You are on page 1of 22


The Reserve Bank of India (RBI) is the central banking institution of India and controls the monetary policy of the Indian rupee. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The share capital was divided into shares of 100 each fully paid which was entirely owned by private shareholders in the beginning.[3] Reserve Bank of India plays an important part in the development strategy of the government. It is a member bank of the Asian Clearing Union. Reserve Bank of India was nationalised in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a term of four years to represent territorial and economic interests and the interests of co-operative and indigenous banks.

The bank was founded in 1935 to respond to economic troubles after the first world war.[4] The Reserve Bank of India was set up on the recommendations of the Royal Commission on Indian Currency and Finance, also known asHiltonYoung Commission.[5] The commission submitted its report in the year 1926, though the bank was not set up for another nine years. The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as to regulate the issue of bank notes, to keep reserves with a view to securing monetary stability in India and generally to operate the currency and credit system in the best interests of the country. The Central Office of the Reserve Bank was initially established in Kolkata, Bengal, but was permanently moved to Mumbai in 1937. The Reserve Bank continued to act as the central bank for

Myanmar till Japanese occupation of Burma and later up to April 1947, though Burma seceded from the Indian Union in 1937. After partition, the Reserve Bank served as the central bank for Pakistan until June 1948 when the State Bank of Pakistan commenced operations. Though originally set up as a shareholders bank, the RBI has been fully owned by the government of India since its nationalization in 1949 Between 1950 and 1960, the Indian government developed a centrally planned economic policy and focused on the agricultural sector. The administration nationalized commercial banks and established, based on the Banking Companies Act, 1949 (later called Banking Regulation Act) a central bank regulation as part of the RBI. Furthermore, the central bank was ordered to support the economic plan with loans. As a result of bank crashes, the reserve bank was requested to establish and monitor a deposit insurance system. It should restore the trust in the national bank system and was initialized on 7 December 1961. The Indian government founded funds to promote the economy and used the slogan Developing Banking. The Government of India restructured the national bank market and nationalized a lot of institutes. As a result, the RBI had to play the central part of control and support of this public banking sector. Between 1969 and 1980, the Indian government nationalized 6 more commercial banks, following 14 major commercial banks being nationalized in 1969 (as mentioned on the RBI website). The regulation of the economy and especially the financial sector was reinforced by the Government of India in the 1970s and 1980s. The central bank became the central player and increased its policies for a lot of tasks like interests, reserve ratio and visible deposits. The measures aimed at better economic development and had a huge effect on the company policy of the institutes. The banks lent money in selected sectors, like agri-business and small trade companies. The branch was forced to establish two new offices in the country for every newly established office in a town. The oil crises in 1973 resulted in increasing inflation, and the RBI restricted monetary policy to reduce the effects. A lot of committees analysed the Indian economy between 1985 and 1991. Their results had an effect on the RBI. The Board for Industrial and Financial

Reconstruction, the Indira Gandhi Institute of Development Research and the Security & Exchange Board of India investigated the national economy as a whole, and the security and exchange board proposed better methods for more effective markets and the protection of investor interests. The Indian financial market was a leading example for so-called "financial repression" (Mackinnon and Shaw). The Discount and Finance House of India began its operations on the monetary market in April 1988; the National Housing Bank, founded in July 1988, was forced to invest in the property market and a new financial law improved the versatility of direct deposit by more security measures and liberalisation. The national economy came down in July 1991 and the Indian rupee was devalued. The currency lost 18% relative to the US dollar, and the Narsimahmam Committee advised restructuring the financial sector by a temporal reduced reserve ratio as well as the statutory liquidity ratio. New guidelines were published in 1993 to establish a private banking sector. This turning point should reinforce the market and was often called neo-liberal. The central bank deregulated bank interests and some sectors of the financial market like the trust and property markets. This first phase was a success and the central government forced a diversity liberalisation to diversify owner structures in 1998. The National Stock Exchange of India took the trade on in June 1994 and the RBI allowed nationalized banks in July to interact with the capital market to reinforce their capital base. The central bank founded a subsidiary companythe Bharatiya Reserve Bank Note Mudran Limitedin February 1995 to produce banknotes. The Foreign Exchange Management Act from 1999 came into force in June 2000. It should improve the foreign exchange market, international investments in India and transactions. The RBI promoted the development of the financial market in the last years, allowed online banking in 2001 and established a new payment system in 20042005 (National Electronic Fund Transfer). The Security Printing & Minting Corporation of India Ltd., a merger of nine institutions, was founded in 2006 and produces banknotes and coins. The national economy's growth rate came down to 5.8% in the last quarter of 20082009 and the central bank promotes the economic development.

