CENTRAL BANKING

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• CENTRAL BANKING
• AND
• THE MONETARY POLICY
• Dr. Mohammed Alwosabi

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• GENERAL INTRODUCTION
• Every country with an established banking system
  has a central bank.
• The central bank of any country can be defined as
  a government authority in charge of regulating
  the countrys financial system, controlling the
  quantity of money and conducting monetary policy.
• There is only one central bank for each country
  with few branches.

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• The central bank is a "bank" in the sense that it
  holds assets (foreign exchange, gold, and other
  financial assets) and liabilities.
• A central bank's primary liabilities are the
  currency outstanding, and these liabilities are
  backed by the assets the bank owns.

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• The central bank is the bank of government. It
  does not provide general banking services to
  individual citizens and business firms
• The central bank is the bank of the banks and
  acts as a lender of last resort to the banking
  sector during times of financial crisis
• The central bank has supervisory powers, to
  ensure that banks and other financial
  institutions do not behave recklessly or
  fraudulently.

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• There is no standard terminology for the name of
  a central bank,
• Many countries use the "Bank of Country" form
  (e.g., Bank of England, Bank of Canada, Bank of
  Russia).
• In other cases, they may incorporate the word
  "Central" (e.g. European Central Bank, Central
  Bank of Bahrain).
• The word "Reserve" is also used, primarily in the
  U.S., Australia, New Zealand, South Africa and
  India.
• Some are styled national banks, such as the
  National Bank of Ukraine.

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• THE MAIN ROLES OF CENTRAL BANK
• The central bank (CB) regulates and supervises
  depository institutions. The main roles of
  central banks are
• To ensure monetary stability through monetary
  policy tools that keep inflation low and stable,
  and, hence, preserving local currency purchasing
  power and promoting economic activity
• To ensure financial stability and to have
  resilient and efficient financial system
• To have effective policy for risk management and
  control supervision

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1. To issue and enforce anti-money laundering and
   fraud laws
2. To enhance the economic development through
   institutional building and market infrastructure
   and through ensuring healthy competition and
   efficient financial markets
3. To create a sound payments system through
   efficient means of transferring funds between
   parties and for commercial transactions
4. To have a real time gross settlement system and
   check clearing system
5. To play the role of economic and financial
   adviser to the government.
6. To help in managing government borrowing

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1. To represent the government in international
   agencies and meetings
2. To strengthen cooperation with international
   financial community
3. To manage the country's foreign exchange and gold
   reserves
4. To issues new currency and withdraw damaged one
5. To collect data and make economic forecasting and
   policy
6. To review and approve annual accounts of all
   banks and conduct regular onsite inspection
7. To evaluate and approve proposed mergers and
   expansions

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• Role of Central Bank Islamic banking and
  finance
• In addition to the above-mentioned general roles,
  CB has a crucial role to supervise and monitor
  Islamic banking and finance.
• To ensure Sharia compliance and to monitor
  Sharia implementations by Islamic financial
  institutions, whether full-fledged or just
  Islamic banking windows
• To set up a Sharia Supervisory Board (SSB) at
  the central bank level to approve the Islamic
  financial products and instruments developed by
  Islamic financial institutions
• To approve the appointment of CEOs and directors
  of Islamic financial institutions
• To monitors the compliance of Islamic banks to
  regulatory requirements

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• MONETARY POLICY AND ITS INSTRUMENTS
• Despite their names, central banks are not banks
  in the sense that commercial banks are.
• They are governmental institutions that are not
  concerned with maximizing their profits, but with
  achieving certain goals for the entire economy.
• The purpose of the central bank is to help
  achieve stable prices, full employment, and
  economic growth through the regulation of the
  supply of money and credit in the economy.

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• Changing the money supply and credit to achieve
  these goals is called monetary policy.
• Monetary policy is the management of the money
  supply for the purpose of maintaining stable
  prices, full employment, and economic growth.

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• The main monetary policy instruments available to
  central banks are (1) open market operation, (2)
  bank reserve requirement, (3) interest rate
  policy (discount rate).
• While capital adequacy is important, it is
  defined and regulated by the Bank of
  International Settlement (BIS), and central banks
  in practice generally do not apply stricter rules.

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• Open Market Operations (OMO)
• Through open market operations, a central bank
  influences the money supply in an economy
  directly.
• An open market operation is the purchase or sale
  of government securities by the central bank in
  the open market.

