Central Bank and its Evolution

What is Central Bank?

A central bank is an institution that manages a country’s currency, money supply, and interest
rates. Central banks also usually oversee the commercial banking system of their respective
countries. Central bank possesses the monopoly of issuing bank notes and thereby increasing
the monetary base in a country. Central banks in most developed nations are institutionally
designed to be independent from political interference1. Still, limited control by the executive
and legislative bodies usually exists2.

Naming of central bank

Central banks were not originally called central banks and were generally known as banks of
issue or national banks. Even today there is no standard terminology for the name of a central
bank, but many countries use the "Bank of Country" form—for example: Bank of England
(central bank of UK as a whole), ‘Bank of Canada’, ‘Bank of Mexico’. Some are styled
"national" banks, such as the National Bank of Ukraine, although the term national bank is also
used for private commercial banks in some countries.

In other cases, central banks may incorporate the word "Central" (for example, European
Central Bank, Central Bank of Ireland, Central Bank of Brazil). Though, the term ‘central bank’
is also used for commercial banks in some countries. Example is ‘Central bank of India’. 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. Other central banks are known as monetary authorities such as the Monetary
Authority of Singapore, Maldives Monetary Authority and Cayman Islands Monetary
Authority. There is an instance where native language was used to name the central bank, such
as 'Bangko Sentral ng Pilipinas'. Many countries have state-owned banks or other quasi-
government entities that have commercial banking functions but their names sounds like
central bank such as Soviet Union's Gosbank (state bank), India’s ‘State Bank of India’,
Pakistan’s ‘National Bank of Pakistan’ The chief executive of a central bank is usually known
as the Governor, President or Chairman.

Evolution of central banking

Now-a-days, every country has a central bank of its own and central bank has become
inevitable for a country. However, this was always not the case. There was a time when there
was no central bank in the world. The origination of central bank is, however, not really known.
The history of central bank is closely related with the invention of paper money. The bank note,
which is basically a ‘promise to pay’, was first invented in China in in the thirteen century by
the ‘song dynasty’. It is said that the ‘Yuan Dynasty’ in China was the first to use notes as the

1
Public governance of central banks: an approach from new institutional economics". The Bulletin of the
Faculty of Commerce (Meiji University) 89 (4). March 2007.
2
"Ownership and independence of FED". Retrieved 29 September 2013
predominant circulating medium of exchange. In 1455, in an effort to control inflation, the
succeeding ‘Ming Dynasty’ ended the use of paper money and closed much of Chinese trade.
However, it is thought that the medieval European ‘Knights Templar’3 ran an early prototype
of a central banking system, as their promises to pay were widely respected, and many regard
their activities as having laid the basis for the modern banking system.

However, the Bank of England, the central bank of UK, is widely considered as the father of
modern central banks, was established in 16944. However, at the beginning of 20th century, the
new world countries and the old world countries like China and India had no central bank.
Sveriges Riksbank, or the Riksbank is generally, called the world's oldest central bank, was
founded in Stockholm from the remains of the failed bank Stockholms Banco in 16645. Some
also believes that the Bank of Amsterdam established in 1609 is the ancestor to modern central
banks.6

The institutions known as central banks today were initially established as commercial banks
or government banks. Their evolution into central banks came with their monopoly of issuing
notes and their role as government’s banker and lender of last resort. Until the beginning of the
20th century, there was no clearly defined concept of central banking. A gradual evolution had
been taking place in various countries through somewhat unconscious process.

The issue of notes as of other currency was always claimed to be a prerogative of the state, but
where as in the case of metallic currency, the state retained its prerogative and hand the issue
of notes over to banks. As more and more banks came to be established, the need for uniformity
in note circulation and better regulation aroused. This led to promulgation of specific laws
granting one bank monopoly or partial monopoly of note issue. This stage was reached by
many European countries by the 19th century. Countries like South Africa, Italy, Canada etc.
took another hundred years to rich at this stage.7In all cases, banks entrusted with the sole
responsibility of note issue become the recognized central bank of their respective countries.
This monopoly privilege was a primary factor in their development into central bank with
special duties and responsibilities. However, there are countries where central bank was
established for facilitating government borrowings. The establishment of Bank of England is
an example. Financially drained by 50 years of war against France, King William was not only
broke in 1693; he was in the middle of the “War of the Grand Alliance” and desperately needed
£1,200,000 to meet the expenditure of the war. He was unable to borrow the money and bankers

3 Knights Templar were among the most wealthy and powerful of the ‘Western Christian military orders’

4( Chapter 7 - The Word's First Central Bank

History of Sveriges Riksbank Riksbank.com Archived 4 May 2008 at the Wayback Machine

5History of Sveriges Riksbank Riksbank.com Archived 4 May 2008 at the Wayback Machine

6 Quinn, Stephen; Roberds, William (2006), "An Economic Explanation of the Early Bank of Amsterdam,
Debasement, Bills of Exchange, and the Emergence of the First Central Bank", Federal Reserve Bank of Atlanta,
Working Paper 2006–13

