Central Banking - Modern Banking

Though most central banks began life as commercial banks with responsibility for special tasks (such as note issue), the modern central bank is a government institution and does not compete with banks operating in the private banking sector. Two key debates dominate the central banking literature. The first relates to the functions of the central bank, the second to the degree of autonomy enjoyed by it.

Modern central banks are normally responsible for monetary control and, in addition, may be involved in prudential regulation and placing government debt on the most favourable terms possible. These three functions are now considered in more detail.

Monetary Control or Price Stability

A country’s money supply is defined as currency in circulation outside the banking system plus deposits held at banks. Banks play an important role in creating money, but so does the central bank. Banks create money by lending out deposits, hence their activities can affect the central bank. The traditional methods for controlling the money supply include the following.

  1. Open market operations: traditionally, this was done by buying and selling gilts (UK government Treasury bills) but since 1996, the Bank of England has also used gilt repos, i.e., a gilt sale and repurchase agreement – the Bank of England sells a gilt with an agreement to buy back the gilt at a specified date, at an agreed rate of interest.
  2. Buying or selling securities in the financial market: this causes the monetary base (the quantity of notes and coins in circulation plus the quantity held by the banking system) to be affected. For example, if the Bank of England prints new money to purchase government securities (a Treasury bill or more recently a repo), then the monetary base will increase. Most of it will be deposited in the banking system, which the commercial banks, in turn, lend out. Or, if the bank sells government securities, the monetary base is reduced.
  3. Reserve ratios: in some countries, banks are required to hold a certain fraction of deposits as cash reserves, and the central bank can influence the money supply. If the reserve ratio is raised, it means banks have to reduce their lending, so the money supply is reduced. This method was standard procedure until the 1980s, and was designed to encourage banks to reduce their amount of credit. In most western countries, the reserve ratio is no longer used as a key monetary tool. For example, in the UK, the reserve ratio in 1971 was 12.5% but in 1981, the government abandoned its use as a means of controlling the growth of credit. It was replaced by a cash ratio, the sole purpose of which is to finance the operations of the Bank of England, and that is currently 0.15% of eligible liabilities for all credit UK institutions.
  4. Discount rate: the rate charged to commercial banks when they want to borrow money from the central bank. Again, by raising the discount rate above the general market interest rate, it is more expensive for commercial banks to borrow in the event that withdrawals suddenly rise. The banks hold more cash in reserves to avoid the ‘‘penal rate’’, which again reduces the money supply because it means fewer deposits are loaned out.

Thus, a central bank can stabilise the price level by the exercise of monetary policy, through control of the money supply and/or the use of interest rates. By the late 1970s and early 1980s, many governments singled out price stability as the key objective of the central bank. Some central banks were given a zero inflation target, or more commonly a range of acceptable inflation rates. For example, in the UK, the Bank of England, through its powerful Monetary Policy Committee, is required to exercise monetary control to meet an inflation rate target of 2.5% plus or minus 1%. Some bank governors (e.g., New Zealand) have their salaries and even job renewal dependent upon their success in meeting targets.

A simplified version of the monetarist version of the link between the money supply and inflation is summarised as follows:

simplified version of the monetarist version

where p̂is the rate of inflation, i.e., the rate of change in the price level over a given period of time (month, year), MS^ is the rate of growth in the money supply, where the money supply can be defined as ‘‘narrow’’ money (e.g., cash + sight deposits at banks) or ‘‘broad’’ money (narrow money + time deposits, CDs, etc.), and ŷ is the rate of growth of real output (e.g., real GNP).

According to this simple equation, if the money supply growth rate exceeds the growth rate of national output, then inflation results. The version can be made more complex by, for example, adding the velocity of money (the number of times money turns over in a given year), but the above is a fairly good representation of the basic ideas. In the 1980s, most countries tried to target the money supply growth rate to match the growth rate in output, but when this largely failed to control inflation, policymakers switched their focus to the interest rate. If the central bank believes the economy is beginning to overheat or will do so in the near future, it will raise a base interest rate, or reduce rates if it concludes the opposite. The change in the base rate is expected to be passed on, via the banking system, to consumers and producers, in the form of higher retail and wholesale rates. By raising (lowering) the interest rate, aggregate demand is reduced (raised) which, in turn, reduces/raises the rate of inflation.

It is fairly straightforward to extend this simple model to include exchange rates. Defineê> 0 as the rate of depreciation in a country’s exchange rate. Then:

rate of depreciation in a country’s exchange rate

where P̂> 0 is the rate of inflation for a country’s major trading partners. The home country’s exchange rate will depreciate if the rate of inflation at home is greater than the rate of inflation for the country’s major trading partners. Also, if exchange rates are fixed between countries, then ê = 0 and all these countries must follow the same monetary policy, to produce identical inflation rates and ensure a fixed exchange rate. If one country’s inflation rate (e.g., Ireland) is higher than those of the other country’s, either Ireland will have to do something to remedy its inflation rate, or the other countries will have to raise theirs, since the exchange rate between these countries is fixed. This issue is at the heart of the debate about the UK joining the euro. If it were to do so, responsibility for monetary policy would shift from a directly elected government (delegated to an ‘‘independent’’ Bank of England) and would be set by the European Central Bank (ECB).

