Chapter Fifteen

Central Banks in the World Today

 Introduction
 Government’s Bank
 Banker’s Bank
 Central Bank Objectives
 Stability
 Low, Stable Inflation
 High & Stable Real Growth
 Financial System Stability
 Interest Rate & Exchange Rate Stability

 Creating a Successful Central Bank

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 Introduction
• The world’s leading central banks played a key role in
bringing the financial system and the economy back to
safe harbor after the peak of the financial crisis in
2008.
• They acted in unprecedented fashion to prevent the
financial system from capsizing and, over time, to
restore financial and economic stability.

“If it looks like a duck, quack like a duck, and acts like a duck, then
it is a duck – or so the saying goes. But what about an institution
that looks like a bank and acts like a bank? Often it is not a bank –
it is a shadow bank”

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Why the Financial System Needs to be Regulated?
1. The collapse of banks and the banking system disrupts both the payments
system and the screening and monitoring of borrowers.
a. Intermediaries are insolvent when their liabilities exceed their assets.
b. Because banks guarantee their depositors cash on demand on a first-come,
first served basis, they are subject to runs. Shadow banks and securities brokers
also face runs because some of their liabilities can be withdrawn at face value
without notice.
c. A bank run can occur simply because depositors have become worried about
a bank’s soundness. Shadow banks also may face runs due to a loss of
confidence.
d. The inability of depositors to tell a sound from an unsound bank can turn a
single bank’s failure into a bank panic, causing even sound banks to fail through
a process called contagion. Shadow banks face similar risks.
e. A financial crisis in which the entire system of banks and shadow banks
ceases to function can be caused by :
i. False rumors.
ii. The actual deterioration of balance sheets for economic reasons.

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 Why the Financial System Needs to be Regulated?
2. The government is involved in every part of the financial system.
a. Government officials may intervene in the financial system in order to
i. Protect small depositors.
ii. Protect bank customers from exploitation.
iii. Safeguard the stability of the financial system.
b. The governments usually establish two-part safety net to protect the
nation’s financial system.
i. The central bank acts as the lender of last resort, providing liquidity to
solvent institutions in order to prevent the failure of a single intermediary
from becoming a system wide panic.
ii. Deposit Insurance Corporation (FDIC) insures individual depositors
helping to prevent bank runs by reducing depositors’ incentive to flee at the
first whiff of trouble.
c. The government’s safety net encourages bank managers to take more risk
than they would otherwise, increasing the problem of moral hazard.

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 Why the Financial System Needs to be Regulated?
3. Through regulation and supervision, central bank reduce the amount of risk
banks can take, lowering their chances of failure.
Regulators and supervisors:
a. Restrict competition.
b. Restrict the types of assets banks can hold.
c. Require banks to hold minimum levels of capital.
d. Require banks to disclose their fees to customers and their financial
indicators to investors.
e. Monitor banks’ compliance with government regulations.
4. Regulators use macro-prudential tools to limit systemic threats to the
financial system. Such risks usually arise from externalities—costly spillovers
from the behavior of intermediaries. These externalities have two sources:
(1) common exposure of intermediaries to frail institutions or to underlying
risks and
(2) pro-cyclicality of the links between financial and economic activity, which
amplifies boom and bust cycles.
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 Central Banks
• The central bank of Pakistan is State Bank of Pakistan
(SBP).
• The people who work there are responsible for making
sure that our financial system functions smoothly so that
the average citizen can carry on without worrying about it.
• Central banks do not act only during times of crisis.
• Their work is vital to the day-to-day operation of any
modern economy.
• Today there are roughly 170 central banks in the world.

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The Basics: How Central Banks
Originated and Their Role Today
• The central bank started out as the
government’s bank and over the years added
various other functions.
• A modern central bank not only manages the
government’s finances but provides an array of
services to commercial banks.

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 The Government’s Bank
• As the government’s bank, the central bank has a
privileged position:
• It has the monopoly on the issuance of currency.
• The central bank creates money.
• Early central banks kept sufficient reserves to
redeem their notes in gold.
• In USA the Federal Reserve has the sole legal
authority to issue U.S. dollar bills, similarly SBP
issuing Pak Rupees.

