Central Banking

 The central bank of a country is the central monetary institution that regulates the supply,
availability and cost of money in the interest of the general public.

 According to the bank for international settlements, a central bank is the bank in any
country to which the duty of regulating the volume of currency and credit in the country is
entrusted .

 The central bank refers to a special group of powers to control the total stock of money in
the country.

— Central bank focus on the stability of economic

system.

— Does not directly deal with the public but through

commercial banks

Function of central banks

 Formulation and implementation of monetary policy (aimed at achieving and maintaining

price stability )

– Formulating monetary policy framework

– Influence the level of interest rate (through bank

liquidity requirement

– Open market operation

 Banker and advisor to the government

– Banker to government

– Public debt management

– Administration of exchange controls

 Management of the money and banking system

– Lender of last resort

– Currency management (notes and coins)

– Banker to private sector banks

– Settlement of inter bank claims

– Supervision of banks
 – Supervision of payment system

– Management of Gold and exchange reserves

– Development of debt markets

– Provision of economic statistics

– Provision of internal corporate support services

and systems

Structure and Independence of Central Banks of Emerging Market Economies

 Central banks of EMEs assume a more complex role in comparison to their counterparts in
industrial nations.

 Apart from central banking functions, banks of EMEs build and reform the financial
infrastructure, develop the financial markets, and help with macroeconomic development.
They also manage foreign exchange reserves and implement policies that promote growth
and exports.

 The central banks of EMEs pursue ―financial inclusion policies‖ which involve enhancing
credit flow to productive export-oriented industries and employment intensive sectors.
They also subsidize banks and increase access to affordable financial services, promote
financial education and literacy, and support small local rural banks.

 To achieve these development roles, the central banks often coordinate monetary policy
decisions with fiscal agents.

The central banks in EMEs have less independence because many decisions regarding foreign
exchange, developing financial institutions and markets, and extending loans to priority regions and
sectors are made jointly with the government

National bank of Ethiopia (NBE)

 Sets limits on the net foreign exchange positions and terms, and the amount of external
indebtedness of banks and other financial institutions.

 Provides short and long term refinancing facilities to banks and other financial institutions.

 Accepts deposit of any kind from foreign sources.

 Acts as banker, fiscal agent and financial advisor to the Government.

 Represents the country in international monetary institutions and acts consistently with
international monetary and banking agreements to which Ethiopia is a party.

Exercises and performs such other powers and activities as central banks customarily perform

Three Players in the Money Supply Process

 1. The Central bank: Federal Reserve System

2. Banks: depository institutions; financial intermediaries

3. Depositors: individuals and institutions

The Fed’s Balance Sheet

 Liabilities

• Currency in circulation: in the hands of the public

• Reserves: bank deposits at the Fed and vault cash

 Assets

• Government securities: holdings by the Fed that affect money supply and earn
interest

• Discount loans: provide reserves to banks and earn the

discount rate

Control of the Monetary Base

High-powered money

MB = C + R

C = currency in circulation

R = total reserves in the banking system

Open Market Purchase: Summary

 The effect of an open market purchase on reserves depends on whether the seller of the
bonds keeps the proceeds from the sale in currency or in deposits.

 The effect of an open market purchase on the monetary base always increases the
monetary base by the amount of the purchase.

Monetary Policy Operation:

 The Market for Reserves and the Federal Funds Rate:

– Demand and Supply in the Market for Reserves

– What happens to the quantity of reserves demanded by banks, holding everything

else constant, as the federal funds rate changes?

– Excess reserves are insurance against deposit outflows

  The opportunity cost of holding these is the interest rate that could have
been earned (iff ) minus the interest rate that is paid on these reserves (ior)

Demand in the Market for Reserves

 Since the fall of 2008, the Fed has paid interest on reserves at a level that is set at a fixed
amount below the federal funds rate target.

 When the federal funds rate is above the rate paid on excess reserves, ior, as the federal
funds rate decreases, the opportunity cost of holding excess reserves falls, and the quantity
of reserves demanded rises.

