a central bank

8/7/2019 A central bank

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A central bank, reserve bank, or moneauthority is the entity responsible for tmonetary policy of a country or of a group ofmember states. It is a bank that can lend moneyto other banks in times of need.[1] Its primaryresponsibility is to maintain the stability of thenational currency and money supply, but moreactive duties include controlling subsidized-loaninterest rates, and acting as a lender of last resortto the banking sectorduring times of financialcrisis (private banks often being integral to thenational financial system). It may also havesupervisory powers, to ensure that banks andother financial institutions do not beharecklessly or fraudulently.

Most richer countries today have

"independent" central bank, that is, one whichoperates under rules designed to prevepolitical interference. Examples include thEuropean Central Bank(ECB) and the Federal
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Reserve System in the United States. Somecentral banks are publicly owned, and others areprivately owned. For example, the United StatesFederal Reserve is a quasi-public corporation.

Activities and responsibilities

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

implementing monetary policy controlling the nation's entire money supply the Government's banker and the bankers'

bank ("lender of last resort") managing the country's foreign exchange

and gold reservesand the Government's

stock register regulating and supervising the banking

industry setting the official interest rate used to

manage bothinflation and the country'sexchange rate and ensuring that this rate

takes effect via a variety of pomechanisms

Monetary policy
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The Bank of England, central bank of the UnitedKingdom

The ECBbuilding in Frankfurt

Central banks implement a country's chosenmonetary policy. At the most basic level, thisinvolves establishing what form of currency thecountry may have, whether a fiat currency, gold-

backed currency (disallowed for countries withmembership of the IMF), currency board or acurrency union. When a country has its ownnational currency, this involves the issue of
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some form of standardized currency, which isessentially a form ofpromissory note: a promiseto exchange the note for "money" under certaincircumstances. Historically, this was often promise to exchange the money for preciousmetals in some fixed amount. Now, when manycurrencies are fiat money, the "promise to pay"consists of nothing more than a promise to paythe same sum in the same currency.

In many countries, the central bank may useanother country's currency either directly (in acurrency union), or indirectly, by using currency board. In the latter case, local currencyis directly backed by the central bank's holdings

of a foreign currency in a fixed-ratio; mechanism is used, notably, in Bulgaria, HongKong and Estonia.

In countries with fiat money, monetary policymay be used as a shorthand form for the interestrate targets and other active measur

undertaken by the monetary authority.

Currency issuance
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United StatesFederal Reserve

Many central banks are "banks" in the sense thatthey hold assets (foreign exchange, gold, andother financial assets) and liabilities. A central

bank's primary liabilities are the currenoutstanding, and these liabilities are backed bythe assets the bank owns.

Central banks generally earn money by issuingcurrency notes and "selling" them to the publicfor interest-bearing assets, such as governmentbonds. Since currency usually pays no interest,the difference in interest generates incomcalled seigniorage. In most central bankingsystems, this income is remitted to government. The European Central Bank remitsits interest income to its owners, the centralbanks of the member countries of the EuropeanUnion.
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Although central banks generally holdgovernment debt, in some countries toutstanding amount of government debt smaller than the amount the central bank maywish to hold. In many countries, central banksmay hold significant amounts of foreicurrency assets, rather than assets in their ownnational currency, particularly when the nationalcurrency is fixed to other currencies.

Naming of central banks

The People's Bank of China, central bank ofPeople's Republic of China

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

Bank of Canada, Bank of Russia). Some arestyled "national" banks, such as the NationalBank of Ukraine; but the term "national bank" ismore often used by privately-owned commercial
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banks, especially in the United States. In othercases, central banks may incorporate the word"Central" (e.g. European Central Bank, CentralBank of Ireland). The word "Reserve" is alsooften included, such as the Reserve Bank ofAustralia, Reserve Bank of India, Reserve Bankof New Zealand, the South African ReserveBank, and U.S Federal Reserve System. Manycountries have state-owned banks or other quasi-

government entities that have entirely separatefunctions, such as financing imports and exports.

