Central bank

The ECB building in Frankfurt

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, such as the European Union. 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 "bailout" 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. A central bank is usually headed by a Governor, President in the case of the European Central Bank or Chief Executive/Managing Director in the case of Hong Kong Monetary Authority and Monetary Authority of Singapore.

In most countries the central bank is state-owned and has a minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. An "independent central bank" is one which operates under rules designed to prevent political interference; examples include the US Federal Reserve, the Bank of England (since 1997), the Reserve Bank of India (1935), the Bank of Mexico (1993), the Bank of Japan, the Bank of Canada, the Reserve Bank of Australia and the European Central Bank.

Activities and responsibilities

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

• monopoly on the issue of banknotes
• the Government's banker and the bankers' bank ("Lender of Last Resort")
• manages the country's foreign exchange and gold reserves and the Government's stock register;
• regulation and supervision of 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

Central vs. national

Any central bank's main responsibility is the management of monetary policy to ensure a stable currency. This is distinct from the goal of a national bank which is to ensure a stable domestic economy. Some central banks, notably the People's Bank of China, clearly and explicitly declare themselves to be national banks. Others, notably the US Federal Reserve System officially do not. In fact the distinction is subtle everywhere except the US, Euroland, and countries with non-convertible currency (including China but also Cuba, North Korea, Vietnam and others). These latter are exceptions because no one else is using their currency, and accordingly managing the currency is managing the economy, more or less exactly. The EU is an exception since many countries share one currency and are only slowly coming together into a common economy, and many historically national banks cooperate in the European Central Bank, a single central bank. The US is unique because, since the Bretton Woods system and the gold standard collapsed in 1971, the US dollar has been a fiat currency and a reserve currency for the entire world, defined as all oil purchasers, who cannot purchase oil without acquiring any US$ - this so-called dollar hegemony means that managing the US dollar therefore not only affects the US economy but all economies. Pressures to contain US dollar inflation tend to be severe, as it is virtually impossible for other countries (who must buy US$ at least for oil) to avoid also having inflation when the US does.

Most day to day functions of a central or national bank are the same. Either a central or national bank is the lender of last resort, and will (at a price) assist banks in cases of financial distress (preventing or stopping bank runs). Unlike a national bank, a central bank usually quite narrowly aims to manage inflation (rising average prices) as well as deflation (falling prices), and intervenes primarily through open market operations in which it achieves its monetary targets by massive buying or selling, rather than by regulations. A national bank will have more mechanisms to deal with asset inflation, regional development, and to require that sustainable development, an industrial policy, or domestic-focused industries are favoured. A national bank is rarely separate from its government, and will be criticized by the government's critics.

Though they are more constrained in using them, central banks usually retain the full range of instruments of national banks, whether they consider themselves to be managing the currency, or the country.

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.

Interest rate interventions are the most common and are dealt with in more detail below.

Limits of enforcement power

Contrary to popular perceptions, central banks are not all-powerful and have limited powers to put their policies into effect. Even the US must engage in buying and selling to meet its targets. In the most famous case of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and (after making $2B himself and forcing the UK to spend over $8B 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 in fact 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 US forbids direct trade with Cuba but US$ are ubiquitous in its economy.

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 even more important, it is defined and regulated by the Bank for International Settlements, and central banks in practice 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").

Capital requirements

All banks are required to hold a certain percentage of their assets as capital. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords). Partly due to concerns about asset inflation and term repurchase agreements, and difficulties in measuring liabilities as accurately as pricing assets, capital requirements are 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

However, the most fundamental leverage and power central banks hold is their reserve requirements. By requiring that a percentage of liabilities be held as cash, absolute limits are set on money supply: When a loan is made between parties, the bank literally must create money. The effects of bank-created money are well understood by economists, but 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 about 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 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 moments' notices, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder however to truly 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 money deposited by commercial banks at the central bank is the real money in the banking system; other versions of what is commonly thought of as 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 amount shown in their bank accounts. But bank accounts record both credit and debits that cancel each other. Only the remaining 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.

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 US 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.

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.

Effectiveness of interest policy

Money can only maintain its buying power when an increase in the money supply is matched by an equavalent increase of the supply of real goods and services. Central Banks often set interest rates at artificially low levels supposedly to stimulate the economy. These low interest rates cause demand for loans to increase excessively and the money supply to expand at a faster rate than the real economy. This results in fast growing amounts of money chasing slowly growing quantities of goods causing the price levels to rise.

Inflationary money such as bankers create from thin air obviously does not increase the real buying power of a country, as their increase of the money supply is not accompanied by an increase of real goods or services. The nominal buying power such money provides to borowers is merely diluted buying power, deluted from the real buying power of someone else. It is indeed buying power stealthy robbed from people having earned theirs through hard labour or in exchange for the delivery of real goods and services. Obviously the stealthly devaluation of peoples' labour and savings progressively discourages producers of real wealth. Eventually they tend to reduce their productive contribution, resulting in slowdown of real growth; just the opposit easy money was supposed to do. So contrary to popular belief excessive money supply can never cause real growth, but merely creates a nominal illusion of progress.

In the end real wealth can only be increased through increasing the availability over real goods and services. And the only way to increase production is by working more or by producing more efficiently. And efficiency can only be increased to any substantial extend through investment in better machines, better techniques or improved infrastructure. Any policy aiming real growth must therefor promote investment and saving, and certainly should never stimulate consumption. Easy money does exactly the opposite: it de-motivates saving, investment and productive contribution, in the long run all slowing down real growth exactly the opposit it was set up to do.

Artificially low intests merely provide artificial borrowing margins creating an illusion of wealth. This easy access to loans is incouraging borrowers to engage in insustainable debt. It temporarily produces an artificial excess of demand over supply, temporarily making everything saleable; from the most obsolete consumer goods to industrial projects whose life-cycle has since long gone by. Artificially low interest rates consequently also tend to immobilise resources in outdated and low-return projects ultimately slowing down productivity gains.

The most devestating effect of easy-money however is that by penalising saving, it stimulates over-consumption, and slows down capital formation; ultimately the indispensable means of all technological progress.

• see: The Path to sustainable Growth. - Lessons from 20 years Growth Differentials in Europe - 2006 - Free Institure for Economic Research.

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

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 (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 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.

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 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.

See also

• List of central banks

External links

Banking Bunkum: A critique of the role of central banks around the world By Henry C K Liu

• http://www.atimes.com/atimes/others/banking-bunkum.html
• http://henryckliu.com/page19.html

• Central Bank Rates Live and current rates of the world's major central banks