What is a Central Bank?
A central bank is a financial institution that is responsible for maintaining the price stability and financial stability of a country.
A central bank is responsible for the monetary policy to maintain price stability in a country. And the central bank regulates the member banks that operate within that country to maintain financial stability in the country.
The central bank is responsible for managing the supply of money in the economy of the country in order to manage inflation and prevent deflation in the economy. The central bank can instruct the Treasury to print currency.
Who Controls the Central Bank?
The laws governing a central bank differ from country to country. But most central banks are designed to be independent of the political government in order for the bank to enact policies that are in the best interests of the country rather than the current government.
Some central banks are owned by the government. Some central banks are owned by its member banks. Some central banks are public companies owned by shareholders. Some central banks are not even government agencies.
In every country, there is a single central bank. Thus, a central bank is a monopoly with no competition, as established by law.
Responsibilities of a Central Bank
A central bank is primarily responsible for the following functions:
Monetary Policy
The most important function of a central bank is to control the money supply in the economy. Through its monetary policy, the central bank will set the size and rate of growth of the supply of money.
A central bank uses its monetary policy to establish price stability and deliver a certain level of certainty in its economy by communicating long-term inflation goals to the public. The objective is generally to maintain an inflation rate at about 2% per year that will allow for steady and manageable growth in the economy.
The central bank can increase interest rates to reduce the money supply since it becomes more expensive to borrow and invest or spend money. This reduced money supply can slow down an overheated economy.
Or the central bank can reduce interest rates to increase the money supply since it becomes less expensive to borrow and invest or spend money. This increased money supply can grow a depressed economy.
Bank Regulation
The central bank is responsible for regulating banks that operate within the country to ensure that the banks follow the law and are financially sound in order to protect the customers of these banks.
The central bank sets minimum requirements for capital reserves, which state the amount of liquidity a bank must have on hand to serve its customers.
And the central bank sets requirements for how much a bank can loan to its customers relative to the amount of deposits it has on its balance sheet. This prevents the bank from overextending itself and lending too much money to customers without sufficient deposits to back these loans.
Regulating banks is of vital importance because the failure of a bank can not only hurt the customers of the bank but it can also have widespread negative effects across an economy.
Lender of Last Resort
A bank is a business. And like any business, a bank needs credit to operate its business. When a bank needs a loan, it turns to the central bank.
The central bank is the lender of last resort for banks.
The central bank also provides credit to the government if the government needs money.
As part of its monetary policy, for example, the central bank can buy government bonds and mortgages from banks in a program called quantitative easing in order to provide cash and liquidity to these banks.
The central bank can also buy government bonds directly from the government in order to provide cash and liquidity to the government.
The central bank also manages the foreign exchange reserves of a country.
Why Were Central Banks Created?
Each country had its reasons for creating its central bank. But generally a country set up its central bank to solve a major financial problem that the country was facing at the time.
Funding for War
The original reasons for the creation of a central bank were to fund wars and promote economic growth.
One of the earliest central banks was Bank of England, which was incorporated by an act of Parliament in 1694. The central bank was set up in order for the English Government to raise funds to wage war against France. Thus, the Bank of England, which is now owned by the English Government, was founded as a private bank to act as banker to the Government.
After a major recession in France in the late 1700s, Napoleon Bonaparte created Banque de France in 1800 to promote the economic recovery of the country. The bank could issue banknotes although other competing financial institutions could also issue banknotes. The bank was owned by Napoleon Bonaparte and his family, as well as other private shareholders. Today, Banque de France, which is owned by the French Government, is a member of the European Central Bank.
The Gold Standard
Today, one of the main functions of a central bank is to maintain price stability in an economy. This was more manageable when currencies were pegged to the gold standard from 1870 to 1914. This meant that the banknotes that were issued and circulated in the economy were backed by actual gold reserves sitting in the vault of a central bank.
The central bank could not simply instruct the Treasury to print an unlimited amount of banknotes as there was a limited amount of gold in the vaults. In this way, it was easier to manage the value of a currency and establish price stability.
