CENTRAL BANKING

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CENTRAL BANKING

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CENTRAL BANKING AND THE MONETARY POLICY Dr. Mohammed Alwosabi GENERAL INTRODUCTION Every country with an established banking system has a central bank. – PowerPoint PPT presentation

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Title: CENTRAL BANKING

1

CENTRAL BANKING
AND
THE MONETARY POLICY
Dr. Mohammed Alwosabi

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.

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.

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.

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.

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

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

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

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.