In some countries, particularly in somCommunist countries, the term national bankmay be used to indicate both the monetary

authority and the leading banking entity, such asthe USSR's Gosbank(state bank). In othercountries, the term national bank may be used toindicate that the central bank's goals are broaderthan monetary stability, such as femployment, industrial development, or other

goals.

Interest rate interventions
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Hong Kong Monetary Authority, housed in theInternational Finance Centre, Hong Kong's defacto central bank.

Contrary to popular perception, central banks arenot all-powerful and have limited powers to puttheir policies into effect. Most importantalthough the perception by the public may bethat the "central bank" controls some or allinterest rates and currency rates, economtheory (and substantial empirical evidenceshows that it is impossible to do both at once inan open economy. Robert Mundell's "impossibletrinity" is the most famous formulation of theselimited powers, and postulates that it impossible to target monetary policy (broadly,interest rates), the exchange rate (through a fixed
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rate) and maintain free capital movement. Sincemost Western economies are now considered"open" with free capital movement, thessentially means that central banks may targetinterest rates or exchange rates with credibility,but not both at once.

Even when targeting interest rates, most centralbanks have limited ability to influence the rates

actually paid by private individuals acompanies. In the most famous case of policyfailure, George Sorosarbitraged thepoundsterling's relationship to the ECU and (aftermaking $2 billion himself and forcing the UK tospend over $8bn defending the pound) forced it

to abandon its policy. Since then he has been aharsh critic of clumsy bank policies and arguedthat no one should be able to do what he did.

The most complex relationships are thobetween theyuan and theUS dollar, andbetween theeuro and its neighbours. The

situation in Cuba is so exceptional as to requirethe Cuban peso to be dealt with simply as anexception, since the United States forbids directtrade with Cuba. US dollars were ubiquitous in
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Cuba's economy after its legalization in 1991,but were officially removed from circulation in2004 and replaced by the convertible peso.

Policy instruments

The main monetary policy instruments availableto central banks are open market operation, bankreserve requirement, interest rate policy, re-lending and re-discount (including using theterm repurchase market), and credit policy (oftencoordinated with trade policy). While capitaladequacy is important, it is defined aregulated by theBank for InternationalSettlements, and central banks in practigenerally do not apply stricter rules.

To enable open market operations, a centralbank must holdforeign exchange reserves(usually in the form ofgovernment bonds) andofficial gold reserves. It will often have someinfluence over any official or mandat

exchange rates: Some exchange rates armanaged, some are market based (free float) andmany are somewhere in between ("managedfloat" or "dirty float").
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Interest rates

By far the most visible and obvious power of

many modern central banks is to influemarket interest rates; contrary to popular belief,they rarely "set" rates to a fixed nuAlthough the mechanism differs from country tocountry, most use a similar mechanism based ona 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) isgenerally to lend money or borrow money intheoretically unlimited quantities, until thtargeted market rate is sufficiently close to thetarget. Central banks may do so by lendingmoney to and borrowing money from (takingdeposits from) a limited number of qualifiedbanks, or by purchasing and selling bonds. As anexample of how this functions, the Bank ofCanada sets a target overnight rate, and a band

of plus or minus 0.25%. Qualified banks borrowfrom each other within this band, but neverabove or below, because the central bank willalways lend to them at the top of the band, and
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take deposits at the bottom of the band; inprinciple, the capacity to borrow and lend at theextremes of the band are unlimited.[3] Othercentral banks use similar mechanisms.

It is also notable that the target rategenerally short-term rates. The actual rate thatborrowers and lenders receive on the market willdepend on (perceived) credit risk, maturity and

other factors. For example, a central bank mightset a target rate for overnight lending of 4.5%,but rates for (equivalent risk) five-year bondsmight be 5%, 4.75%, or, in cases ofinvertedyield curves, even below the short-term rate.Many central banks have one primary "headline"

rate that is quoted as the "central bank rate." Inpractice, they will have other tools and rates thatare used, but only one that is rigorously targetedand enforced.