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 The Government’s Bank
• The central bank can control the availability of
money and credit in a country's economy.
• Most central banks go about this by adjusting
short-term interest rates: monetary policy.
• They use it to stabilize economic growth and
information.

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 The Government’s Bank
• The primary reason for a country to create its
own central bank, then, is to ensure control
over its currency.
• Giving the currency-printing monopoly to someone
else could be disastrous.
• In the European Monetary Union, 16 European
countries have ceded their right to conduct
independent monetary policy to the European
Central Bank (ECB).
• This was part of a broader move toward economic
integration.

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 The Banker’s Bank
• The political backing of the government,
together with their sizeable gold reserve, made
early central banks the biggest and most
reliable banks around.
• The notes issued by the central bank were viewed
as safer than those of smaller banks.
• The safety and convenience quickly persuaded
most other banks to hold deposits at the central
bank as well.

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 The Banker’s Bank
• As the banker’s bank, the central bank took
on the roles it plays today:
1. To provide loans during times of financial stress,
2. To manage the payments system, and
3. To oversee commercial banks and the financial
system.
• The ability to create money means that the
central bank can make loans even when no
one else can.

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 The Banker’s Bank
• No bank, no matter how well managed, can
withstand a run.
• To stave off such a crisis, the central bank can
lend reserves or currency to sounds banks.
• By ensuring that sound banks and financial
institutions can continue to operate, the central
bank makes the whole financial system more
stable.

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 The Banker’s Bank
• Every country needs a secure and efficient
payments system.
• Financial institutions need a cheap and reliable
way to transfer funds to one another.
• The fact that all banks have account at the
central bank makes the it the natural place for
interbank payments to be settled.
• In 2009, an average of more than $2.5 trillion
per day was transferred over Fedwire (FT
System in USA).
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 The Banker’s Bank
• Finally, someone has to watch over commercial
banks and nonbank financial institutions so that
savers and investors can be confident these
institutions are sound.
• Those who monitor the financial system must
have sensitive information.
• Government examiners and supervisors are the
only ones who can handle such information
without conflict of interest.

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 The Banker’s Bank
• As the government’s bank and the banker’s
bank, central banks are the biggest, most
powerful players in a country’s financial and
economic system.
• However, an institution with the power to
ensure that the economic and financial systems
run smoothly also has the power to create
problems.

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 The Banker’s Bank
• It is essential that we understand what a central
bank is not.
• It does not control securities markets, though it
may monitor and participate in bond and stock
markets.
• It does not control the government’s budget.
• Central Bank only acts as the Treasury’s bank.

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The Functions of a Modern Central
Bank

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Stability: The Primary Objective of
All Central Banks
• What makes the private sector incapable of
doing what we have entrusted to the
government?
• In the cases of pollution and national defense, the
answer is more obvious.
• Government involvement is justified by the
presence of externalities or public goods.
• Economic and financial systems, when left on
their own, are prone to episodes of extreme
volatility.

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Stability: The Primary Objective of
All Central Banks
• Central bankers work to reduce the volatility
of the economic and financial systems by
pursuing five specific objectives:
1. Low and stable inflation.
2. High and stable real growth, together with high
employment.
3. Stable financial market and institutions.
4. Stable interest rates.
5. A stable exchange rate.

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Stability: The Primary Objective of
All Central Banks
• It is important to realize that instability in any
of these poses an economy-wide risk that
individuals can’t diversify away.
• The job of the central bank is to improve
general economic welfare by managing and
reducing risk.
• Understand that it is probably impossible to
achieve all five of their objectives
simultaneously.
• Tradeoffs must be made.
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 Low, Stable Inflation
• Many central banks take their primary job as
the maintenance of price stability.
• They strive to eliminate inflation.
• The consensus is that when inflation rises, the
central bank is at fault.
• The purchasing power of one dollar, one yen,
or one rupees should remain stable over long
periods of time.
• Maintaining price stability enhances money’s
usefulness both as a unit of account and as a
store of value.
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 Low, Stable Inflation
• Prices provide the information individuals and
firms need to ensure that resources are
allocated to their most productive uses.
• But, inflation degrades the information content
of prices.
• If the economy is to run efficiently, we need to
be able to tell the reason why prices are
changing.

