Central Banking

When there is a need for an organization to

exist, one will surely spring out and serve the
need. Such is what happened throughout the
world from the past to the present. Many
organizations have existed for many, years
and continue to serve the interest of the
nation. But with the passage of time, self
interest slowly eased out the concern for
national welfare. When this happens, the
need for organizing an institution to control
the activities of organizations becomes a
serious concern.
This was true with the case of banks. When
they acted independent and without any
form of control from any institution, they
ended up doing more harm than good to the
economy. Hence , they need to put up an
organization that monitors and controls
their activities, this mechanism was set up
and called central bank.

What a central bank is, why and how it

performs its various functions shall be
covered in this chapter.
Historical Development of Banking
Modern banking structure and practices did
not come as a result of deliberate planning.
Rather, present day banking institutions,
evolved from simple enterprises to more
complicated giants. Just, like the modern day
species of animals that became the subject of
Charles Darwin’s studies, the first bank were
much different from modern banks. But unlike
Darwin’s subject which evolved in millions of
years, the evolution of modern banking covers
only a span of a little more than two hundred
years.
 The Crucial First Steps
Before the first banks came into being, there
were goldsmiths and silversmiths in Europe
during the middle, Ages who kept their inventories
in safekeeping devices they own. The extra spaces
in the safes were rented by owners of valuable
items like gold coins also for safe keeping A
depositor receipt was issued by the smith to the
customer, whenever valuables were accepted for
deposit. The receipt served as, proof of ownership
of the valuables deposited I the safe and was
surrendered when valuables were withdrawn.
 Withdrawals were made whenever
the depositor needed his gold coins as
payment for purchases he made.
Oftentimes, the payment received by
the seller was also deposited with a
smith usually the same one contracted
by the buyer of his goods. As such, the
first step towards the invention of
banks had already been made.
 And so each time, a depositor of valuables
purchased goods, he goes to the smith,
withdraws his gold coins, pays the seller ,
who, in turn, goes to the smith and deposits
the coins. This was a cumbersome means of
payment until an innovation was introduced:
the buyer of the goods just signs an
endorsement at the back of the depository
receipt, the seller accepts it as payment, then
goes to the smith to withdraw the coins at his
convenient time sometimes, the seller just
asks the smith to change the receipt with a
new one and in his name and leave the coins
intact and in the safekeeping of the smith
 The convenience brought by the
endorsement made transactions
between buyer and seller easier and
resulted to a bigger volume of trade.
In the meantime, the smith, because
of the growing number of depositors,
became a full time keeper of valuable.
He adapted a new name of his
business by calling it a bank, and
himself, a banker.
Second Gear
To facilitate a faster means of exchanges the bank
introduced another innovation, i.e., replacing the
depository receipt with bearer receipt. Previously, by
endorsing the depository receipt to a person, the need
to personally withdraw the gold coins is eliminated
from the task of the original depositor. But since
endorsement can only be made for a new number of
times, the last endorse is forced to make a personal
withdrawal of the coins from the bank this
inconvenience is eliminated under the bearer receipt
arrangement, as the receipt can be transferred in an
unlimited number of times without bearer to withdraw
the gold coins from the bank because he can use the
bearer receipt (or banknote as it is specially called) as
payment for anything he buys.
 Crescendo
In the beginning , the total amount of the
gold coins and other valuables deposited In
the vaults of the bank corresponds to the
total amount of receipts or notes issued to
the depositors. If alt holders of notes and
receipts withdraw all their deposits at the
same time, there will be enough coins and
valuables to cover the withdrawals.
 Later, however the banker found out that
simultaneous withdrawals rarely occur (except
when there is a bank run). So, he thought of a
bright idea. He will issue more notes way above
the amount of valuables in his safe, and no one
will ever know. Well and good , but he is only
right up to a certain point, beyond that point, he
will experience difficulties in servicing daily
withdrawals. But the temptation to issue more
notes is too strong to resist because of the
prospect of more gain. This he does until he
reaches the breaking point and the depositors are
seriously affected.
 The need for a centralized banking
Authority
It cannot be expected from any organization to
always consider decisions that will benefit society,
Even if intentions are good, the outcome may not
be so. This is surprising because of the concern for
growth and stability by any enterprise including
banks. Sometimes, the quest for more profits
places the financial viability of a bank in jeopardy.
For instance, a bank may recklessly invest most of
its funds in high risk financial instruments. When
the bank fails, its depositor will be seriously
affected as many of them will not be able to make
withdrawals whenever needed.
 Another area of concern is the possibility of serving
foreign clients to the detriment of local qualified
borrowers. Thus and other activities may require some
form of control from the government. Hence, the need
for a centralize banking authority.
Finally, because banking is a very important
economic concern of nations, banks are not regarded
as ordinary business which in the event of failure can
be replaced easily by others. As much, their activities
must be monitored closely so as to provide them with
assistance when required and to control their
activities when necessary.
The above – mentioned possibilities are only some
of the reasons why development –oriented nations of
the world organized their own central banks.
Central Bank Defined
A central bank is defined by several
writers. These definitions presented below.
Collin defines central baking as “ the
main government –controlled bank in a
country, which controls the financial affairs
of the country by fixing main interest rates,
issuing currency, supervising all others
banks within the country and counselling
the foreign exchange rate’',
 Kidwell and Peterson define central bank as “
an institution that is responsible for managing a
nation’s money supply (monetary aggregates) in
its best interest’’.
A central bank, according to Horvitz and Ward,
refers to “ the institution that a nation endows
with power to manage and provide services to its
money and banking system, and foreign exchange
system’’.
Kohn defines a central bank as an “ official
institution with broad responsibilities for a
nation’s payment system; established to help
maintain the liquidity of private banks’’.
 Mishkin defines a central bank as “ the
government agency that oversees the banking
system and is responsible for the amount of
money and credit supplied in the economy”

