to other banks in times of need.[1]

Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

Most richer countries today have an "independent" central bank, that is, one which operates under rules designed to prevent political interference. Examples include the European Central Bank (ECB) and the Federal Reserve System in the United States.

Some central banks are publicly owned, and others are privately owned. For example, the Reserve Bank of India is publicly owned and directly governed by the Indian government.

Another example is the United States Federal Reserve, which is a quasi-public corporation.[2]

The major difference is that government owned central banks do not charge the taxpayers interest on the national currency, whereas privately owned central banks do charge interest.[3]

See also Bank for International Settlements and Federal Reserve.

Contents

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

  • implementing monetary policy
  • controlling the nation's entire money supply
  • the Government's banker and the bankers' bank ("leader of last resort")
  • managing the country's foreign exchange and gold reserves and the Government's stock register
  • regulating and supervising the banking industry
  • setting the official interest rate – used to manage both inflation and the country's exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms

Monetary policy

Central banks implement a country's chosen monetary policy.

At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the IMF), currency board or a currency union.

When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for "money" under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of nothing more than a promise to pay the same sum in the same currency.

In many countries, the central bank may use another country's currency either directly (in a currency union), or indirectly, by using a currency board. In the latter case, local currency is directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this mechanism is used, notably, in Hong Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the interest rate targets and other active measures undertaken by the monetary authority.

Currency issuance

Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold, and other financial assets) and liabilities. A central bank's primary liabilities are the currency outstanding, and these liabilities are backed by the assets the bank owns.

Central banks generally earn money by issuing currency notes and "selling" them to the public for interest-bearing assets, such as government bonds. Since currency usually pays no interest, the difference in interest generates income, called seigniorage. In most central banking systems, this income is remitted to the government. The European Central Bank remits its interest income to its owners, the central banks of the member countries of the European Union.

Although central banks generally hold government debt, in some countries the outstanding amount of government debt is smaller than the amount the central bank may wish to hold. In many countries, central banks may hold significant amounts of foreign currency assets, rather than assets in their own national currency, particularly when the national currency is fixed to other currencies.

Naming of central banks

There is no standard terminology for the name of a central bank, but many countries use the "Bank of Country" form (e.g., Bank of England, Bank of Canada, Bank of Russia).

Some are styled "national" banks, such as the National Bank of Ukraine; but the term "national bank" is more often used by privately-owned commercial banks, especially in the United States.

In other cases, central banks may incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland).

The word "Reserve" is also often included, such as the Reserve Bank of Australia, Reserve Bank of India, Reserve Bank of New Zealand, the South African Reserve Bank, and U.S Federal Reserve System.

Many countries have state-owned banks or other quasi-government entities that have entirely separate functions, such as financing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the USSR's Gosbank (state bank).

In other countries, the term national bank may be used to indicate that the central bank's goals are broader than monetary stability, such as full employment, industrial development, or other goals.

Interest rate interventions

Typically a central bank controls certain types of short-term interest rates. These influence the stock and bond markets as well as mortgage and other interest rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council; in the case of the Federal Reserve, the Board of Governors.

Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Fed, they are the local Federal Reserve Banks; for the ECB they are the national central banks.

Limits of enforcement power

Contrary to popular perception, central banks are not all-powerful and have limited powers to put their policies into effect.

Most importantly, although the perception by the public may be that the "central bank" controls some or all interest rates and currency rates, economic theory (and substantial empirical evidence) shows that it is impossible to do both at once in an open economy.

Robert Mundell's "impossible trinity" is the most famous formulation of these limited powers, and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain free capital movement.

Since most Western economies are now considered "open" with free capital movement, this essentially means that central banks may target interest rates or exchange rates with credibility, but not both at once.

Even when targeting interest rates, most central banks have limited ability to influence the rates actually paid by private individuals and companies. In the most famous case of policy failure, George Soros arbitraged the pound sterling's relationship to the European Currency Unit (ECU) and (after making $2 billion himself and forcing the UK to spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies and argued that no one should be able to do what he did.

The most complex relationships are those between the Renminbi (yuan) and the US dollar, and between the euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially removed from circulation in 2004 and replaced by the convertible peso.

Policy instruments

The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves (usually in the form of government bonds) and official gold reserves. It will often have some influence over any official or mandated exchange rates: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest rates

By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited.[1] Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.

"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.[2] Liu explains further that "the U.S. 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 because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of central banks in general.

A typical central bank has several interest rates or monetary policy tools it can set to influence markets.

  • Marginal lending rate (currently 1.75% in the Eurozone) – a fixed rate for institutions to borrow money from the central bank. (In the USA this is called the discount rate).
  • Main refinancing rate (1.00% in the Eurozone) – 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 USA this is called the federal funds rate).
  • Deposit rate (0.25% in the Eurozone) – the rate parties receive for deposits at the central bank.

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

Open market operations

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:

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.

Capital requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Reserve requirements

In practice, many banks are required to hold a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th century gold standard and late 20th century dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China retains (and uses) more powers over reserves because the yuan that it manages is a non-convertible currency.

Even if reserves were not a legal requirement, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. It is common to think of commercial banks as passive receivers of deposits from their customers and, for many purposes, this is still an accurate view.