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 Low, Stable Inflation
• Most people agree that low inflation should be
the primary objective of monetary policy.
• How low should inflation be?
• Zero is probably too low.
• There would be a risk of deflation.
• This makes debts more difficult to repay,
increasing default, affecting the health of banks.

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 Low, Stable Inflation
• Zero inflation would also be difficult for
companies.
• If an employer wished to cut labor costs, it would
need to cut nominal wages which is difficult to do.
• So, a small amount of inflation makes labor
markets work better, at least from an
employer’s point of view.

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• High inflation is more volatile than low
inflation.
• Volatile inflation means more risk which
requires compensation.
• High inflation means a higher risk premium, so
loan rates are higher.
• Volatile inflation makes long-term planning
even more difficult.

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 High & Stable Real Growth
• To foster maximum sustainable growth in
output and employment is one of Chairman
Bernanke’s goals.
• This means he is working to dampen the
fluctuations of the business cycle.
• By adjusting interest rates, central bankers
work to moderate these cycles and stabilize
growth and employment

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 High & Stable Real Growth
• A period of above-average growth has to be
followed by a period of below-average growth.
• The job of the central bank during such periods
is to change interest rates to adjust growth.
• In the long run, stability leads to higher
growth.
• The greater the uncertainty about future business
conditions, the more cautious people will be in
making investments of all kinds.

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 Financial System Stability
• The Fed was founded to stop the financial
panics that plagued the U.S. during the late
19th and early 20th centuries.
• Given the recent crisis, we know that financial
and economic catastrophes are not limited to
the history books.
• Accordingly, financial system stability is an
integral part of every modern central banker’s
job.

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 Financial System Stability
• If people lose faith in financial institutions and
markets, they will rush to low-risk alternatives.
• Intermediation will stop.
• The possibility of a severe disruption in the
financial markets is a type of systematic risk.
• Central banks must control this risk.
• The value at risk is the important measure here.
• This measures the risk of the maximum potential
loss.

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Interest-Rate and Exchange-Rate
Stability
• These goals are secondary to those of low
inflation, stable growth, and financial stability.
• In the hierarchy, interest-rate stability and
exchange-rate stability are means for achieving
the ultimate goal of stabilizing the economy.
• They are not ends unto themselves.

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Interest-Rate and Exchange-Rate
Stability
• Why is interest-rate volatility a problem?
1. Most people respond to low interest rates by
borrowing and spending more and vice versa.
• Interest-rate volatility makes output unstable.
2. Interest-rate volatility means higher risk and
therefore a higher risk premium.
• Risk makes financial decisions more difficult,
lower productivity, and lessen efficiency.

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Interest-Rate and Exchange-Rate
Stability
• The value of a country’s currency affects the
cost of imports to domestic consumers and the
cost of exports to foreign buyers.
• When the exchange rate is stable, the dollar
price of goods is predictable and planning
ahead is easier for everyone.
• For emerging market countries (like Pakistan),
exports and imports are central to the structure
of the economy.
• Stable exchange rates are very important.
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Central Bank Objectives:
Summary

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Meeting the Challenge: Creating a
Successful Central Bank
• Today economists are exploring how to improve
financial regulation, and reconsidering the role that
central banks should play in financial supervision.
• To be successful, a central bank must:
1. Be independent of political pressure,
2. Make decisions by committee,
3. Be accountable to the public and transparent in
communicating its policy actions, and
4. Operate within an explicit framework that clearly states its
goals and makes clear the trade-offs among them.

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 The Need for Independence
• The idea of central bank independence, that
central banks should be independent of
political pressure, is a new one.
• After all, the central bank originated as the
government's bank.

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 The Need for Independence
• Independence has two operational
components.
1. Monetary policymakers must be free to
control their own budgets.
2. The bank’s policies must not be reversible by
people outside the central bank.

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 The Need for Independence
• Successful monetary policy requires a long time
horizon.
• The temptation to forsake long-term goals for short-
term gains is impossible for most politicians to resist.
• Knowing these tendencies, governments have
moved responsibility for monetary policy into a
separate, largely apolitical, institution (i.e.
central bank).