The foregoing definitions indicate that a central

bank is a government-controlled institution that
ensures the financial health of the nation
through proper management of money and
credit.
Objectives of Central Bank
The principal objectives of a modern
central bank are :
1. To oversee the financial health of
private banks;
2. To maintain monetary and credit
conditions that encourage a high level
of employment; and
3. To assure a reasonably stable level of
prices.
Selected countries and the names of their central Banks
Country Name of Central Bank Location
1. Argentina Banco Central de la Republica Buenos
2. Australia Argentina Aires
3. Belgium Reserve Bank of Australia Sydney
4. Brazil Banque Nationale de Belgique Brussels
5. Burma Banco Central de Brazil Brazilia
6. Canada Union of Burma Bank Rangoon
7. Chile Bank of Canada Ottawa
8. China Banco Central de Chile Santiago
9. Columbia People’s Bank of China Beijing
10. Egypt Banco de Republica Bogota
11. France Central Bank of Egypt Cairo
12. Germany Banque de France Paris
13. India Deutsche Bundesbank Frankfurt
14. Indonesia Reserve Bank of India Bombay
15. Israel Bank Indonesia Jakarta
16. Japan Bank of Israel Jerusalem
17. Korea (south) Nippon Ginko Tokyo
Bank of Korea Seoul
Country Name of Central Bank Location
18. Malaysia Bank Negara Malaysia Kuala Lumpur
19. Mexico Banco de Mexico Mexico
20. Netherlands de Nederlandsche Bank Amsterdam
21. New Zealand Reserve Bank of New Zealand Wellington
22. Philippines Bangko Sentral ng Pilipinas Manila
23. Saudi Arabia Saudi Arabian Monetary Agency Riyadh
24. Singapore Monetary Authority of Singapore Singapore
25. Spain Banco de Espana Madrid
26. Switzerland Schweizerische National Bank Zurich
27. Taiwan Central Bank of China Taipei
28. Thailand. Bank of Thailand Bangkok
29. United Bank of England London
Kingdom
30. United States Federal Reserve of System Washington
 A healthy economy requires the existence of
private banks that are able to perform their
assigned roles, which are to hold the deposits
of individuals and business firms, and to use
these funds to make loans to individuals and
business.
When banks perform their functions
without jeopardizing the interests of clients,
owners, and the general public, they are said
to be financially healthy. When banks engage
in activities that appear to be inimical to the
said interests, the central bank, through its
supervisory powers, can compel them to go
back to sound banking practices.
 A high level of employment, if not full employment, is
an objective of the central bank. This is so because this
condition will accelerate the full utilization of economic
resources. Business firms will be able to maintain
employment at desirable levels if the monetary and
credit conditions are conductive to business activities.
The central bank, though the use of various tools at its
disposal can manipulate the factors to obtain favorable
monetary and credit conditions.
A stable level of prices is a pre-requisite to, a growing
economy. The central bank, through the mechanism of
interest rates and other tools, can achieve this if they
are properly employed.
Functions of Central Banks