CENTRAL BOARD OF DIRECTORS The Central Board of Directors is the main committee of the central bank. The Government of India appoints the directors for a four-year term. The Board consists of a governor, four deputy governors, fifteen directors to represent the regional boards, one from the Ministry of Finance and ten other directors from various fields. GOVERNORS The current Governor of RBI is Duvvuri Subbarao. The RBI extended the period of the present governor up to 2013. There are four deputy governors, currently K. C. Chakrabarty, Subir Gokarn, Anand Sinha and H.R.Khan SUPPORTIVE BODIES The Reserve Bank of India has four regional representations: North in New Delhi, South in Chennai, East in Kolkata and West in Mumbai. The representations are formed by five members, appointed for four years by the central government and servebeside the advice of the Central Board of Directorsas a forum for regional banks and to deal with delegated tasks from the central board. The institution has 22 regional offices. The Board of Financial Supervision (BFS), formed in November 1994, serves as a CCBD committee to control the financial institutions. It has four members, appointed for two years, and takes measures to strength the role of statutory auditors in the financial sector, external monitoring and internal controlling systems. The Tarapore committee was set up by the Reserve Bank of India under the chairmanship of former RBI deputy governor S. S. Tarapore to "lay the road map" to capital account convertibility. The five-member committee recommended a three-year time frame for complete convertibility by 19992000.

On 1 July 2007, in an attempt to enhance the quality of customer service and strengthen the grievance redressal mechanism, the Reserve Bank of India created a new customer service department. OFFICES AND BRANCHES The Reserve Bank of India has 4 zonal offices.[26] It has 19 regional offices at most state capitals and at a few major cities in India. Few of them are located in Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, Chennai, Delhi, Guwahati, Hyderabad, Jaipur, Jammu, Kanpur, Kolkata, Lucknow, Mumbai, Nagpur, Patna, and Thiruvananthapuram. Besides it has 09 sub-offices at Agartala, Dehradun, Gangtok, Kochi, Panaji, Raipur, Ranchi, Shimla and Srinagar. The bank has also two training colleges for its officers, viz. Reserve Bank Staff College at Chennai and College of Agricultural Banking at Pune. There are also four Zonal Training Centres at Belapur, Chennai, Kolkata and New Delhi.

Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank notes of all denominations. The distribution of one rupee notes and coins and small coins all over the country is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank has a separate Issue Department which is entrusted with the issue of currency notes. The assets and liabilities of the Issue Department are kept separate from those of the Banking Department. Originally, the assets of the Issue Department were to consist of not less than two-fifths of gold coin, gold bullion or sterling securities provided the amount of gold was not less than 40 crore (400 million) in value. The remaining threefifths of the assets might be held in rupee coins, Government of India rupee securities, eligible bills of exchange and promissory notes payable in India. Due to the exigencies of the Second World War and the post-war period, these provisions were considerably modified. Since 1957, the Reserve Bank of India is required to maintain gold and foreign exchange reserves of 200 crore (2 billion), of which at least 115 crore (1.15 billion) should be in gold and 85

crore (850 million) in the form of Government Securities.[citation needed] The system as it exists today is known as the minimum reserve system.

The Reserve Bank of India is the main monetary authority of the country and beside that the central bank acts as the bank of the national and state governments. It formulates, implements and monitors the monetary policy as well as it has to ensure an adequate flow of credit to productive sectors. Objectives are maintaining price stability and ensuring adequate flow of credit to productive sectors. The national economy depends on the public sector and the central bank promotes an expansive monetary policy to push the private sector since the financial market reforms of the 1990s. The institution is also the regulator and supervisor of the financial system and prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objectives are to maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public. The Banking Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI) for effective addressing of complaints by bank customers. The RBI controls the monetary supply, monitors economic indicators like the gross domestic product and has to decide the design of the rupee banknotes as well as coins.