This passive view of bank activity is misleading when it comes to considering what determines the nation's money supply and credit. Loan activity by banks plays a fundamental role in determining the money supply. The central-bank money after aggregate settlement - final money - can take only one of two forms:

  • physical cash, which is rarely used in wholesale financial markets,
  • central-bank money.

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.

Exchange requirements

To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

Margin requirements and other tools

In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.

Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral.

Examples of use

The People's Bank of China has been forced into particularly aggressive and differentiating tactics by the extreme complexity and rapid expansion of the economy it manages.

It imposed some absolute restrictions on lending to specific industries in 2003, and continues to require 1% more (7%) reserves from urban banks (typically focusing on export) than rural ones. This is not by any means an unusual situation.

The USA historically had very wide ranges of reserve requirements between its dozen 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.

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 Treasury, 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".

Many countries such as the United States will monitor and control the banking sector through different agencies and for different purposes, although there is usually significant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and other types of financial institutions may be subject to different (and occasionally overlapping) regulation. Some types of banking regulation may be delegated to other levels of government, such as state or provincial governments.

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.

Independence

Over the past decade, there has been a trend towards increasing the independence of central banks as a way of improving long-term economic performance. However, while a large volume of economic research has been done to define the relationship between central bank independence and economic performance, the results are ambiguous.

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 this context, independence is usually defined as the central bank’s operational and management independence from the government.

The literature on central bank independence has defined a number of types of independence.

Legal independence
The independence of the central bank is enshrined in law. This type of independence is limited in a democratic state; in almost all cases the central bank is accountable at some level to government officials, either through a government minister or directly to a legislature. Even defining degrees of legal independence has proven to be a challenge since legislation typically provides only a framework within which the government and the central bank work out their relationship.
Goal independence
The central bank has the right to set its own policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government departments. This increases the transparency of the policy setting process and thereby increases the credibility of the goals chosen by providing assurance that they will not be changed without notice. In addition, the setting of common goals by the central bank and the government helps to avoid situations where monetary and fiscal policy are in conflict; a policy combination that is clearly sub-optimal.
Operational independence
The central bank has the independence to determine the best way of achieving its policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence. The granting of independence to the Bank of England in 1997 was, in fact, the granting of operational independence; the inflation target continued to be announced in the Chancellor’s annual budget speech to Parliament.
Management independence
The central bank has the authority to run its own operations (appointing staff, setting budgets, etc) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence. One of the most common statistical indicators used in the literature as a proxy for central bank independence is the “turn-over-rate” of central bank governors. If a government is in the habit of appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the central bank through its choice of governors.

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 (1997) 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 the People's Republic of 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". The People's Bank of China's independence can thus be read more as independence from the USA which rules the financial markets, than from the Communist Party of China which rules the country. The fact that the Communist Party 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. (all nominees for this post are recommended by the owners of the Federal Reserve, as are all the board members), and his choice must be confirmed by the Congress.

International organizations such as the World Bank, the BIS and the IMF are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence. The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and increased transparency in the policy-making process.

The IMF’s FSAP review self-assessment, for example, includes a number of questions about central bank independence in the [[transparency] section. An independent central bank will score higher in the review than one that is not independent.

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 of the Mongols introduced fiat currency to China, which was imposed by force by the confiscation of specie.

The oldest central bank in the world is the Sveriges Riksbank in 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.

Although central banks are generally associated with fiat money, under the international gold standard of the nineteenth and early twentieth centuries central banks developed in most of Europe and in Japan, though elsewhere free banking or currency board]s were more usual at this time. Problems with collapses of banks during downturns, however, was leading to wider support for central banks in those nations which did not as yet possess them, most notably in Australia.

With the collapse of the gold standard after World War II, central banks became much more necessary and widespread. 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, whilst Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of the Great Depression in 1934.

By 1935, the only significant indepedent nation that did not possess a central bank was Brazil which developed a precursor thereto in 1945 and created its present central bank twenty years later. When African and Asian countries gained independence, all of them rapidly established central banks or monetary unions.

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 People's Bank of China 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 other than currency exchange and base interest rates.

Criticism

According to the Austrian School of Economics, central banking is responsible for the cause of the boom bust economic cycle because central banks set interest rates too low and cause inflation.

According to the Austrian Business Cycle Theory, the business cycle unfolds in the following way.

Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system.

This in turn leads to an unsustainable "monetary boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable.

A correction or "credit crunch" commonly called a "recession" or "bust" occurs when credit creation cannot be sustained.

Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. F.A. Hayek won the Nobel Prize in economics in 1974 based on his elaborations on this theory. (Questions about American History You're Not Supposed to Ask, Woods, Jr., Thomas, 2007, Crown Forum, isbn=978-0-307-34668-1)

Hayek claimed that: The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process. In accordance with arguments outlined in his essay "The Use of Knowledge in Society, he argued that monopolistic governmental agency like a central bank can neither possess the relevant information which should govern supply of money, nor have the ability to use it correctly. ("The Collected Works of F.A. Hayek" , Hayek, Friedrich, 1989, University of Chicago Press, isbn=9780226320977)

Demurrage currencies provide an alternative and perhaps complementary means towards central banking's goal of sustaining economic growth with different specific characteristics and a mechanism that follows naturally from the use of commodity currencies, is more uniform in operation, does not devalue the currency unit, and is more predictable and potentially more decentralized in its operation. Historically, the idea of demurrage influenced John Maynard Keynes' prescription for net-inflationary central bank policy.

References


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