A central bank is mandated to

perform functions which may be
briefly summed up as follows: it is “
the nation’s monetary authority and
fiscal agent of the government.”
 Specifically, the central bank is required to
undertake the following function:
1. as a bank of issue
2. as the government’s banker, agent, and adviser
3. as the custodian of cash reserves of bank
4. as the custodian and manager of the nation’s
international serves
5. as the lender of last resort
6. as the clearing house between banks
7. as the controller of credit
8. as the agency for international monetary
cooperation.
Bank of Issue
There was a time when the state and
some banks issued notes and coins, Fiscal
indiscretion of the currency’s value. Many
note- issuing banks also did not fare better,
for they abused the power of note issue.
The situation citied above led to the need
for centralizing the power or note issue.
This power was granted solely to central
banks. The following are the reasons why
this was granted solely to central banks:
1. to bring about uniformity in note
circulation and to attain effective
supervision over such note issue indirectly;
2. to control the credit granting power of
commercial banks through control of their
demands for note currency;
3. to give prestige to the central bank; and
4. to take advantage of the profits derived
from the note issue, which provides a
source of revenue for the government.
Government’s Banker, Agent and Adviser

The central bank acts as the

government’s banker as it conducts the
banking transactions of the government
and its various agencies. When the
government anticipate taxes or loans to
be raised from the public, and money is
needed immediately, the central bank
makes temporary advances to the
government.
 In emergency cases like war and depression, the central bank
makes extraordinary advances to the government.
The central bank buys and sells foreign currency to finance the
government’s importation of goods and services and for the
payment of foreign debts.
As an agent of the government, the central bank performs
financial agency services. These services consists of the following:
1. receive subscriptions for government loans;
2. pay interest due on the national debt;
3. ad minister and manage the national debt including the issue
and redemption of treasury bills ,bonds and notes.

Finally, the central bank provides advice and information to the

government regarding the monetary and financial conditions of
the economy.
Custodian of Cash Reserves of Banks
When customers deposit money in a bank, they-
expect that they can make withdrawals anytime. As
such, there is a need for banks to set aside a certain
amount of money to guarantee withdrawals
anytime they are made. Experience shows;
however, that withdrawals, on the average, do not
exceed a certain percentage of total deposits.
Banks are now required by law to put up as
reserve an amount equivalent to a fraction of the
bank’s deposit liabilities. To make sure- that the
required reserves are strictly adhered to, they are
kept in the custody of the central bank.
 There are two general purposes why
banks are required to keep reserves.
1. To insure the solvency or liquidity of
banks for the normal withdrawal needs
of depositors. This purpose prevents “
bank runs” from starting or developing.
2. To control or limit the amount of credit
that banks may grant. This requirement
prevents unlimited credit expansion.
Custodian and Manager of the Nation’s
International Reserves
Trade between countries requires
payments for goods and services sold.
This and other requirements will need a
system to facilitate transactions. The
system calls for the maintenance of
international reserves and the central
bank assumes the role of custodian and
manager of the nation’s international
reserves. These reserves are the means
of settling international debts.
The specific purposes of maintaining
international reserves are as follows:
1. to cover deficits in the country’s balance of
payments with other countries;
2. to provide a means of payment for
international obligation incurred by the
government or by private individuals;
3. for use in emergencies;
4. to provide a means of redeeming national
currency locally and abroad in case of the
need to comply with international agree-
merits; and
5. to provide a means for limiting credit
expansion.
Lender of Last Resort

When individuals or institutions need

to borrow money, they go to financial
institutions like banks and apply for loans.
When banks fall short of funds, however,
they attempt to borrow from other
financing institutions. When funds are not
available from any other source, their last
resort is the central bank.
As a lender of last resort, the central bank is
engaged in a range of activities which
include the following:
1. rediscounting
2. lending money to the government when
in financial distress
3. issuance of emergency notes in a
monetary crisis.
4. buying of securities in the open market
5. liberalizing or contracting of credit
extension at its own initiative
6. granting of emergency loans to banks in
financial need.
 Rediscounting refers to an activity of the
central bank which discounts bills of exchange
already discounted, by commercial banks. For
example; Mr. Benjamin Fabian borrowed money
from a bank in the amount of Php1million at 18%
interest . He issued a promissory note in the same
amount which was discounted at 18% and got the
proceeds of Php 820,000. Because of financial
distress, the bank applied for a loan with the
central bank rediscounted some of the bank’s
holding of promissory notes including that of Mr.
Fabian’s. The central bank rediscounted the notes
at 16% and the bank received the proceeds
including the Php840,000 for Mr. fabian’s note.
As the Clearinghouse Between Banks