The central bank manages to reach the goals of the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

The bank issues and exchanges or destroys currency and coins not fit for circulation. The objectives are giving the public adequate supply of currency of good quality and to provide loans to commercial banks to maintain or improve the GDP. The basic objectives of RBI are to issue bank notes, to maintain the currency and credit system of the country to utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic structure of the country so that it can achieve the objective of price stability as well as economic development, because both objectives are diverse in themselves.

The central bank had to perform a wide range of promotional functions to support national objectives and industries. The RBI faces a lot of inter-sectoral and local inflation-related problems. Some of this problems are results of the dominant part of the public sector.

The RBI is also a banker to the government and performs merchant banking function for the central and the state governments. It also acts as their banker. The National Housing Bank (NHB) was established in 1988 to promote private real estate acquisition.[31] The institution maintains banking accounts of all scheduled banks, too. ==Policy rates and reserve ratios==

Policy rates, Reserve ratios, lending, and deposit rates as of 9th March, 2012 Bank Rate 9.50% Repo Rate 8.50% Reverse Repo Rate 7.50% Cash Reserve Ratio (CRR) 4.75% Statutory Liquidity Ratio (SLR) 24.0% Base Rate 10.00%10.75% Reserve Bank Rate 4% Deposit Rate 8.50%9.25% Bank Rate: RBI lends to the commercial banks through its discount window to help the banks meet depositors demands and reserve requirements. The interest rate the RBI charges the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if it wants to reduce the liquidity and money supply in the system, it will increase the bank rate. As of 13 Feb, 2012 the bank rate was 9.5%. CASH RESERVE RATIO (CRR): Every commercial bank has to keep certain minimum cash reserves with RBI. RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or decrease the reserve requirement depending on whether it wants to affect a decrease or an increase in the money supply. An increase in Cash Reserve Ratio (CRR) will make it mandatory on the part of the banks to hold a large proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply. The current rate is 4.75%. ( As on Date- 9 March, 2012). Statutory Liquidity Ratio (SLR): Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and advances to investment in government and approved securities.

In well-developed economies, central banks use open market operationsbuying and selling of eligible securities by central bank in the money marketto influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the commercial and industrial sectors. In the open money market, government securities are traded at market related rates of interest. The RBI is resorting more to open market operations in the more recent years. GENERALLY RBI USES THREE KINDS OF SELECTIVE CREDIT CONTROLS: 1. Minimum margins for lending against specific securities. 2. Ceiling on the amounts of credit for certain purposes. 3. Discriminatory rate of interest charged on certain types of advances. DIRECT CREDIT CONTROLS IN INDIA ARE OF THREE TYPES: 1. Part of the interest rate structure i.e. on small savings and provident funds, are administratively set. 2. Banks are mandatory required to keep 24% of their deposits in the form of government securities. 3. Banks are required to lend to the priority sectors to the extent of 40% of their advances.


ORGANISATION STRUCTURE : CENTRAL BOARD OF DIRECTORS In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is changed. There are two principal stages of money creation. First, a central bank introduces new money into the economy (termed 'expansionary monetary policy') by purchasing financial assets or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money (i.e. cash plus demand deposits) in the economy so that it is a multiple (known as the money multiplier) of the amount originally created by the central bank. Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6407.3bn in January 2005, to $8318.9bn in January 2009

Central bank is the first source of money supply in the form of currency in circulation. The Reserve Bank of Indian is the note issuing authority of the country. The RBI ensures availability of currency to meet the transaction needs of the economy. The Total Volume of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption. The commercial banks are the second most important sources of money supply. The money that commercial banks supply is called credit money. The process of 'Credit Creation' begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. In fact banks cannot lend the entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Here bank's lend the money and the process of credit creation starts. Suppose there are a number of Commercial Banks in the Banking System Bank 1, Bank 2, Bank 3, & So on. To begin with let us suppose that an individual "A" makes a deposit of Rs. 100 in bank 1. Bank "1" is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate) which is decided by the RBI's Monetary Policy from the deposits made by 'A'. Bank "1" is required to maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable funds of Rs. 95(100 5). Let the Bank "1" lend Rs. 95 to a borrower; say B. the method of lending is the same that is bank 1 opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits & lending, the balance sheet of bank reads as given below:Central bank is the first source of money supply in the form of currency in circulation. The Reserve Bank of Indian is the note issuing authority of the

