A
central bank,
reserve bank, or
monetary authority is a banking institution
granted the exclusive privilege to lend a government its currency.
Like a normal commercial bank, a central bank charges interest on
the loans made to borrowers, primarily the government of whichever
country the bank exists for, and to other commercial banks,
typically as a 'lender of last resort'. However, a central bank is
distinguished from a normal commercial bank because it has a
monopoly on creating the currency of that nation, which is loaned
to the government in the form of legal tender. It is a bank that
can lend money to other banks in times of need. Its primary
function is to provide the nation's
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 United States Federal Reserve
is a quasi-public corporation.
Activities and responsibilities
Functions of a central bank (not all functions are carried out by
all banks):
- implementing monetary policy
- determining Interest rates
- 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 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 Bulgaria
, 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 India
, Reserve Bank of Australia
, 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
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
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
Bank of Israel
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. 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. 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. 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.
As the first public bank to "offer accounts not directlyconvertible
to coin", the
Bank of Amsterdam
established in 1609 is considered to be the "first true central
bank".
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 boards 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
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 independent 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. 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.
Austrians argue that through excessive monetary creation, a Central
bank debases the money supply of a country through the inflationary
cycle. Furthermore, the excessive printing of money is only
valuable to the few private interests immediately in possession of
the newly created currency. Once the excessive currency is in
circulation, it destroys the integrity of the overall money supply,
and the negative implications come to hinder the general public.
Due to the "independent" interests that control a central bank,
corruption and deviant operating can occur. By acting as a "lender
of last resort", a Central bank causes its respective nation of
service to become a debtor entity, and is plunged into an
irreconcilable obligation to repay the loans offered it by the
central bank.
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
Keynes' prescription for net-inflationary central
bank policy.
See also
References
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