7 Central Banking M. H. De Cock

advised him to introduce a subscription system where the subscribers were to be incorporated
by the name of the Governor and Company of the Bank of England. Thus Bank of England
was formed by a law. Bank of England subscribed £1,200,000 (at 8 percent) loan to the
government against the monopoly of issuing bank note. The bank was given exclusive
possession of the government's balances, and was allowed to count the government bonds as
reserves, giving it the ability to create even more money against this reserve. It is said that the
Riksbank was established to finance wars of the ‘Age of Liberty’. Banque de France, the central
bank of France was established in 1800 mainly to finance to lend money to the government to
meet the expenditure of ‘War of the Second Coalition’.

Elsewhere in the world, the U.S. Congress created the US Federal Reserve On 23 December
1913 through the passing of The Federal Reserve Act. Earlier, Bank of North America
established in 1781 and then First Bank of the United States in founded in 1791 worked as de
facto central bank for USA. 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 subsequently had Central Bank of Brazil in 1965. After gaining
independence, African and Asian countries also established central banks or monetary unions.
In Asia, Bank of Japan was established in 1882 which was reconstructed in reorganized in
19428 after a post ware suspension of its activity for a short period. The People's Bank of China
evolved its role as a central bank starting in about 1979 with the introduction of market reforms.
This bank was established in 1948. Between 1950 and 1978 the PBC was the only bank in the
People's Republic of China and was responsible for both central banking and commercial
banking operations. Reserve bank of India was established in 1935. State bank of Pakistan was
established in 1948. Bangladesh bank was established in 1972 under BB Order 1972.

Although central banks today are generally associated with fiat money9, the 19th and early 20th
centuries central banks in most of Europe and Japan developed under the international gold
standard10, elsewhere free banking or currency boards11 were more usual at this time. Partial

8
Japan encyclopedia, p. 708., p. 708, at Google Books
9
Fiat money is currency which derives its value from government regulation or law. It differs from commodity
money and representative money. Commodity money is created from precious metal such as gold or silver, which
has uses other than as a medium of exchange, while representative money simply represents a claim on such
precious metal

10
A gold standard is a monetary system in which the standard economic unit of account is based on a fixed
quantity of gold. Three types can be distinguished: gold specie standard, gold bullion standard, and gold exchange
standard. In the gold specie standard, the monetary unit is associated with the value of circulating gold coins or
the monetary unit has the value of a certain circulating gold coin, but other coins may be made of less valuable
metal. The gold bullion standard is a system in which gold coins do not circulate, but the authorities agree to sell
gold bullion on demand at a fixed price in exchange for the circulating currency. The gold exchange standard
usually does not involve the circulation of gold coins. But government guarantees a fixed exchange rate to the
currency of another country that uses a gold standard (specie or bullion), regardless of what type of notes or coins
are used as a means of exchange.

11
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign
currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the
exchange rate target.
fiduciary system was introduced in England in 1844 and subsequently adopted by many
countries. In this system, a fixed amount laid down by law, which could be covered only by
government securities, while all notes issued in excess of that have to be covered by gold.

With the increasing use of deposit money created by the commercial banks and the growing
need for some form of credit control by a central bank, it came to be more generally realized
that a monopoly of note issue in itself tended to give a central bank some measures of control
over undue credit expansion by the commercial banks, since the expansion of credit obviously
led to an increased demand for currency note. Gradually other functions began to be
accomplished the first one was to act a government’s banker, agent and advisor. The Bank of
England, for example, first took over from the Exchequer the duty of receiving subscriptions
of government loans in 171812. Then it undertook in 1751 the service of paying interest on the
national debt. In addition to the permanent loan given to the government in return for the
monopoly of the loan issue, earlier central bank required to make advance to the government.
The Netherlands Bank was obliged by law in 1888 to grant accommodation to the Government
in the form of advance on current account. Since 1914, central banks had been making
accommodation of money to the government. The huge cost of the war of 1914-18 and the
enormous loan requirements of the State placed a heavy burden on the credit structure of the
countries which were involved in the war. Central bank of these countries had to assist in the
process of adaptation to the war economy setting aside central banking tradition. Actions of
central bank were governed mainly by the requirement of the war finance and the post war
adjustment in the country like Britain, USA, Franc, Germany and so no. As a result of this
financing activates, the large number of banks which were established or reorganized after that
war had the powers of making advances t the state or buying Government securities severely
restricted in excess of certain percentage of their paid up capital . Then again during the great
depression, banks were again obliged to provide financial facilities demanded by the
governments. Central Banks established after 1933, such as those of Argentina and EL
Salvador were subject to severe restriction on lending to the government, limits were set by the
laws. This restrictions were later relaxed. In the next stage, central bank became the custodian
of the commercial banks' cash reserve. Banks in England found it advantageous to maintain
account with Bank of England and deposit their cash reserve with it. This practice was further
deepened when BOE opened branches in various parts of England by 1854 and assumed the
function of the clearance differences between banks. Gradually this process of evolution also
took place in other countries. With the establishment of Federal Reserve Bank s in the USA in
1914, a new principle regarding bank reserves was introduced, namely statutory provision that
the member banks had to maintain with the Fed minimum credit balances depending on the
amount of their demand and time deposits. This statutory requirement was replicated by South
Africa in 1920, by Mexico in 1932, by New Zealand in 1934 and later by almost every country.
The percentage, however, varied from country to country.