There is a great number of bank clients who

draw checks and drafts on their banks. These
are presented, later, by other banks on behalf
of their clients for payment.
When checks and drafts are few and far in-
between, it may be convenient for the drawer’s
bank and the drawee’s bank to deal directly
with each other. As transactions involving bills
of exchange have grown considerably, direct
clearing between banks became uneconomical
and inconvenient. A simpler method is for the
banks to settle their daily differences by using
debit and credit adjustments in their
respective accounts with the central bank.
When because of clearing, a bank’s credit
balance with the central bank falls below
the minimum requirement, the banks has
three options to cover the shortage:
1. to draw checks;
2. to request for a rediscounting with the
central bank; and
3. to barrow from other banks with excess
reserves.
Controller of Credit
Credit is an activity that can be used
positively or negatively. When the right
amount of credit is used productively, it boosts
the nation’s chance for economic growth. When
credit is granted in amounts more than the
economy can take, the economy becomes prone
to difficulties.
The importance of credit cannot be
overemphasized . Many countries want to
develop their economies by investing in good
programs and projects, but they could not do it
because of financial constraints.
Credit can also be abused, however.
Too much dependence on credit creates
negative effects like: (1) it leads to
wasteful government spending, (2) it
creates inflation, (3) it burdens future
generations, (4) it dampens production
of goods and services, and (5) it reduce
future consumption and savings.
The foregoing statements indicate the
need for proper control of credit at the
macroeconomic level. The must be a
central agency that will assume the
role of controller of credit. The role was
assigned to the central bank.
Agency for International Monetary
Cooperation.
Our monetary system, as well as
the monetary systems of other
countries cannot be so independent
from one another. Nations found
out through experience that, to
survive, international monetary
cooperation is necessary. The
central banks were assigned to
handle this task.
 Among the functions performed by central banks regarding
international monetary cooperation are the following.

1. Holding claims- When foreign currencies find their way in the

central bank’s coffers, the central bank has the right to
demand payment in gold immediately from the central bank
which issued the currency. Instead of demanding payment,
however, central banks often agree to continue to hold claims.
This arrangement makes the operation of central banks more
efficient and economical.
2. Granting loans- Oftentimes, central banks grant loans to each
other.
3. Swap agreements- These are agreement between central bank
where a certain amount of the currency of a central bank is
exchanged with an equivalent amount of currency of another
central bank. The central bank. The central banks are allowed
to use the swapped money for whatever purpose.
 Organization and management of
central banks
Central banks are organized as corporate
bodies. They may be privately owned, publicly-
owned or a combination of both. Central bank
operate independently, but their degree of the
United States (the Federal Reserve System),
for example, appears to be remarkably free of
the political pressures that influence other
government agencies. The members of the
board of the federal reserve are appointed for a
non-renewable 14 year term, eliminating some
of the incentives for the governors to curry
favor with the president and Congress.
 The bank of England, even if it is one of the oldest central
banks, has a low degree of independence. It can only make
recommendations as to what monetary policy should be. The
decision to raise or lower interest rates resides not with the
government of the Bank of England but with the chancellor of
the Exchequer.
As corporations, central banks also make profits which are
distributed according to the provisions of the law creating
them. The Bangko Sentral ng Pilipinas. (BSP), for instance,
remitted profits to the Government in 1998 in the amount of
Php 6.233 billion.
Central banks have boards of directors, either elected by
stockholders appointed by the government, or a mixture of the
both means. The BSP is a government corporation. The
Bangko Sentral Monetary Board is composed of seven
members appointed by the President of the Philippines for a
term of six years. The seven members of the board consists of
(1) the government of the BSP, who shall be chairman, (2) a
member of the cabinet, and (3) five members from the private
sector, to serve full-time.
THANK YOU
AND
GODBLESS 