"The rate at which the central bank lends moneycan indeed be chosen at will by the central bank;

this is the rate that makes the finheadlines." - Henry C.K. Liu. Liu explfurther that "the U.S. central-bank lending rate isknown as the Fed funds rate. The Fed sets a
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target for the Fed funds rate, which its OpenMarket Committee tries to match by lending orborrowing in the money market ... a fiat moneysystem set by command of the central bank. TheFed is the head of the central-bank because theU.S. dollar is the key reserve currency international trade. The global money market isa USA dollar market. All other currenmarkets revolve around the U.S. dollar market."

Accordingly the U.S. situation is not typical ofcentral banks in general.

A typical central bank has several interest ratesor monetary policy tools it can set to influencemarkets.

Marginal lending rate (currently 1.75% inthe Eurozone) a fixed rate for institutionsto borrow money from the central bank. (Inthe USA this is called the discount rate).

Main refinancing rate (1.00% in theEurozone) the publicly visible interest rate

the central bank announces. It is also knownas minimum bid rate and serves as a biddingfloor for refinancing loans. (In the USA thisis called the federal funds rate).
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Deposit rate(0.25% in the Eurozone) therate parties receive for deposits at the centralbank.

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

Open market operations

Through open market operations, a central bank

influences the money supply in an economydirectly. Each time it buyssecurities,exchanging money for the security, it raises themoney supply. Conversely, selling of securitieslowers the money supply. Buying of securitiesthus amounts to printing new money w

lowering supply of the specific security.

The main open market operations are:

Temporary lending of money forcollateralsecurities ("Reverse Operations" or"repurchase operations", otherwise known

as the "repo" market). These operations arecarried out on a regular basis, where fixedmaturity loans (of 1 week and 1 month forthe ECB) are auctioned off.
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Buying or selling securities ("directoperations") on ad-hoc basis.

Foreign exchange operations such as forexswaps.

All of these interventions can also influence theforeign exchange market and thus the exchangerate. For example the People's Bank of Chinaand the Bank of Japan have on occasion bought

several hundred billions ofU.S. Treasuries,presumably in order to stop the decline of theU.S. dollarversus the renminbi and the yen.

Capital requirements

All banks are required to hold a cpercentage of their assets as capital, a rate whichmay be established by the central bank or the
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banking supervisor. For international banksincluding the 55 member central banks of theBank for International Settlements, the thresholdis 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such asgovernment bonds) are considered to have lowerrisk and are either partially or fully excludedfrom total assets for the purposes of calculatingcapital adequacy. Partly due to concerns about

asset inflation and repurchase agreements,capital requirements may be considered moreeffective than deposit/reserve requirements inpreventing indefinite lending: when at tthreshold, a bank cannot extend another loanwithout acquiring further capital on its balance

sheet.

Reserve requirements

In practice, many banks are required to hold apercentage of their deposits as reserves. Suchlegal reserve requirements were introduced inthe nineteenth century to reduce the risk of
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banks overextending themselves and sufferingfrom bank runs, as this could lead to knock-oneffects on other banks.See also moneymultiplier, Ponzi scheme. As the early 20thcentury gold standard and late 20th centurydollar hegemony evolved, and as banksproliferated and engaged in more compltransactions and were able to profit fdealings globally on a moment's notice, these

practices became mandatory, if only to ensurethat there was some limit on the ballooning ofmoney supply. Such limits have become harderto enforce. The People's Bank of China retains(and uses) more powers over reserves becausethe yuan that it manages is a non-convertible

currency.

Even if reserves were not a legal requirement,prudence would ensure that banks would hold acertain percentage of their assets in the form ofcash reserves. It is common to think

commercial banks as passive receivers deposits from their customers and, for manypurposes, this is still an accurate view.
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This passive view of bank activity is misleadingwhen it comes to considering what determinesthe nation's money supply and credit. Loactivity by banks plays a fundamental role indetermining the money supply. The central-bankmoney after aggregate settlement - final money -can take only one of two forms:

physical cash, which is rarely used

wholesale financial markets, central-bank money.