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Decision Making by Committee
• Monetary policy decisions are made
deliberately, after significant amounts of
information are collected and examined.
• Crises do occur, requiring someone to be in
charge.
• During normal operations, however, it is better
to rely on a committee than an individual.

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Decision Making by Committee
• Pooling the knowledge, experience, and
opinions of a group of people reduces the risk
that policy will be dictated by an individual’s
quirks.
• Vesting so much power in one individual also poses
a legitimacy problem.
• Therefore, monetary policy decisions are made
by committee in all major central banks in the
world.

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The Need for Accountability and
Transparency
• Central bank independence is inconsistent with
representative democracy.
• How can we have faith in our financial system
if there are no checks on what the central
bankers are doing?
• Proponents of central bank independence had a
twofold solution.

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The Need for Accountability and
Transparency
1. Politicians would establish a set of goals.
2. The policymakers would publicly report their
progress in pursuing those goals.
• Explicit goals foster accountability and
disclosure requirements create transparency.
• The institutional means for assuring
accountability and transparency differ from
one country to the next.

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The Need for Accountability and
Transparency
• The economy and financial markets should
respond to information that everyone received,
not to speculation about what policymakers are
doing.
• Policy makers need to be as clear as possible.
• Transparency can help counter the uncertainties
and anxieties that feed liquidity and
deleveraging spirals.

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 The Policy Framework, Policy
Trade-offs, and Credibility
• To meet these objectives, central bankers must
be independent, accountable, and good
communicators.
• These qualities make up what we call the
monetary policy framework.
• This exists to resolve ambiguities that arise in the
course of the central bank’s work.
• Officials have told us what they are going to do.
• This helps people plan and keeps officials
accountable to the public.

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Central Bank Design:
Summary

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Fitting Everything Together: Central
Banks and Fiscal Policy
• Responsible fiscal policy is essential to the success of
monetary policy.
• There is no way for a poorly designed central bank to
stabilize prices, output, the financial system, and
interest and exchange rates, regardless of the
government’s behavior.
• To be successful, a central bank must be independent,
accountable, and clear about its goals.
• It must also have a well-articulated communications
strategy and a sound decision-making mechanism.

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 End

Central Banks in the World Today

Functions Of Central Bank –
Summary

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 Functions of a Central Bank
• A central bank is a financial institution that is owned by the
government, which has a central role of managing the currency.
• Has the following function:
• Issue of Currency- The Central Bank (CB) prints notes and coins for
the government, which is normally backed up by the holding of
government bonds.
• Reserve Management- The CB manages the portfolio of foreign
exchange reserves of the country and may buy or sell them to
influence the exchange rate.
• Banker to the Government- The CB collects tax revenue and disburses
expenditure provided by the government.
• Government debt management – In many developing countries, the
CB often issues long term government debt (like in Pak SBP on behalf
of the federal government issues PIBs).
 Functions of a Central Bank
• Banking Supervisions- In many countries including the UK and
Germany, the CB regulates the commercial banking system to
maintain financial stability.

• Maintain Financial Stability- via the lender of the last resort –

provides emergency liquidity to ensure that non profit making
companies do not collapse, damaging the whole economy. A
recent example, KASB Bank.
 Functions of a Central Bank
• Monetary Policy functions:
• Interest Rate Control - The CB increases interest rates by purchasing
government bonds. This removes liquid funds from the banking
system and leads to an increase in the interest rate. This is because the
public is more likely to save if there are fewer liquid investments
available for them to purchase.
• On the other hand if the CB wants to reduce interest rates they sell
government bonds. This leads to more liquidity in the market,
encouraging less saving, consequently reducing interest rates. Often
there is an administered interest rate that the CB offers to financial
institutions that are short of liquidity. This is often referred to as the
discount rate. Commercial banks typically pass on the administered
interest rate on the form of a mortgage rate (x% above the base rate).
 Functions of a Central Bank
• Central banks may focus on the control of the money supply
rather then on the interest rate. The same operations are used to
increase or decrease the money supply. If the CB buys bonds,
less money is available in the economy and the money supply is
reduced.

• On the other hand, if the CB sells bonds, more money is

available in the economy, resulting in increased money supply.