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• To reduce inflation, the central bank conducts a
  contractionary monetary policy using the open
  market operation. Central bank sells government
  securities ? people pay money to buy government
  securities from the central bank ? banks deposit
  decreases ? banks reserves decrease ? Loans
  decrease ? money supply (Ms) decreases ? AD
  decreases ? AD curve shifts leftward.

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• To reduce unemployment, the central bank conducts
  an expansionary monetary policy using the open
  market operation. Central bank buys government
  securities ? people receive money from the
  central bank ? banks deposit increases ? banks
  reserves increase ? Loans increase ? money supply
  (Ms) increases ? AD increases ? AD curve shifts
  rightward.

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• Discount Rate
• The discount rate is the interest rate the
  central bank charges the commercial banks and
  other depository institutions when they borrow
  reserves from it.
• To reduce inflation, the central bank conducts a
  contractionary monetary policy using the discount
  rate.
• It increases the discount rate ? higher cost of
  borrowing reserves ? banks borrow less reserves
  from central bank ? but with a given required
  reserves banks decrease their lending to decrease
  their borrowed reserves ? Loans decrease ? money
  supply (Ms) decreases ? AD decreases ? AD curve
  shifts leftward.

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• To reduce unemployment, the central bank conducts
  an expansionary monetary policy, using the
  discount rate. It decreases the discount rate ?
  lower cost of borrowing reserves ? banks borrow
  more reserves from central bank ? banks increase
  their lending ? Loans increase ? money supply
  (Ms) increases ? AD increases ? AD curve shifts
  rightward.

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• Reserve Requirements
• Another significant power that central banks hold
  is the ability to establish reserve requirements
  for other banks. All depository institutions in
  the country are required to hold a minimum
  percentage of deposits as reserves (cash or
  deposited with the central bank). This minimum
  percentage is known as a required reserve ratio.

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• To reduce inflation, the central bank conducts a
  contractionary monetary policy using the required
  reserve ratio. It requires depository
  institutions to hold more reserves, which results
  in increasing the reserves and thus reducing the
  amount they are able to lend ? Loans decrease ?
  money supply (Ms) decreases ? AD decreases ? AD
  curve shifts leftward.

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• To reduce unemployment, the central bank conducts
  an expansionary monetary policy using the
  required reserve ratio. Required reserves
  decrease ? loans increase ? Ms increase ? AD
  increase ? AD curve shifts rightward.

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• Capital requirements
• All banks are required by the central bank to
  hold a certain percentage of their assets as
  capital.
• For international banks, including the 55 member
  central banks of the Bank of International
  Settlement (BIS), the minimum capital requirement
  is 8 of risk-adjusted assets, whereby certain
  assets (such as government bonds) are considered
  to have lower risk and are either partially or
  fully excluded from total assets for the purposes
  of calculating capital adequacy.

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• Partly due to concerns about asset inflation and
  repurchase agreements, capital requirements may
  be considered more effective than deposit/reserve
  requirements in preventing indefinite lending
  when a bank cannot extend another loan without
  acquiring further capital on its balance sheet.

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• In conclusion,
• To increase commercial bank lending the central
  bank can lower reserve requirements, lower
  capital requirements, lower the discount rate, or
  buy government securities.
• To decrease commercial bank lending the central
  bank can raise the reserve requirements, raise
  the capital requirements, raise the discount
  rate, or sell government securities.

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• CENTRAL BANKS INDEPENDENCE
• Although central banks are part of the
  government, they usually have much more
  independence than other government agencies.
• The literature on central bank independence has
  defined a number of types of independence. The
  most important ones are

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• Goal independence The central bank has the
  ability to set its monetary policy goals, whether
  inflation targeting, control of the money supply,
  or maintaining a fixed exchange rate.
• While this type of independence is more common,
  many central banks prefer to announce their
  policy goals in partnership with the appropriate
  government authority. The setting of common goals
  by the central bank and the government helps to
  avoid situations where monetary and fiscal policy
  are in conflict a policy combination that is
  clearly sub-optimal.

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• Instrument (Operational) independence The
  central bank has the ability to determine the
  best way of achieving its policy goals, including
  the types of instruments used and the timing of
  their use. This is the most common form of
  central bank independence.
• Management Independence The central bank has the
  authority to run its own operations (appointing
  staff, setting budgets, etc) without excessive
  involvement of the government.
• The other forms of independence are not possible
  unless the central bank has a significant degree
  of management independence.

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• Governments generally have some degree of
  influence over even "independent" central banks
• the aim of independence is primarily to prevent
  short-term interference.
• International organizations such as the World
  Bank, the BIS and the IMF are strong supporters
  of central bank independence.
• This results, in part, from a belief in the
  intrinsic merits of increased independence, and
  from the connection between increased
  independence for the central bank and increased
  transparency in the policy-making process.