However, after the gold standard ended and a banknote was pegged to nothing but the volatility of human emotion in the marketplace, the central bank had to step in to establish some price stability.
Problems Faced by Central Banks
Central banks around the world face the same problems of bad investments and economic uncertainty as any regular bank or any business. But unlike regular banks or businesses, central banks do not have a lender of last resort that they can turn to.
Underperforming Assets
The central bank must collect on loans that it made to the government, banks, and businesses when it purchased government bonds, mortgages, or corporate debt. If the economy is not doing well, these borrowers may have a difficult time repaying these loans, and the central bank may have to extend even more loans to them.
This would leave the central bank with a bloated balance sheet of underperforming assets that are worth less in value than they were originally worth.
Economic Uncertainty
Every economy is uncertain and unpredictable. The monetary policy of the central bank may not produce the desired effect in the economy.
For example, it is common for an increase in the money supply delivered by the central bank to not make its way into the economy. This may happen because the central bank did not provide enough incentive for banks to loan money to businesses and individuals. Some banks hoard the new cash in their capital reserves and do not loan the money.
In some cases, even if the banks do offer to loan this money to businesses and individuals, these potential borrowers may simply not be inclined to borrow and spend and invest the money at that time.
As such, because there are so many players in the economy that must act in the manner desired by the central bank, the results of the monetary policy of the central bank are unpredictable, and the monetary policy that is implemented might be ineffective.
Financial Size
The amounts of money and assets that are transacted by the central bank are so large that the central bank’s actions can significantly affect the prices of the assets that it is involved in. This could affect the overall market in an unpredictably negative or positive manner.
Large-scale purchases by the central bank of fixed-income securities in the open market will cause the prices of these assets to increase and their interest rates to fall. This will affect the returns of these assets that are held by other holders of these assets.
Large-scale sales by the central bank of fixed-income securities in the open market will cause the prices of these assets to fall and their interest rates to rise. This will also affect the returns of these assets that are held by other holders of these assets.
Next, let’s look at a few examples of some central banks:
The Federal Reserve
The Federal Reserve System (or the Fed) is the central bank of the United States of America.
Creation of the Fed
A number of bank failures in the U.S. in the 1800s led to U.S. Congress setting up the Federal Reserve System and 12 regional Federal Reserve Banks in 1913.
The regional Reserve Banks are in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The 12 Federal Reserve Districts operate independently but under the supervision of the Federal Reserve Board of Governors in Washington, D.C.
Objectives of the Fed
The initial objective of the Fed was to provide a more stable banking system. Today, the Fed performs 5 main functions to promote the effective operation of the U.S. economy:
– Conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.
– Promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad.
– Promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole.
– Fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments.
– Promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.
The Structure of the Fed
The Federal Reserve Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee (FOMC) make decisions that are meant to promote the health of the U.S. economy and the stability of the U.S. financial system.
Federal Reserve Board of Governors consists of 7 members who are nominated by the President of the United States, and confirmed by the Senate. A full term is 14 years.
The Federal Open Market Committee consists of 12 members: the 7 members of the Federal Reserve Board of Governors, the President of the Federal Reserve Bank of New York, and 4 of the remaining 11 Presidents of the Reserve Banks who serve 1-year terms on a rotating basis.
The Federal Open Market Committee holds 8 regularly scheduled meetings per year. The Committee reviews economic and financial conditions, and sets the monetary policy.
Monetary Policy
The Fed influences the money supply by changing the reserve requirements of banks.
When the Fed increases the reserve requirements, banks have less money to loan to businesses and individuals to spend and invest in the economy.
When the Fed reduces the reserve requirements, banks have more money to loan to businesses and individuals to spend and invest and grow the economy.
When the Fed increases the discount rate that banks pay to the Fed on short-term overnight loans, banks have less money to loan to businesses and individuals to spend and invest in the economy.
When the Fed reduces the discount rate that banks pay on short-term overnight loans, banks have more money to loan to businesses and individuals to spend and invest and grow the economy.
