ECON248: Money and Banking Ch.7: Central Banking Dr.
Mohammed Alwosabi
General Introduction
• Every country with an established banking
CHAPTER 7 system has a central bank.
• The central bank of any country can be
defined as a government authority in charge
CENTRAL BANKING of regulating the country’s financial system,
controlling the quantity of money and
AND conducting monetary policy.
THE MONETARY POLICY • There is only one central bank for each
country with few branches.
Dr. Mohammed Alwosabi
1 2
• The central bank is a "bank" in the sense • The central bank is the bank of the banks
that it holds assets (foreign exchange, gold, and acts as a lender of last resort to the
and other financial assets) and liabilities. banking sector during times of financial
crisis
• A central bank's primary liabilities are the
• The central bank has supervisory powers, to
currency outstanding, and these liabilities ensure that banks and other financial
are backed by the assets the bank owns. institutions do not behave recklessly or
• The central bank is the bank of government
government. fraudulently.
fraudulently
It does not provide general banking services • There is no standard terminology for the
to individual citizens and business firms name of a central bank,
3 4
• Many countries use the "Bank of Country" The Main Roles of Central Bank
form (e.g., Bank of England, Bank of Canada, 1. To ensure monetary stability through
Bank of Russia).
monetary policy tools that keep inflation
• In other cases, they may incorporate the low and stable, and, hence, preserving
word "Central" (e.g. European Central Bank,
Central Bank of Bahrain). local currency purchasing power and
promoting economic activity
• The word "Reserve" is also used, primarily
i the
in th U.S.,
U S Australia,
A t li NewN Zealand,
Z l d South
S th 2 To ensure financial stability and to have
2.
Africa and India. resilient and efficient financial system
• Some are styled national banks, such as the 3. To create a sound payments system
National Bank of Ukraine. through efficient means of transferring
funds between parties and for commercial
transactions
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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
4. To have effective policy for risk 10. To collect data and make economic
management and control supervision forecasting and policy
5. To have a real time gross settlement 11. To represent the government in
system and check clearing system international agencies and meetings
12. To strengthen cooperation with
6. To play the role of economic and financial international financial community
adviser to the government.
13. To issue and enforce anti-money
7 To help in managing government
7. laundering and fraud laws
borrowing
14. To review and approve annual accounts of
8. To manage the country's foreign exchange all banks and conduct regular onsite
and gold reserves inspection
9. To issues new currency and withdraw 15. To evaluate and approve proposed
damaged one mergers and expansions
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Role of Central Bank – Islamic Banking and 3. To approve the appointment of CEOs and
Finance directors of Islamic financial institutions
• In addition to the above-mentioned general 4. To monitors the compliance of Islamic
roles, CB has a crucial role to supervise banks to regulatory requirements
and monitor Islamic banking and finance.
1. To ensure Shari’a compliance and to
monitor Shari’a implementations by Islamic
financial institutions, whether full-fledged
or just
j t Islamic
I l i banking
b ki windows
i d
2. To set up a Shari’a Supervisory Board
(SSB) at the central bank level to approve
the Islamic financial products and
instruments developed by Islamic financial
institutions
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Monetary Policy and its Instruments • Changing the money supply and credit to
• Despite their names, central banks are not achieve these goals is called monetary
banks in the sense that commercial banks policy.
are. • Monetary policy is the management of the
• They are governmental institutions that are money supply for the purpose of
not concerned with maximizing their profits, maintaining stable prices, full employment,
but with achieving certain goals for the and economic growth.
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. 11 12
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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
• The main monetary policy instruments Open Market Operations (OMO)
available to central banks are (1) open • Through open market operations, a central
market operation, (2) bank reserve bank influences the money supply in an
requirement, (3) interest rate policy economy directly.
(discount rate). • An open market operation is the purchase
• While capital adequacy is important, it is or sale of government securities by the
defined and regulated by the Bank of central bank in the open market
market.
International Settlement (BIS), and central
banks in practice generally do not apply
stricter rules.