country. The RBI ensures availability of currency to meet the transaction needs of the economy. The Total Volume of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption. The commercial banks are the second most important sources of money supply. The money that commercial banks supply is called credit money. The process of 'Credit Creation' begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. In fact banks cannot lend the entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Here bank's lend the money and the process of credit creation starts. Suppose there are a number of Commercial Banks in the Banking System Bank 1, Bank 2, Bank 3, & So on. To begin with let us suppose that an individual "A" makes a deposit of Rs. 100 in bank 1. Bank "1" is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate) which is decided by the RBI's Monetary Policy from the deposits made by 'A'. Bank "1" is required to maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable funds of Rs. 95(100 5). Let the Bank "1" lend Rs. 95 to a borrower; say B. the method of lending is the same that is bank 1 opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits & lending The amount advanced to D will return ultimately to the banking system, as described in case of B and the process of deposits and credit creation will continue until the reserve with the banks is reduced to zero. The final picture that would emerge at the end of the process of deposit & credit creation by the banking system is presented in the consolidated balance sheet of all banks are as under:-

The combined Balance sheet of Banks It can be seen from the combined balance sheet that a primary deposits of Rs. 100 in a bank 1 leads to the creation of the total deposit of Rs. 2,000. The combined balance sheet also shows that the banks have created a total credit of Rs. 2,000. And maintained a total cash reserve of Rs.100.Which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks. CONCLUSION:To conclude, we can say that credit creation by banks is one of the important & only sources to generate income. And when the reserve requirement increased by the central bank it would directly affect on the credit creation by bank because then the lendable funds with the bank decreases and vice versa.

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availablity of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States.

Central banks have not always existed. In early economies, governments would supply currency by minting precious metals with their stamp. No matter what the creditworthiness of the government, the worth of the currency depended on the value of its underlying precious metal. A coin was worth its gold or silver content, as it could always be melted down to this. A country's worth and economic clout

was largely to its holdings of gold and silver in the national treasury. Monarchs, despots and even democrats tried to skirt this inviolate law by filing down their coinage or mixing in other substances to make more coins out of the same amount of gold or silver. They were inevitably found out by the traders, money lenders and others who depended on the worth of that currency. This the reason that movies show pirates and thieves biting Spanish dubloons to ascertain the value of their booty and loot. The advent of paper money during the industrial revolution meant that it wasn't too difficult for a country to alter its amount of money in circulation. Instead of gold, all that was needed to produce more banknotes was paper, ink and a printing press. Because of the skepticism of all concerned, paper money was backed by a "promise to pay" upon demand. A holder of a "pound sterling" note of the United Kingdom could actually demand his pound of silver! When gold became the de facto backing of the world's currency a "gold standard" was developed where nations kept sufficient gold to back their "promises to pay" in their national treasuries. The problem with this standard was that a nation's economic health depended on its holdings of gold. When the treasury was bare, the currency was worthless. In the 1800s, even commercial banks in Canada and the United States issued their own banknotes, backed by their promises to pay in gold. Since they could lend more than they had to hold in reserves to meet their depositers demands, they actually could create money. This inevitably led to "runs" on banks when they could not meet their depositers demands and were bankrupt. The same happened to smaller countries. Even the United States Treasury had to be rescued by JP Morgan several times during this period. In the late 1800s and early 1900s, countries legislated their exclusive monopoly to issue currency and banknotes. This was in response to "financial panics" and bank insolvencies. This meant that all currency was issued and controlled by the national governments, although they still maintained gold reserves to support their currencies. Commercial banks still could create money by lending more than their depositors had placed with the bank, but they no longer had the right to issue banknotes. Modern Monetary Policy Modern central banking dates back to the aftermath of great depression of the 1930s. Governments, led by the economic thinking of the great John Maynard