The Fed can also increase or decrease the federal funds rate, which is the interest rate that financial institutions can charge each other for overnight loans. As with the discount rate, if the fed funds rate is increased, the bank has less money to loan, and if it is reduced, the bank has more money to loan.
The Fed can also buy or sell government securities in the open market to change the money supply. When the Fed buys securities, it supplies cash to the market. When the Fed sells securities, it withdraws cash from the market.
Who Owns the Fed?
The Fed is not “owned” by anyone. The Board of Governors in Washington, D.C., is an independent agency of the U.S. federal government and reports to and is directly accountable to the Congress. The U.S. Congress oversees the Fed.
Bank of Canada
Bank of Canada is the central bank of Canada.
Creation of Bank of Canada
Bank of Canada was founded in 1934. In 1938, it became a Crown corporation that belongs to the federal government.
Objectives of Bank of Canada
The principal role of the Bank of Canada is “to promote the economic and financial welfare of Canada” as defined in the Bank of Canada Act.
The Bank of Canada is responsible for:
– Monetary policy: It influences the supply of money circulating in the economy, using its monetary policy framework to keep inflation low and stable.
– Financial system: It promotes safe, sound and efficient financial systems, within Canada and internationally, and conducts transactions in financial markets in support of these objectives.
– Currency: It designs, issues and distributes Canada’s bank notes.
– Funds management: It is the “fiscal agent” for the Government of Canada, managing its public debt programs and foreign exchange reserves.
– Retail payments supervision: Under the Retail Payment Activities Act, the Bank of Canada will be responsible for supervising payment service providers.
Structure of Bank of Canada
The Bank of Canada is led by the Governing Council, which consists of the Governor, the Senior Deputy Governor, and the Deputy Governors.
The Governing Council sets the monetary policy and promotes a safe and efficient financial system.
There is also an Executive Council of the Bank of Canada, which is made up of the Governing Council and the Chief Operating Officer. The Executive Council sets the strategy for the Bank of Canada.
There is also a Board of Directors, which is appointed by the Minister of Finance for a 3-year term, subject to the approval of the Governor in Council (the federal Cabinet). It consists of the Governor, the Senior Deputy Governor, 12 outside directors, and the Deputy Minister of Finance who has no vote.
The Governor and the Senior Deputy Governor are appointed by the Board of Directors, and not by the federal government, in order to maintain the central bank’s independence of the government. These appointments are approved by the federal Cabinet for a 7-year term.
Monetary Policy
The monetary policy is conducted by influencing short-term interest rates. This is achieved by adjusting the target for the overnight rate, otherwise known as the policy interest rate.
Each business day, financial institutions in Canada move the money of their customers from one financial institution to another financial institution. At the end of each day, these financial institutions need to settle all these payments amongst themselves. Some financial institutions may have sent out more in payments than they received, while others may have received more than they sent.
To get back to balance, financial institutions can borrow money from each other for one day in the overnight market. The Bank of Canada sets a target for the interest rate that financial institutions are allowed to charge each other when they make these overnight loans.
This interest rate is the starting point from which all other interest rates are set that affect ordinary Canadians. By setting this rate, the Bank of Canada influences interest rates such as the prime rate of commercial banks (used for loans such as lines of credit), mortgage rates, and interest rates paid on deposits, guaranteed investment certificates, and other savings.
This rate is normally set on 8 fixed announcement dates per year. The Council reaches its decisions about the rate by consensus, and not by individual votes.
Who Owns the Bank of Canada?
The Bank of Canada is a special type of Crown corporation that is owned by the federal government of Canada. It operates independently of the federal government.
Bank of England
Bank of England is the central bank of the United Kingdom.
Creation of Bank of England
The Bank of England was incorporated as a private bank by an act of Parliament in 1694 to act as banker to the Government.
Objectives of Bank of England
The primary objectives of the Bank of England are to maintain monetary stability by influencing market interest rates that maintain price stability in the UK. And to maintain financial stability by supervising banks and insurers to protect the entire financial system.