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• THE BANK FOR INTERNATIONAL SETTLEMENTS (BIS)
• The Bank for International Settlements (BIS) is
  an international organization, which fosters
  international monetary and financial cooperation
  and serves as a bank for central banks.
• The BIS fulfils this mandate by acting as
• a forum to promote discussion and policy analysis
  among central banks and within the international
  financial community
• a center for economic and monetary research
• a prime counterparty for central banks in their
  financial transactions
• agent or trustee in connection with international
  financial operations

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• The BIS banking services are provided exclusively
  to central banks and other international
  organizations.
• The BIS does not accept deposits from, or provide
  financial services to, private individuals or
  corporate entities.
• The head office of BIS is in Basel, Switzerland
  and there are two representative offices in the
  Hong Kong and in Mexico City.
• Established on 17 May 1930, the BIS is the
  world's oldest international financial
  organization.

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• The BIS unit of account is the IMF special
  drawing rights, which are a basket of convertible
  currencies. The reserves that are held account
  for approximately 7 of the world's total
  currency.
• The BIS carries out its work through
  subcommittees, the secretariats it hosts, and
  through its annual General Meeting of all
  members.
• The BIS' main role is in setting capital adequacy
  requirements. BIS requires bank capital/asset
  ratio to be above a prescribed minimum
  international standard, for the protection of all
  central banks involved.

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• Another role for BIS is make reserve requirements
  transparent.
• The BIS also comments on global economic and
  financial developments and identifies issues that
  are of common interest to central banks.
• The BIS carries out research and analysis to
  contribute to the understanding of issues of core
  interest to the central bank community, to assist
  the organization of meetings of Governors and
  other central bank officials and to provide
  analytical support to the activities of the
  various Basel-based committees.

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• BASEL ACCORDS
• The Basel Committee on Banking Supervision is an
  institution created in 1974 by the central bank
  Governors of the Group of Ten nations (Belgium,
  Canada, France, Germany, Italy, Japan, the
  Netherlans, Sweden, Switzerland, the United
  Kingdom, and the United States).
• Its membership is now composed of senior
  representatives of bank supervisory authorities
  and central banks from the G-10 countries, and
  representatives from Luxembourg and Spain. It
  usually meets at the Bank for International
  Settlements in Basel, where its 12 member
  permanent Secretariat is located.

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• The Basel Committee formulates broad supervisory
  standards and guidelines and recommends
  statements of best practice in banking
  supervision in the expectation that member
  authorities and other nations' authorities will
  take steps to implement them through their own
  national systems, whether in statutory form or
  otherwise.

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• Basel I is the term which refers to a round of
  deliberations by central bankers from around the
  world, and in 1988, the Basel Committee on
  Banking Supervision (BCBS) in Basel, Switzerland,
  published a set of minimal capital requirements
  for banks.
• This is also known as the 1988 Basel Accord. It
  was enforced by law in the Group of Ten (G-10)
  countries in 1992, with Japanese banks permitted
  an extended transition period.
• Basel I primarily focused on credit risk. Banks
  with international presence are required to hold
  as capital at least 8  of the risk-weighted
  assets.

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• Basel I is now widely viewed as outmoded, and a
  more comprehensive set of guidelines, known as
  Basel II are in the process of implementation by
  several countries.
• Basel II is the second of the Basel Accords,
  which are recommendations on banking laws and
  regulations issued by the BCBS.
• The purpose of Basel II, which was initially
  published in June 2004, is to create an
  international standard that banking regulators
  can use when creating regulations about how much
  capital banks need to put aside to guard against
  the types of financial and operational risks
  banks face.

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• Several countries started to implement Basel II
  in 2008.
• Advocates of Basel II believe that such an
  international standard can help protect the
  international financial system from the types of
  problems that might arise should a major bank or
  a series of banks collapse.
• In practice, Basel II attempts to accomplish this
  by setting up rigorous risk and capital
  management requirements designed to ensure that a
  bank holds capital reserves appropriate to the
  risk the bank exposes itself to through its
  lending and investment practices.

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• Generally speaking, these rules mean that the
  greater risk to which the bank is exposed, the
  greater the amount of capital the bank needs to
  hold to safeguard its solvency and overall
  economic stability.
• Although Basel II makes great strides toward
  limiting excess risk taking by internationally
  active banking institutions it increased
  complexity compared to Basel I, which raised the
  concerns that it might be unworkable.

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