The currency component of the money supply isfar smaller than the deposit componeCurrency and bank reserves together make upthe monetary base, called M1 and M2.

Exchange requirementsTo influence the money supply, some centralbanks may require that some or all foreignexchange receipts (generally from exports) be
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capital markets. For example, a central bankmay regulate margin lending, wherebyindividuals or companies may borrow againstpledged securities. The margin requiremenestablishes a minimum ratio of the value of thesecurities to the amount borrowed.

Central banks often have requirements for thequality of assets that may be held by financial

institutions; these requirements may act as alimit on the amount of risk and leverage createdby the financial system. These requirements maybe direct, such as requiring certain assets to bearcertain minimum credit ratings, or indirect, bythe central bank lending to counterparties only

when security of a certain quality is pledged ascollateral.

Examples of use

The People's Bank of China has been forced intoparticularly aggressive and differentiating tacticsby the extreme complexity and rapid expansionof the economy it manages. It imposed some
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absolute restrictions on lending to speciindustries in 2003, and continues to require 1%more (7%) reserves from urban banks (typicallyfocusing on export) than rural ones. This is notby any means an unusual situation. The USAhistorically had very wide ranges of reserverequirements between its dozen branchesDomestic development is thought to optimized mostly by reserve requirements rather

than by capital adequacy methods, since theycan be more finely tuned and regionally varied.

Banking supervision and other activities

In some countries a central bank through itssubsidiaries controls and monitors the bankingsector. In other countries banking supervision iscarried out by a government department such as


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runaway lending bubbles based on a single pointof failure, the credit culture of the few largebanks.

Independence

Over the past decade, there has been a trendtowards increasing the independence of centralbanks as a way of improving long-teconomic performance. However, while a largevolume of economic research has been done todefine the relationship between central bankindependence and economic performance, theresults are ambiguous.

Advocates of central bank independence argue

that a central bank which is too susceptible topolitical direction or pressure may encourageeconomic cycles ("boom and bust"), aspoliticians may be tempted to boost economicactivity in advance of an election, to detriment of the long-term health of

economy and the country. In this conindependence is usually defined as the centralbanks operational and managementindependence from the government.
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The literature on central bank independence hasdefined a number of types of independence.

Legal independenceThe independence of the central bank isenshrined in law. This type of independenceis limited in a democratic state; in almost allcases the central bank is accountable atsome level to government officials, either

through a government minister or directly toa legislature. Even defining degrees of legalindependence has proven to be a challengesince legislation typically provides only aframework within which the governmenand the central bank work out t

relationship.

Goal independence

The central bank has the right to set its ownpolicy goals, whether inflation targetingcontrol of the money supply, or maintaininga fixed exchange rate. While this type ofindependence is more common, many


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central banks prefer to announce their policygoals in partnership with the appropriategovernment departments. This increases thetransparency of the policy setting processand thereby increases the credibility of thegoals chosen by providing assurance thatthey will not be changed without notice. Inaddition, the setting of common goals by thecentral bank and the government helps to

avoid situations where monetary and fiscalpolicy are in conflict; a policy combinationthat is clearly sub-optimal.

Operational independence

The central bank has the independence to

determine the best way of achieving itspolicy goals, including the types instruments used and the timing of their use.This is the most common form of central


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It is argued that an independent central bank canrun a more credible monetary policy, makingmarket expectations more responsive to signalsfrom the central bank. Recently, both the Bankof England (1997) and the European CentralBank have been made independent and follow aset of published inflation targets so that marketsknow what to expect. Even the People's Bank ofChina has been accorded great latitude due to

the difficulty of problems it faces, though in thePeople's Republic of China the official role ofthe bank remains that of a national bankratherthan a central bank, underlined by the officialrefusal to "unpeg" the yuan or to revalue it"under pressure". The People's Bank of China's

independence can thus be read more independence from the USA which rules thefinancial markets, than from the CommunistParty of China which rules the country. The factthat the Communist Party is not elected alsorelieves the pressure to please people, increasing

its independence.