 Downward sloping demand curve that becomes flat (infinitely elastic) at ior

Supply in the Market for Reserves

 Two components: nonborrowed and borrowed reserves

 Cost of borrowing from the Fed is the discount rate

 Borrowing from the Fed is a substitute for borrowing from other banks

 If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero

 The supply curve will be vertical

 As iff rises above id, banks will borrow more and more at id, and relend at iff

n The supply curve is horizontal (perfectly elastic) at id

How Conduct of Open Market Operations Affect the Federal Funds Rate

 Effects of open an market operation depends on whether the supply curve initially
intersects the demand curve in its downward sloped section versus its flat section.

 An open market purchase causes the federal funds rate to fall whereas an open market sale
causes the federal funds rate to rise (when intersection occurs at the downward sloped
section).

 Open market operations have no effect on the federal funds rate when intersection occurs
at the flat section of the demand curve.

How Changes in the Discount Rate Affect the Federal Funds Rate

 If the intersection of supply and demand occurs on the vertical section of the supply curve,
a change in the discount rate will have no effect on the federal funds rate.

 If the intersection of supply and demand occurs on the horizontal section of the supply
curve where iff = id , a change in the discount rate shifts that portion of the supply curve and
the federal funds rate may either rise or fall depending on the change in the discount rate.

Conventional Monetary Policy Tools

  During normal times, the Federal Reserve uses three tools of monetary policy—open
market operations, discount lending, and reserve requirements—to control the money
supply and interest rates, and these are referred to as conventional monetary policy tools.

Open Market Operations

 Dynamic open market operations

– intended to change reserves and monetary base

 Defensive open market operations

– Repurchase agreements (Repo)

– Matched sale-purchase agreements (Reverse Repo)

 Primary dealers

 TRAPS

– Open market operations are conducted electronically with dealers in government

securities, known as primary dealers, by a

computer system called TRAPS

Discount Policy and the Lender of Last Resort

 Discount window – there are three types of Fed discount loans to banks

 Primary credit: standing lending facility

– Healthy banks are allowed to borrowed all they want at very short maturities

– It is set usually 1 percentage point higher than

the federal funds rate target

 Secondary credit: For banks with some financial problems

 Seasonal credit: for banks whose loans are

seasonal in nature( Agri., vacation banks)

 Lender of last resort to prevent financial panics

– Creates moral hazard problem

Relative Advantages of the Different Monetary Policy Tools

 Open market operations are the dominant policy tool of the Fed since it has complete
control over the volume of transactions, these operations are flexible and precise, easily
reversed, and can be quickly implemented.
  The discount rate is less well used since it is no longer binding for most banks, can cause
liquidity problems, and increases uncertainty for banks. The discount window remains of
tremendous value given its ability to allow the Fed to act as a lender of last resort.

 Reserve requirement: it is less frequently used as it

may create uncertainty for bank managers

Nonconventional Monetary Policy Tools During the Global Financial Crisis

 Liquidity provision: The Federal Reserve implemented unprecedented increases in its

lending facilities to provide liquidity to the financial markets

– Discount Window Expansion

– Term Auction Facility

– New Lending Programs

 Large-scale asset purchases: During the crisis, the Fed started new asset purchase programs
to lower interest rates for particular types of credit.

– Government Sponsored Entities Purchase Program

 Forward Guidance

– By committing to the future policy action of keeping the federal funds rate at zero
for an extended period, the Fed could lower the market‘s expectations of future
short-term interest rates, thereby causing the long- term interest rate to fall.

 Negative Interest Rates on Banks‘ Deposits

– Setting negative interest rates on banks‘ deposits is supposed to work to stimulate

the economy by encouraging banks to lend out the deposits they were keeping at
Secondary Functionsthe central bank, thereby encouraging households and
businesses to spend more. However, there are doubts that negative interest rates
on deposits will have the intended, expansionary effect.

. Commercial Banking

 Primary functions:

– Accepting deposits (Saving deposit,

Demand/current deposit and Time deposit)

– Lending Money (Overdrafts, Cash credits, Loans and Advances, Discounting of Bills
of Exchange)

 Secondary functions:

– Agency services
 – General utility services

 Agency Services:

– Collection of cheques, drafts and bills for their customer

– Execution of standing orders e.g: payment of commercial bills, subscription to clubs,

rent and salaries.. and collection of dividend, pensions etc.