With regard to reserve requirement, with a view to regulating the note issue and safeguarding
the value of the currency, central bank was originally required almost everywhere to maintain
a minimum reserve of gold and silver or as become more general during the twenties, against

12
Central Banking, H. M. Dekonck, page 37.
both its note and deposit liabilities. After World war I, foreign exchange was admitted along
with gold as part of the legal minimum reserve to be held by the central bank in a variety of
countries. During the great depression of 1030s, this condition was relaxed and during world
war II, this condition was suspended.

In addition to custodial of cash reserve of commercial banks and nation's reserve of foreign
currency, central banks started become the bank of rediscount and lender of last resort. During
1920 central bank started the function of central clearance, settlement and transfer. Then as a
result of a abandonment of gold standard, deflationary pressure of 1930s, fluctuation of
exchange rate credit control and control of money supply become the primary function of
central bank

Since the breakdown of the Bretton Woods system13, the history of the central banking have
been eventful mainly with the implications of two new phenomena: (1) The emergence of
stagflation in the early 1970s and (2) The radical transformation of the financial environment

Stagflation challenged the foundations of the prevailing postwar confidence in the maintenance
of full employment and in an exploitable trade-off between unemployment and inflation.14 The
stylized response to the first oil shock, consisting of expansionary fiscal policies and
accommodating monetary conditions, failed to ensure lasting gains in output or employment.
This development prepared the ground for a more sober assessment of the power of the state
to master economic developments and for a revival of laissez-faire philosophy. And lead to
more prudent policy and cautious macroeconomic approach to be taken by the central bank.

The transformation of the financial environment took place through the ascendancy of free
market philosophy, an acceleration of advances in information technology and conceptual
breakthroughs in finance. The impact of this transformation on central banking was pervasive.
It gave renewed prominence to safeguarding the stability of the financial system

The other changes were in terms of creation of new central banks. The past two decades have
seen enormous changes in central banks and their practices. In some countries, older
institutions have been fundamentally restructured. In other, such as the countries of the former
Soviet Union, entirely new central banks have been established. The member countries of the
European Union have created a supranational central bank that oversees a monetary union.

After the financial crisis of 2007-2008, Central banks debate whether they should experiment
with new measures like negative interest rates or direct financing of government, "lean even
more on politicians to do more". The European Central Bank and The Bank of Japan whose
economies are in or close to deflation, continue quantitative easing buying securities to
encourage more lending. The Basel Committee has come with new accord named Basel III

13
Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the
exchange rate by tying its currency to gold and the ability of the IMF to bridge temporary imbalances of payments
14 * The Evolution of Central Bank Governance around the World, by Christopher Crowe & Ellen E. Meade
recommending comprehensive risked based supervision of member banks that most of the
central banks have already adopted.

In the discussion of evolution of central bank, some people divide the whole history into four
periods (a) Pre-classical, (b) Classical, (c) Traditional and (d) Modern.

The main function of archaic pre-classical central banks, when they were set up in Europe in
the 18th and 19th centuries was to ‘provide finance on beneficial, subsidized terms to the
government of the day, in return with certain monopoly rights in note issuing’. Their creation
resulted from the coupling of the government’s urgent need for money with the bank
promoters’ desire for the profits of both speculation and monopoly.

Later, during the classical times, the major objectives of central banking has been to keep
financial stability, including currency convertibility into specie, with a new attention to their
supervisory role. The control over money supply was dominated by the convertibility target.
The monetary functions of central banks were largely grafted onto the supervisory functions
and not the reverse.

Then, when central banking entered its traditional stage, it became heavily involved in
discretionary monetary management. Discretion was often used to make it easier and cheaper
for governments to finance their deficits, also using direct controls on credit allocation, which
acted on the banking industry as instruments of both implicit taxation and protection from
competition. From this point of view an ‘exchange of favour’ took place between
governments and banking resembling ‘archaic’ times.

Finally, the primary objective of modern central banking is maintaining price stability. It is the
general style of monetary policy that makes the main difference between traditional and
modern central banking: the latter is more precisely anti-inflation oriented with a lower degree
of goal independence, whilst its instrument independence is higher. It does not rely on direct
controls. It tends to overcome its credibility problem in a rational expectations context by
following predictable and transparent rules. Its much lower ambition in influencing the
macroeconomic cycles and in fine-tuning aggregate demand in the short term echoes certain
aspects of classical central banking.