Keynes, realized that collapsing money supply and credit availability greatly contributed to the savagery of this depression. This realization that money supply affected economic activity led to active government attempts to influence money supply through "monetary policy". At this time, nations created central banks to establish "monetary authority". This meant that rather than accepting whatever happened to money supply, they would actively try to influence the amount of money available. This would influence credit creation and the overall level of economic activity. Modern monetary policy does not involve gold to a great extent. In 1968, the United States rescinded its promise to pay in gold and effectively removed itself from the "gold standard". Since then, it has been the job of the Federal Reserve to control the amount of money and credit in the U.S. economy. I doing this, it wants to maintain the purchasing power of the U.S. dollar and its comparative worth to other currencies. This might sound easy, but it is a complex task in an information age where huge amounts of money travels in electronic signals in microseconds around the world. The Effectiveness of Monetary Policy Economists debate the relevant measures of money supply. "Narrow" money supply or M1 is currency in circulation and the currency in easily accessed chequing and savings accounts. "Broader" money supply measures such as M2 and M3 include term deposits and even money market mutual funds. Economists debate the finer points of the implementation and effectiveness of monetary policy but one thing is obvious. At the extremes, monetary policy is a potent force. In countries such as the Russian Republic, Poland or Brazil where the printing presses run full tilt to pay for government operations, money supply is expanding rapidly and the currency becomes rapidly worthless compared to goods and services it can buy. Very high levels of inflation or "hyperinflation" is the result. With 30-40% monthly inflation rates, citizens buy hard goods as soon as they receive payment in the currency and those on fixed income have their investments rendered worthless. At the other extreme, restrictive monetary policy has shown its effectiveness with considerable force. Germany, which experienced hyperinflation during the Weimar Republic and never forgot, has maintained a very stable monetary regime and resulting low levels of inflation. When Chairman Paul Volcker of the U.S.

Federal Reserve applied the monetary brakes during the high inflation 1980s, the result was an economic downturn and a large drop in inflation. The Bank of Canada, headed by John Crow, targeted 0-3% inflation in the early 1990s and curtailed economic activity to such an extent that Canada actually experienced negative inflation rates in several months for the first time since the 1930s. Without much debate, the effectiveness of monetary policy, its timing and its eventual impacts on the economy are not obvious. That central banks attempt influence the economy through monetary is a given. In any event, insights into monetary policy are very important to the investor. The availability of money and credit are key considerations in the pricing of an investment. Operations of a Modern Central Bank The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy: 1. Open market operations 2. Reserve requirements 3. The 'Discount Window' Open market operations are just that, the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates, the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole. Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. chequing accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as

less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply. Lastly, the Discount Window is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole. Central banks function to maintain financial stability: An uncompleted task Central banks cannot achieve price and financial stability with one instrument (interest rates). A counter-cyclical regulatory system is needed to dampen asset booms and to smooth busting bubbles. To use such macro-prudential instruments effectively, regulators need courage, quantitative triggers, and independence; they will be criticised by lenders, borrowers and politicians in both booms and busts.

The events of the last year have reminded us all that a central bank does not just have one responsibility, that of achieving price stability. It is indeed its first core purpose (CP1); but as the sole institution that can create cash, and hence bank reserve balances, a central bank has a responsibility for acting as the lender of last resort and maintaining financial stability. This is its second core purpose (CP2).

Two goals but only one instrument One of the major problems of central banking is that the pursuit of these two core purposes can often conflict, not least because the central bank currently appears to have only one instrument, its command over the short-term interest rate. Indeed, a central purpose of the first two great books on central banking, Henry Thorntons (1802), Inquiry into the Paper Credit of Great Britain, and Walter Bagehots (1878), Lombard Street, was to outline ways to resolve such a conflict, especially when an (external) drain of currency threatened maintenance of the gold standard at the same time as an internal drain led to a liquidity panic and contagious bank failures. Under such circumstances, however, with rising risk aversion, the central bank would find that it had two instruments, due to its ability to expand its own balance sheet, e.g. by last-resort lending, at the same time as keeping interest rates high, (to deter gold outflows and unnecessary (speculative) borrowing). The greater problem, then and now, was how to avoid excessive commercial bank expansion during good times. With widespread confidence, the commercial banks neither want nor need to borrow from the central bank. A potential restraint is via shrinking the central banks own balance sheet, open market sales, thereby raising interest rates. But increasing interest rates during good times, (gold reserves rising and high; inflation targets met), i.e. leaning into the wind, is then against the rules of the game, and such interest rates adjustments small enough to be consistent with such underlying rules are unlikely to have much effect in dampening down the upswing of a powerful asset price boom-and-bust cycle. CP1: Price stability versus CP2: Financial stability Although the terminology has altered, this basic problem has not really changed since the start of central banking in the 19th century. An additional analytical twist was given by Hy Minsky, who realised that the better the central bank succeeded with CP1 (price stability), the more it was likely to imperil CP2 (financial stability). The reason is that the greater stability engendered by a successful CP1 record is likely to reduce risk premia, and thereby asset price volatility, and so support additional leverage and asset price expansion. The three main examples of financial instability that have occurred in industrialised