It must be stressed that the methods for controlling the money supply described above have been largely abandoned by countries in the developed world. In its place, most central banks have a committee that meets on a regular basis and decides what interest rate should be set to ensure the country’s inflation rate meets some government target. Any change in the interest rate should affect aggregate demand, which in turn will keep inflation in check. For example, if a central bank announces a lower rate, it signals that it is trying to raise demand, in order to keep the inflation rate from falling below the set target. Targeting the money supply growth rate is no longer fashionable, though in some countries, notably Japan, it continues, but in addition to setting interest rates to control demand.

Prudential Control

The central bank (or another government institution – see below) is expected to protect the economy from suffering the effects of a financial crisis. It is widely accepted that the banking system has a unique position in the national economy. A widespread collapse can lead to a decline in the intermediation, money transmission and liquidity services supplied by banks, which will, in turn, contribute to an inefficient allocation of resources in the economy. There are additional macroeconomic ramifications if there is a continuous reduction in the money supply growth rate or rise in interest rates.

A bank run begins when customers withdraw their deposits because they fear the bank will fail. Immediately, the bank finds it is unable to supply one of its key services: liquidity. The banking system is particularly vulnerable to contagion effects: a lack of confidence associated with one poorly performing bank spreads to other, healthy, banks because agents know that once a run on deposits begins, liquidated bank assets will decline in value, so everyone will want to withdraw their deposits before the run gains any momentum. In the absence of perfect information about the quality of each bank, the sudden collapse of one bank often prompts runs on other, healthy, banks.

The vulnerability of banks to contagion creates systemic risk: the risk that the economic system will break down as a result of problems in the banking sector. To expand on this theme, disturbances in a financial institution or market could spread across the financial system, leading to widespread bank runs by wholesale and retail depositors, and possibly collapse of the banking system. This will severely hamper money transmission which, in the extreme, could cause a breakdown in the economy as it reverts to barter exchange.

The threat of contagion and systemic risk has meant governments are inclined to treat banks as special and to provide, through the central bank, lender of last resort or lifeboat facilities. By acting as lender of last resort, a central bank can supply liquidity to solvent banks threatened by contagion effects. Increasingly, central banks have pressured healthy banks to assist the bailout of troubled banks – known as a lifeboat rescue operation. If the central bank intervenes to assist weak or failing banks, it will be concerned as to how these banks are regulated and supervised because of the moral hazard that inevitably arises when private institutions know they have a chance of being bailed out by government funds if they encounter difficulties. Some central banks operate a ‘‘too big to fail’’ policy, whereby large banks are bailed out but smaller ones are left to collapse.

Government Debt Placement

If a central bank has this responsibility, it is expected to place government debt on the most favourable terms possible. Essentially, a government can instruct the central bank to raise seigniorage income through a variety of methods, which include a reserve ratio (requiring banks to set aside a certain percentage of their deposits as non-interest earning reserves held at the central bank – an implicit tax), interest ceilings, issuing new currency at a rate of exchange that effectively lowers the value of old notes, subsidizing loans to state owned enterprises and/or allowing bankrupt state firms that have defaulted (or failed to make interest payments) on their loans to continue operating. Or, the inflationary consequences of an ongoing liberal monetary policy will reduce the real value of government debt.

This third objective is important in emerging markets, but by the close of the 20th century has become less critical than the other two functions in the industrialised world, where policies to control government spending means there is less government debt to place. A notable recent exception is Japan, where the debt to GDP ratio is 145 and rising (2002 figures). In emerging markets, central banks are usually expected to fulfil all three objectives – ensuring financial and price stability, and assisting the government in the management of a sizeable government debt. While all three are critical for the development of an efficient financial system, the central banks of these countries face an immense task, which they are normally poorly equipped to complete because of inferior technology and chronic shortages of well-trained staff.

The Bank of England had a long tradition of assuming responsibility for all three functions, but in 1997 the Chancellor of the Exchequer announced the imminent separation of the three functions, leaving the Bank of England with responsibility over monetary policy the FSA44 regulates financial institutions, including consumer protection and prudential control of the banking sector. The Japanese government created the Financial Supervisory Agency in 1997, to supervise banks and other financial institutions. Part of the Prime Minister’s office, this Agency has taken over the job previously undertaken by the Ministry of Finance and Banking of Japan.

The United States assigns responsibility for prudential regulation to several organizations including the Federal Reserve, Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Federal Reserve also sets an independent monetary policy. Until France became part of Euroland, the 20 000 plus employees of the Banque du France played a dual role: implementing monetary policy and regulating/supervising the banking system. In Germany, since the advent of the euro, the Bundesbank has lost its raison d’ˆetre, and has lobbyied hard to assume a regulatory role.