Governments generally have some degree ofinfluence over even "independent" centrabanks; the aim of independence is primarily to
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prevent short-term interference. For example,the chairman of the U.S. Federal Reserve Bankis appointed by the President of the U.S. (allnominees for this post are recommended by theowners of the Federal Reserve, as are all theboard members), and his choice must confirmed by the Congress.

International organizations such as the World

Bank, the BIS and the IMF are strong supportersof central bank independence. This results, inpart, from a belief in the intrinsic merits ofincreased independence. The support foindependence from the internationalorganizations also derives partly from th

connection between increased independence forthe central bank and increased transparency inthe policy-making process. The IMFs FSAPreview self-assessment, for example, includes anumber of questions about central baindependence in the transparency section. An

independent central bank will score higher in thereview than one that is not independent.
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History

In Europe prior to the 17th century most moneywas commodity money, typically gold or silver.However, promises to pay were wide

circulated and accepted as value at least fivehundred years earlier in both Europe and Asia.The medieval European Knights Templarranprobably the best known early prototype of a
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central banking system, as their promises to paywere widely regarded, and many regard theiractivities as having laid the basis for the modernbanking system. At about the same time, KublaiKhan of the Mongols introduced fiat currency toChina, which was imposed by force by theconfiscation ofspecie.

The oldest central bank in the world is the

Riksbankin Sweden, which was opened in 1668with help from Dutch businessmen. This wasfollowed in 1694 by theBank of England,created by Scottish businessmanWilliamPaterson in the City of London at the request ofthe English government to help pay for a war.

Although central banks are generally associatedwith fiat money, under the international goldstandard of the nineteenth and early twentiethcenturies central banks developed in most ofEurope and in Japan, though elsewhere freebanking orcurrency boards were more usual at

this time. Problems with collapses of banksduring downturns, however, was leading wider support for central banks in those nations
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which did not as yet possess them, most notablyin Australia.

With the collapse of the gold standard afterWorld War II, central banks became much morewidespread. The US Federal Reservewascreated by theU.S. Congress through thepassing of theGlass-Owen Bill, signed byPresident Woodrow Wilson on December 23,

1913, whilst Australia established its first centralbank in 1920, Colombia in 1923, Mexico andChile in 1925 and Canada and New Zealand inthe aftermath of the Great Depression in 1934.By 1935, the only significant indepedent nationthat did not possess a central bank was Brazil,

which developed a precursor thereto in 1945 andcreated its present central bank twenty yearslater. When African and Asian countries gainedindependence, all of them rapidly establishedcentral banks or monetary unions.

The People's Bank of China evolved its role as a

central bank starting in about 1979 with theintroduction of market reforms in that country,and this accelerated in 1989 when the countrytook a generally capitalist approach
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This expansion of credit causes an expansion ofthe supply of money, through themoneycreation process in a fractional reserve bankingsystem. This in turn leads to an unsustainable"monetary boom" during which the "artificiallystimulated" borrowing seeks out diminishinginvestment opportunities. This boom results inwidespread malinvestments, causingcapitalresources to be misallocated into areas

would not attract investment if the money supplyremained stable. A correction or "creditcrunch" commonly called a "recession" or"bust" occurs when credit creation cannot besustained. Then the money supply suddenly andsharply contracts when markets finally "clear",

causing resources to be reallocated back towardsmore efficient uses. The main proponents of theAustrian business cycle theory historically wereLudwig von Mises and Friedrich Hayek. F.A.Hayek won the Nobel Prize in economics in1974 based on his elaborations on this theory.

Hayek claimed that: The past instability of themarket economy is the consequence of

exclusion of the most important regulator of themarket mechanism, money, from itself bein
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regulated by the market process. In accordancewith arguments outlined in his essay The Use ofKnowledge in Society, he argued thatmonopolistic governmental agency like a centralbank can neither possess the relevainformation which should govern supply money, nor have the ability to use it correctly.
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a central bank

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