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• To reduce inflation, the central bank • To reduce unemployment, the central bank
conducts a contractionary monetary policy conducts an expansionary monetary policy
using the open market operation. using the open market operation.
• Central bank sells government securities Ö • Central bank buys government securities Ö
people pay money to buy government people receive money from the central bank
securities from the central bank Ö banks Ö banks deposit increases Ö banks
deposit decreases Ö banks reserves reserves increase Ö Loans increase Ö
decrease Ö Loans decrease Ö money money supply (Ms) increases Ö AD
supply (Ms) decreases Ö AD decreases Ö increases Ö AD curve shifts rightward.
AD curve shifts leftward.
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Discount Rate • To reduce inflation, the central bank
• The discount rate is the interest rate the conducts a contractionary monetary policy
central bank charges the commercial banks using the discount rate.
and other depository institutions when they • It increases the discount rate Ö higher cost
borrow reserves from it. of borrowing reserves Ö banks borrow less
reserves from central bank Ö but with a
given required reserves banks decrease
their lending to decrease their borrowed
reserves Ö Loans decrease Ö money
supply decreases Ö AD decreases Ö AD
curve shifts leftward.
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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
• To reduce unemployment, the central bank Reserve Requirements
conducts an expansionary monetary policy, • Another significant power that central banks
using the discount rate. hold is the ability to establish reserve
• It decreases the discount rate Ö lower cost requirements for other banks. All depository
of borrowing reserves Ö banks borrow more institutions in the country are required to
reserves from central bank Ö banks hold a minimum percentage of deposits as
increase their lending Ö Loans increase Ö reserves (cash or deposited with the central
money supply (Ms) increases Ö AD bank). This minimum percentage is known
increases Ö AD curve shifts rightward. as a required reserve ratio.
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• To reduce inflation, the central bank • To reduce unemployment, the central bank
conducts a contractionary monetary policy conducts an expansionary monetary policy
using the required reserve ratio. using the required reserve ratio.
• It requires depository institutions to hold • Required reserves decrease Ö loans
more reserves, which results in increasing increase Ö Ms increase Ö AD increase Ö
the reserves and thus reducing the amount AD curve shifts rightward.
they are able to lend Ö Loans decrease Ö
money supply (Ms) decreases Ö AD
decreases Ö AD curve shifts leftward.
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Capital requirements • Partly due to concerns about asset inflation
• All banks are required by the central bank to and repurchase agreements, capital
hold a certain percentage of their assets as requirements may be considered more
capital. effective than deposit/reserve requirements
• For international banks, including the 55 in preventing indefinite lending: when a
member central banks of the Bank of bank cannot extend another loan without
International Settlement (BIS),
(BIS) the minimum acquiring
q g further capital
p on its balance
capital requirement is 8% of risk-adjusted sheet.
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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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
• In conclusion, Central Banks Independence
• To increase commercial bank lending the • Although central banks are part of the
central bank can lower reserve requirements, government, they usually have much more
lower capital requirements, lower the independence than other government
discount rate, or buy government securities. agencies.
• To decrease commercial bank lending the • The literature on central bank independence
central bank can raise the reserve has defined a number of types of
requirements, raise the capital requirements, independence.
raise the discount rate, or sell government • The most important ones are:
securities.
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1. Goal Independence: 2. Instrument (Operational) Independence:
• The central bank has the ability to set its • The central bank has the ability to
monetary policy goals, whether inflation determine the best way of achieving its
targeting, control of the money supply, or policy goals, including the types of
maintaining a fixed exchange rate. instruments used and the timing of their
• While this type of independence is more use.
common many central banks prefer to
common, • This is the most common form of central
announce their policy goals in partnership bank independence.
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. 27 28
3. Management Independence: • International organizations such as the
• The central bank has the authority to run World Bank, the BIS and the IMF are strong
its own operations (appointing staff, supporters of central bank independence.
setting budgets, etc) without excessive • Increased independence for the central bank
involvement of the government. increases transparency in the policy-making
process.