– Purchase and sell of securities for customers

– Conduct stock exchange transactions such as buying and selling of shares

– Acting as executors and Trustees

– Providing income tax services

‒ Conduct foreign exchange business

 General Utility Services:

– Safe keeping of valuables

– Issue of commercial letter of credit and traveler's cheque

– Collecting trade information of foreign countries

– Arranging business tours

– Providing suitable investment advisory services

Render services for a nominal fee.

 Balance Sheet of Commercial Bank:

– The balance sheet of a bank reveals the solvency of the bank.

– Bank is said to be solvent when the money value of liabilities equals the money
value of assets.

– Bank can be said to be insolvent when the money value of assets falls below that of
liabilities.

Property & Assets

– Cash in hand & with Central Bank

– Balance with other banks (first line of defense)

– Money at call & short notice (second line of defense)

– Bills discounted

– Investments
 – Advances

– Fixed Assets

– Acceptance & Endorsements

Capital and liabilty

– Capital

– Reserve Fund & Other Reserve

– Deposits & other accounts

– Borrowing from other banks & agents

– Bills for collection being bills receivable(as per contra)

– Acceptance, endorsements & other obligations(as per Cont

How a bank manages its assets and liabilities. The bank has four
primary concerns:

1. Liquidity management

2. Asset management

— Managing credit risk

— Managing interest-rate risk

3. Liability management

Managing capital adequacy

Asset Management

 The attempt to earn the highest possible return on assets while minimizing the risk.

1. Get borrowers with low default risk, paying high interest rates

2. Buy securities with high return, low risk

3. Diversify

4. Manage liquidity

Liability Management

 Managing the source of funds, from deposits, to CDs, to other debt.

1. Important since 1960s

 2. No longer primarily depend on deposits

3. When see loan opportunities, borrow or issue CDs to acquire funds

1. Tradeoff between safety (high capital) and ROE.

Higher is bank capital, lower is return on equity

ROA = Net Profits/Assets

ROE = Net Profits/Equity Capital

EM = Assets/Equity Capital

ROE = ROA ´ EM

Capital , EM ¯, ROE ¯

2. Banks also hold capital to meet capital requirements. The Basel Committee on Banking
Supervision sets minimum capital requirements — the

ratio of bank capital to risk weighted assets

Measuring Bank Performance

Much like any business, measuring bank performance requires a look at the income statement. For
banks, this is separated into three parts:

oOperating Income oOperating Expenses oNet Operating Income

Note how this is different from, say, a manufacturing firm‘s income statement.

 Bank performance measures:

o ROA = Net Profits/ Assets

o ROE = Net Profits/ Equity Capital

o NIM = [Interest Income – Interest Expenses]/

Assets

International Banking

 Banks monitor the business sector through the evaluation, pricing, credit granting functions.
In this context the operation of an international trade services, that have as a consequence
either the creation and management of financial means, or the transport of capital from
the surplus units of country in an other or the mediation in the frame of national financier
system are called ―international banking activity‖

• Banking transactions crossing national boundaries

• Undertake international lending

 • All claims of domestic banks office on foreign residents

• Claims of foreign bank offices on local residents

• Claims of domestic bank offices on domestic

residents in foreign currency

IBs-Services offered

 International banks do everything domestic banks do:

 Arrange trade financing , foreign exchange

 Offer hedging functions for foreign currency receivables and payables through
forward and option contracts

 Offer investment banking services:

• Underwrite Eurobonds and foreign bonds

 International banks provide services to those engaged in international trade and investment
: risk sharing, liquidity and information

 Like domestic banks international banks accept deposits and lend

 International banks lower transaction costs and lower information costs

 International financial regulations can lead to innovation in

banking

Reasons for international banking

 Low marginal costs

 Knowledge advantage

 Home nation information services

 Prestige

 Regulatory advantage

 Whole sell defensive strategy

 Retail defensive strategy

 Growth

Risk deduction