countries in the last century (USA 1929-33, Japan 1999-2005, sub-prime 2007/8) have all taken place following periods of stellar CP1 performance. We still have not resolved this conundrum. It shows up in several guises. For example, there is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are systemic; do we have any clear, ex ante, definition of systemic, or do we decide, ex post, on a case-by-case basis? Bank risk and bank-system risk Perhaps these problems are insoluble; certainly they have not been solved. Indeed, recent developments, notably the adoption of a more risk-sensitive Basel II CAR and the move towards fair value or mark-to-market accounting, have arguably tilted the regulatory system towards even greater pro-cyclicality. A possible reason for this could be that the regulators have focussed unduly on trying to enhance the risk management of the individual bank and insufficiently on the risk management of the financial system as a whole. The two issues, individual and systemic risk performance, are sometimes consistent, but often not so. For example, following some financial crisis, the safest line for an individual bank will be to cut lending and to hoard liquidity, but if all banks try to do so, especially simultaneously, the result could be devastating. The bottom line is that central banks have failed to make much, if any, progress with CP2, just at the time when their success with CP1 has been lauded. This is witnessed not only by the events of 2007/8, but also by the whole string of financial crises (a sequence of turmoils) in recent decades. Now, there are even suggestions that central banks should have greater (even statutory) responsibility for achieving financial stability, (e.g. the Paulson report). But where are the (regulatory) instruments that would enable central banks to constrain excess leverage and irrational euphoria in the upswing? Public warnings, e.g. in

Financial Stability Reviews, are feeble, bendy reeds. All that central banks have to offer are mechanisms for picking up the pieces after the crash, and the more comprehensively they do so (the Greenspan/Bernanke put), the more the commercial banks will enthusiastically join in the next upswing. Counter-cyclical instruments Besides such public warnings, which the industry typically notices and then ignores, the only counter-cyclical instruments recently employed have been the Spanish pre-provisioning measures, and the use of time-varying loan to value (LTV) ratios in a few small countries, e.g. Estonia and Hong Kong. But the Spanish measures have subsequently been prevented by the latest accounting requirements, the IFRS of the IASB; and the recent fluctuations in actual LTVs have been strongly pro-cyclical, with 100+ LTVs in the housing bubble being rapidly withdrawn in the housing bust. Indeed, any attempt to introduce counter-cyclical variations in LTVs or in capital/liquidity requirements will always run into a number of generic criticisms:

It will disturb the level playing field, and thereby cause disintermediation to less regulated entities (in other segments of the industry, or in other countries). It will thus both be unfair and ineffective. It will increase the cost of intermediation during the boom and thereby reduce desirable economic expansion (and financial innovation). It will increase complexity and add to the informational burden.

These criticisms have force. Indeed, there are empirical studies that suggest that countries which allow a less regulated, and more innovative and dynamic, financial system grow faster than their more controlled brethren, despite being more prone to financial (boom/bust) crises. Nevertheless it should be possible to construct a more counter-cyclical, time-varying regulatory system in such a way as to mitigate these problems, so long as the regulations are relaxed in the downturn after having been built up in the boom. But those same generic criticisms will also mean that regulators/supervisors will be roundly condemned for tightening regulatory conditions in asset prime booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own

improved policies. Regulators/supervisors will need some combination of courage, reliance on quantitative triggers, and independence from government if they are to have the strength of mind and purpose to use potential macroprudential instruments to dampen financial booms.