Transcript MB-CentralBanking12

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 country’s
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:
1. 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
2. To ensure financial stability and to have
resilient and efficient financial system
3. To have effective policy for risk
management and control supervision
4. To issue and enforce anti-money laundering
and fraud laws
5. To enhance the economic development
through institutional building and market
infrastructure and through ensuring healthy
competition and efficient financial markets
6. To create a sound payments system through
efficient means of transferring funds between
parties and for commercial transactions
7. To have a real time gross settlement system
and check clearing system
8. To play the role of economic and financial
adviser to the government.
9. To help in managing government borrowing
10. To represent the government in
international agencies and meetings
11. To strengthen cooperation with
international financial community
12. To manage the country's foreign exchange
and gold reserves
13. To issues new currency and withdraw
damaged one
14. To collect data and make economic
forecasting and policy
15. To review and approve annual accounts of
all banks and conduct regular onsite
inspection
16. 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.
1. To ensure Shari’a compliance and to monitor
Shari’a implementations by Islamic financial
institutions, whether full-fledged or just
Islamic banking windows
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
3. To approve the appointment of CEOs and
directors of Islamic financial institutions
4. 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:
1.
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.
2. 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.
3. 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:
1. a forum to promote discussion and policy
analysis among central banks and within the
international financial community
2. a center for economic and monetary research
3. a prime counterparty for central banks in their
financial transactions
4. 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.