• the aim
th i off independence
i d d is
i primarily
i il to
t
prevent short-term interference.
• Governments generally have some degree
of influence over even "independent"
central banks;
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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
• The BIS fulfils this mandate by acting as:
The Bank For International Settlements (BIS)
1. a forum to promote discussion and policy
analysis among central banks and within
• The Bank for International Settlements (BIS) the international financial community
is an international organization, which 2. a center for economic and monetary
fosters international monetary and research
financial cooperation and serves as a bank
for central banks. 3. a prime counterparty for central banks in
their financial transactions
4. agent or trustee in connection with
international financial operations
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• The BIS banking services are provided • The BIS unit of account is the IMF special
exclusively to central banks and other drawing rights, which are a basket of
international organizations. convertible international currencies and it is
• The BIS does not accept deposits from, or acceptable in settlements of debts between
provide financial services to, private countries.
individuals or corporate entities. • The reserves that are held account for
• The head office of BIS is in Basel,
Basel approximately 7% of the world's
world s total
Switzerland and there are two representative currency.
offices in the Hong Kong and in Mexico City. • The BIS carries out its work through
• Established on 17 May 1930, the BIS is the subcommittees, the secretariats it hosts,
world's oldest international financial and through its annual General Meeting of
organization. all members.
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• The BIS' main role is in setting capital • The BIS also comments on global economic
adequacy requirements. and financial developments and identifies
• BIS requires bank capital/asset ratio to be issues that are of common interest to
above a prescribed minimum international central banks.
standard, for the protection of all central • The BIS carries out research and analysis to
banks involved. contribute to the understanding of issues of
• Another role for BIS is to make reserve core interest to the central bank
requirements transparent. 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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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
Basel Accords • Its membership is now composed of senior
• The Basel Committee on Banking representatives of bank supervisory
Supervision is an institution created in 1974 authorities and central banks from the G-10
by the central bank Governors of the Group countries, and representatives from
of Ten nations (Belgium, Canada, France, Luxembourg and Spain. It usually meets at
Germany, Italy, Japan, the Netherlands, the Bank for International Settlements in
Sweden, Switzerland, the United Kingdom, Basel,, where its 12 member ppermanent
and the United States). Secretariat is located.
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• The Basel Committee formulates broad • Basel I is the term which refers to a round of
supervisory standards and guidelines and deliberations by central bankers from
recommends statements of best practice in around the world, and in 1988, the Basel
banking supervision in the expectation that Committee on Banking Supervision (BCBS)
in Basel, Switzerland, published a set of
member authorities and other nations' minimal capital requirements for banks.
authorities will take steps to implement
• This is also known as the 1988 Basel
them through
g their own national systems,
y , Accord It was enforced by law in the Group
Accord.
whether in statutory form or otherwise. of Ten (G-10) countries in 1992, with
Japanese banks permitted an extended
transition period.
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• Basel I primarily focused on credit risk. • Basel II is the second of the Basel Accords,
Banks with international presence are which are recommendations on banking
required to hold as capital at least 8 % of the laws and regulations issued by the BCBS.
risk-weighted assets. • The purpose of Basel II, which was initially
• Basel I is now widely viewed as outmoded, published in June 2004, is to create an
and a more comprehensive set of international standard that banking
guidelines, known as Basel II are in the regulators can use when creating
process of implementation by several regulations about how much capital banks
countries. need to put aside to guard against the types
of financial and operational risks banks
face.
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ECON248: Money and Banking Ch.7: Central Banking Dr. Mohammed Alwosabi
• Several countries started to implement • In practice, Basel II attempts to accomplish
Basel II in 2008. this by setting up rigorous risk and capital
• Advocates of Basel II believe that such an management requirements designed to
international standard can help protect the ensure that a bank holds capital reserves
international financial system from the types appropriate to the risk the bank exposes
of problems that might arise should a major itself to through its lending and investment
bank or a series of banks collapse. p
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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