Central bank

From Traderpedia

The primary monetary authority in a country or region (e.g. Euro zone).

A central bank (reserve bank or monetary authority) is an entity responsible for monetary policy of its country (or in the case of the EU, group of member countries). Among its responsibilities are the stability of the national currency and money supply, including interest rates; and acting as a lender of last resort to the banking sector and the national financial system as a whole. 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 Auhority and Monetary Authority of Singapore.

In most countries the central bank is state-owned and has some 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 UK Bank of England (since 1997) and the European Central Bank. The Australian central bank is called the Reserve Bank of Australia which sets interest rate independent of government policy.


[edit] 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 currency exchange rate.

The central bank's main responsibility is the management of monetary policy to ensure a stable economy, including a stable currency. It aims to manage inflation (rising average prices) as well as deflation (falling prices). It is the lender of last resort, and will (at a price) assist banks in cases of financial distress (see also bank runs).

Furthermore, it will hold reserves of foreign currency, usually in the form of sovereign bonds, and gold and have a range of influence over exchange rates. Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float") or (dirty float).

Typically a central bank seeks to impose centralized control over interest rates, the price of credit. These are seen as important, since they influence the stock and fixed income markets as well as mortgages and other credit 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.

[edit] Instruments of monetary policy

[edit] Open Market Operations

With the open market operations, a CB directly influences the money supply in an economy. 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:

  • Lending 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 swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the Chinese Central Bank 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.

[edit] Interest rates

A central bank has several interest rates it can set to influence markes.

  • Marginal Lending Rate (currently 3% in the Eurozone) A fixed rate for institutions to borrow money from the CB.
  • Main Refinancing Rate (2% 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% 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.

[edit] Reserve requirements

Every bank over a minimum size needs to delegate a percentage of its deposits (2% in the Eurozone) 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.

[edit] 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 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". The Fed also auctions off Treasuries.

[edit] 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 the economy in advance of an election, to the detriment of the long-term health of the economy. In addition, it is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect.

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 of the United States|Congress.

[edit] History

One of the oldest banks that performed some of the duties of a central bank was the Bank of Sweden that was opened in 1668 with help from Dutch businessmen. This was followed in 1694 by the Bank of England, created by a businessman in the City of London at the request of the British 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.

[edit] External links