Central Bank

A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country, or group of member states (as in the EU). Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system).

Central Bank

A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country, or group of member states (as in the EU). Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system).

It may also have supervisory powers to ensure that banks and other financial institutions do not behave recklessly or fraudulently. A central bank is usually headed by a Governor, President in the case of the European Central Bank or Chief Executive/Managing Director in the case of Hong Kong Monetary Authority and Monetary Authority of Singapore.

In most countries the central bank is state-owned and has some degree of autonomy which allows for the possibility of government intervening in monetary policy. An "independent central bank" is one which operates under rules designed to prevent political interference; examples include the US Federal Reserve, the Bank of England (since 1997), Reserve Bank of India (1935), the Bank of Canada and the European Central Bank.

Contents:
1 Activities and responsibilities
2 Instruments of monetary policy
2.1 Open Market Operations
2.2 Interest rates
2.3 Reserve requirements
2.4 Capital Requirements
3 Banking supervision and other activities
4 Independence
5 History

Activities and responsibilities

Functions of a central bank (not all functions carried out by all banks): monopoly on the issue of banknotes the Government's banker and the bankers' bank ("Lender of Last Resort") manages the country's foreign exchange and gold reserves and the Government's stock register; regulation and supervision of the banking industry; setting the official interest rate - used to manage both inflation and the country's exchange rate.

The central bank's main responsibility is the management of monetary policy to ensure a stable economy, including a stable currency. It aims to manage inflation (rising average prices) as well as deflation (falling prices). It is the lender of last resort, and will (at a price) assist banks in cases of financial distress (see also bank runs).

Furthermore, it will hold foreign exchange reserves (usually in the form of government bonds) and official gold reserves, and will often have some influence over exchange rates. Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Typically a central bank controls certain types of short-term interest rates. These influence the stock- and bond markets as well as mortgage and other interest rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council (in the case of the Federal Reserve, the Board of Governors).

Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Fed, they are the local Federal Reserve Banks, for the ECB they are the national central banks.

Instruments of monetary policy

Open Market Operations

Through open market operations, a central bank influences the money supply in an economy directly. Each time it buys securities, exchanging money for the security, it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.

The main open market operations are: Temporary lending of money for collateral securities ("Reverse Operations"). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned off. Buying or selling securities ("Direct Operations") on ad-hoc basis. Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the People's Bank of China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus the Renminbi and the Yen.

Interest rates

A central bank has several interest rates it can set to influence markets. Marginal Lending Rate (currently 3% in the Eurozone) A fixed rate for institutions to borrow money from the CB. Main Refinancing Rate (2% in the Eurozone) This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans (In the US this is called the Discount rate). Deposit Rate (1% in the Eurozone) The rate parties receive for deposits at the CB.

These rates directly affect the rates in the money market, the market for short term loans.

Reserve requirements

Many banks are required to delegate a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier.

Capital Requirements

Reserve requirements have now largely been replaced as a tool by capital requirements. Rather than x% of liabilities being held as cash, banks are these days required to hold y% of their assets as capital. For internatonal banks, the threshold is 8% (see the Basel Capital Accords.

This acts similarly to a deposit requirement in that it prevents indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Banking supervision and other activities

In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as The Ministry of Finance, or an independent government agency (eg UK's Financial Services Authority). It examines the banks' balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Independence

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust"), as politicians may be tempted to boost the economy in advance of an election, to the detriment of the long-term health of the economy. In addition, it is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U.S., and his choice must be confirmed by the Congress.

History

One of the oldest banks that performed some of the duties of a central bank was the Bank of Sweden that was opened in 1668 with help from Dutch businessmen. This was followed in 1694 by the Bank of England, created by a businessman in the City of London at the request of the English government to help pay for a war. The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by President Woodrow Wilson on December 23, 1913.

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