There are potential conflicts if one institution is responsible for the three objectives of price stability, prudential regulation and government debt placement. Given the inverse relationship between the price of bonds and interest rates, a central bank with control over government debt policy might be tempted to avoid raising interest rates (to control inflation) because it would reduce the value of the bank’s debt portfolio. Or, it might increase liquidity to ease the placement of government debt, which might put it at odds with an inflation policy.

Consider a country experiencing a number of bank failures, which, in turn, threaten the viability of the financial system. If the central bank is responsible for the maintenance of financial stability in the economy, it may decide to inject liquidity to try and stem the tide of bank failures. It does this by increasing the money supply and/or reducing interest rates, so stimulating demand. The policy should reduce the number of bankruptcies (personal and corporate), thereby relieving the pressure on the banking system.

However, if the central bank’s efforts to shore up the banking system are prolonged, this may undermine the objective of achieving price stability. Continuous expansionary monetary policy may cause inflation if the rate of growth in the money supply exceeds the rate of growth of national output. The central bank may be faced with a conflict of interest: does it concentrate on the threat to the financial system or is priority given to control of inflation? The dilemma may explain the recent trend to separate them. If the central bank is not responsible for financial stability, it can pursue the objective of price stability unhindered.

Under the Maastricht Treaty (agreed in 1991, signed in 1992), the euro is controlled by the European Central Bank, which has sole responsibility for one goal: price stability.

However, if a central bank is the ultimate source of liquidity it must, even if only indirectly, play a role in the regulation and supervision of banks. Consider the position of the European Central Bank. Suppose Italian banks came under threat after EU citizens moved their deposits to what they perceived to be safer, more efficient banks offering better rates in other member states. The Italian government will have to approach the ECB for an injection of liquidity, which means the ECB will want to be involved in prudential regulation and supervision, even if these functions have been devolved to the ‘‘state’’ central banks.

Canada and the USA are examples of countries with long histories where responsibility for monetary control lies with the Bank of Canada and the Federal Reserve Board, respectively.

As noted above, the supervisory function is shared among several agencies in the USA, including the Federal Reserve. In Canada, the Superintendent of Financial Institutions has responsibility for inspection and regulation. The Bank of Canada is responsible for monetary control. However, in every instance where a bank has been threatened with failure, the Bank of Canada has taken part in the decision about whether it should be supported or allowed to fail. So even in a country where the monetary and supervisory functions are officially separate, the central bank plays a pivotal role in the event of problem banks.

A study by Good hart and Schoenmaker (1995) looked at the arguments for and against the separation of monetary policy from supervision. They could not find overwhelming support for either approach, consistent with their finding that of the 26 countries examined, about 50% assign the functions to separate bodies. Since the research was published, several countries have changed policy and the computations would show the majority separate the two responsibilities. Nonetheless, given the current trends, it is interesting that neither model was found to be superior.

Another key issue is the extent to which central banking is given independence from government. There is a general view that an independent central bank, unfettered by government directives, can better achieve the goal of price stability. For a government, the control of inflation will be one of several macroeconomic objectives; others are unemployment and balance of trade or exchange rate concerns. If a government decides that the rate of unemployment must be brought down because it is unacceptably high, one option is to stimulate the economy through lower interest rates, which, in turn, has implications for future inflation. It is argued that the goal of price stability requires a long term, reputable commitment to monetary control, which is at odds with the short-term concerns of politicians. Inflation targets, etc., are seen as more credible if a central bank, independent of government interference, is given sole responsibility for price stability.

In countries where the central bank is independent, the government cannot use it in the manner described above. Under the 1998 Bank of England Act, the Bank acquired some degree of independence from the Treasury over monetary policy. The Act created the Monetary Policy Committee, consisting of the Governor, two deputies and two senior Bank employees. The Bank does not enjoy full autonomy because the Treasury appoints the four outside experts and approves all members of the Monetary Policy Committee. The target inflation rate (currently 2.5%), which the MPC must meet, is also set by the Treasury. The Governor is obliged to write to the Chancellor of the Exchequer if the target is not met, give or take 1%.

The Bank of Japan Act (April 1998) granted the Bank independence to a degree; it has sole responsibility for ensuring price stability. The Governor, Vice-Governor and Policy Board are appointed by Cabinet, but it cannot dismiss them. The final decision on monetary policy is taken by the Policy Board, though in a country of deflation, it has no inflation targets per se to meet. The once powerful Ministry of Finance and Economic Planning Agency no longer has members on the Policy Board, but their representatives can express opinions at meetings.

Independence is also an issue if a country is committed to a regime of fixed, managed or targeted exchange rates. It is the central bank that buys or sells foreign currency on behalf of a government committed to, say, a quasi-fixed exchange rate, only allowing fluctuation within a narrow band. In this situation, the central bank (or banks) will be trading against the market – trying to restore the value of a currency threatened with depreciation or appreciation. While the central bank or the coordinated efforts of several central banks might be able to stabilise a currency in the short term, the position cannot be sustained indefinitely. Attempts to shore up a currency may also come into direct conflict with monetary policy, as was illustrated earlier. Under a fixed exchange rate regime, the central bank will find its monetary policy is dependent on the monetary regimes (and inflation rates) of other key economies.


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