The Central Bank
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A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country or of a group of member states, such as the European Union. Its primary responsibility is to maintain the stability of the national currency and money supply, and to achieve other specific goals like constraining inflation. More active duties include controlling subsidized loan interest rates, and acting as a "bailout" lender of last resort, which is an institution willing to extend credit when no one else will, to the banking sector during times of financial crisis. It may also have supervisory powers to ensure that banks and other financial institutions do not behave recklessly or fraudulently.
In most countries the central bank is state-owned and has a minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy.
Activities and Responsabilities
Functions of a central bank (not all functions carried out by all banks):
- implementing the basis of monetary policy
- monopoly on the issue of banknotes
- the Government's banker and the bankers' bank ("Lender of Last Resort")
- manages the country's foreign exchange and gold reserves and the Government's stock register;
- regulation and supervision of the banking industry:
- setting the official interest rate - used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms
Monetary Policy
Central banks implement a country's chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for "money" under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, the "promise to pay" consists of nothing more than a promise to pay the same sum in the same currency.
Many central banks are "banks" in the sense that they hold 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. Unusually, however, central banks may "create" new money to back its own liabilities, to theoretically unlimited amounts.
Interest Rate Intervention
Typically a central bank controls certain types of short-term interest rates. These influence the stock - and bond markets as well as mortgage and other interest rates. The European Central Bank (ECB) for example announces its interest rate at the meeting of its Governing Council (in the case of the Federal Reserve, the Board of Governors).
Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Fed, they are the local Federal Reserve Banks, for the ECB they are the national central banks.
Appart from other duties and responsibilities, by far the most visible and obvious power of many modern central banks is to influence market interest rates.
The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, which is generally the rate that large banks use to borrow and lend from one another, and a band of plus or minus 0.25%.
Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited. Other central banks use similar mechanisms.
It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for five-year bonds might be 5%, 4.75%, or even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "Central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.
A typical central bank has several interest rates or monetary policy tools it can set to influence markets.
- Marginal Lending Rate which is a fixed rate for institutions to borrow money from the CB.
- Main Refinancing Rate. This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans (In the US this is called the Discount rate).
- Deposit Rate which is the rate parties receive for deposits at the Central Bamk.
These rates directly affect the rates in the money market, the market for short term loans.
Ricky Schmidt
January 22, 2007
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