The Bank of England is responsible for:
– Overseeing the economic health of the UK
– Issuing banknotes, setting interest rates, and governing the value of British Pound Sterling
– Planning and executing monetary policy in alignment with the government’s economic policies
– Implementing economic interventions to manage economic growth
– Regulating and ensuring the integrity of banks, financial institutions, and financial markets
– Acting as the lender of last resort in financial matters
The Bank of England is also the official gold custodian of other central banks. Its vault holds gold worth over £200 billion for the UK and other central banks.
Structure of Bank of England
The Bank of England is comprised of the Governor, the Court of Directors, and some Subcommittees.
The Governor is selected from within the bank. The Court of Directors is the main administrative body that oversees the strategy and operations. The 3 main subcommittees are:
– Monetary Policy Committee (MPC), which sets monetary policy and interest rates.
– Financial Policy Committee (FPC), which ensures stability in the financial system.
– Prudential Regulation Authority (PRA), which regulates the financial services industry.
The Monetary Policy Committee of the Bank of England sets its monetary policy. The MPC announces its new policy 8 times per year.
The MPC consists of 9 members: the Governor, the three Deputy Governors for Monetary Policy, Financial Stability, and Markets and Banking, the Chief Economist, and 4 external members appointed by the UK Chancellor.
The decision of the MPC is made by the vote of each member, not by consensus. If there is a tie in the votes, the Governor casts the deciding vote.
Who Owns the Bank of England?
The Bank of England started out as a private bank with private shareholders in 1694. In 1946, the UK Government nationalized the bank so it is now owned by the English Government. The UK Parliament oversees the Bank of England.
Swiss National Bank
Swiss National Bank is the central bank of Switzerland (officially called Swiss Confederation).
Creation of Swiss National Bank
The Swiss National Bank was created by virtue of the Federal Act on the Swiss National Bank in 1906. The bank was established to conduct the monetary policy of Switzerland as an independent central bank.
Objectives of Swiss National Bank
The primary goal of the Swiss National Bank is to ensure price stability, which it defines as a rise in consumer prices of less than 2% per year.
The main functions of the Swiss National Bank are to:
– Implement monetary policy by setting the policy rate to keep the short-term Swiss franc money market rates close to the policy rate.
– Issue banknotes of Swiss francs.
– Settle payments between financial institutions that transact using the Swiss Interbank Clearing (SIC) payment system. The payments are settled in SIC via sight deposit accounts held with the Swiss National Bank.
– Manage national and foreign currency reserves.
– Act as the banker to the government of Switzerland (the Confederation). It processes payments on behalf of the Confederation, issues money market debt, handles the custody of securities, and carries out foreign exchange transactions.
– Maintain the stability of the financial system by analyzing sources of risk in the financial system.
Structure of Swiss National Bank
The Swiss National Bank is a special statute joint-stock company which has Shareholders.
The central bank has a Bank Council which oversees and controls the strategy and operations of the central bank. The Bank Council consists of 11 members. The President, Vice-President, and 6 members of the Bank Council are appointed by the Federal Council (government cabinet of Switzerland). The remaining 5 members are appointed by the Shareholders at a General Meeting of Shareholders, which is held once a year in April.
There is also the Governing Board, which is the managing and executive body of the central bank. It is responsible for monetary policy, asset investment strategy, and international monetary cooperation. The members of the Governing Board and their deputies are appointed for a 6-year term by the Federal Council upon recommendation of the Bank Council. Re-election is possible.
Who Owns the Swiss National Bank?
The Swiss National Bank is a special statute joint-stock company governed by Swiss federal law.
Its shares are registered shares and are listed on the Swiss stock exchange since 1907. The share capital amounts to 25 million Swiss francs. About 55% of its shares are held by public entity shareholders including Swiss cantons and banks. The remaining 45% of its shares are held by private shareholders.
The government of Switzerland does not hold any shares of the Swiss National Bank.