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A central bank, reserve bank, or monetary authority is an institution that manages a state's currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the amount of money in the nation, and usually also prints the national currency, which usually serves as the nation's legal tender. Examples include the European Central Bank (ECB) and the Federal Reserve of the United States.
The primary function of a central bank is to manage the nation's money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. Still, limited control by the executive and legislative bodies usually exists.
The chief executive of a central bank is normally known as the Governor, President or Chairman.
Prior to the 17th century most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The Song Dynasty was the first to issue generally circulating paper currency, while the Yuan Dynasty was the first to use notes as the predominant circulating medium. In 1455, in an effort to control inflation, the succeeding Ming Dynasty ended the use of paper money and closed much of Chinese trade. The medieval European Knights Templar ran an early prototype of a central banking system, as their promises to pay were widely respected, and many regard their activities as having laid the basis for the modern banking system.
As the first public bank to "offer accounts not directly convertible to coin", the Bank of Amsterdam established in 1609 is considered to be the precursor to modern central banks. The central bank of Sweden ("Sveriges Riksbank" or simply "Riksbanken") was founded in Stockholm from the remains of the failed bank Stockholms Banco in 1664 and answered to the parliament ("Riksdag of the Estates"). One role of the Swedish central bank was lending money to the government.
In England in the 1690s, public funds were in short supply and were needed to finance the ongoing conflict with France. The credit of William III's government was so low in London that it was impossible for it to borrow the £1,200,000 (at 8 per cent) that the government wanted. In order to induce subscription to the loan, the subscribers were to be incorporated by the name of the Governor and Company of the Bank of England. The bank was given exclusive possession of the government's balances, and was the only limited-liability corporation allowed to issue banknotes. The lenders would give the government cash (bullion) and also issue notes against the government bonds, which can be lent again. The £1.2M was raised in 12 days; half of this was used to rebuild the Navy.
The establishment of the Bank of England, the model on which most modern central banks have been based, was devised by Charles Montagu, 1st Earl of Halifax, in 1694, to the plan which had been proposed by William Paterson three years before, but had not been acted upon. He proposed a loan of £1.2M to the government; in return the subscribers would be incorporated as The Governor and Company of the Bank of England with long-term banking privileges including the issue of notes. The Royal Charter was granted on 27 July through the passage of the Tonnage Act 1694.
Although some would point to the 1694 establishment Bank of England as the origin of central banking, it did not have the functions as a modern central bank, namely, to regulate the value of the national currency, to finance the government, to be the sole authorised distributor of banknotes, and to function as a 'lender of last resort' to banks suffering a liquidity crisis. The modern central bank evolved slowly through the 18th and 19th centuries to reach its current form.
Although the Bank was originally a private institution, by the end of the 18th century it was increasingly being regarded as a public authority with civic responsibility toward the upkeep of a healthy financial system. The currency crisis of 1797, caused by panicked depositors withdrawing from the Bank led to the government suspending convertibility of notes into specie payment. The bank was soon accused by the bullionists of causing the exchange rate to fall from over issuing banknotes, a charge which the Bank denied. Nevertheless, it was clear that the Bank was being treated as an organ of the state.
Henry Thornton, a merchant banker and monetary theorist has been described as the father of the modern central bank. An opponent of the real bills doctrine, he was a defender of the bullionist position and a significant figure in monetary theory, his process of monetary expansion anticipating the theories of Knut Wicksell regarding the "cumulative process which restates the Quantity Theory in a theoretically coherent form". As a response 1797 currency crisis, Thornton wrote in 1802 An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, in which he argued that the increase in paper credit did not cause the crisis. The book also gives a detailed account of the British monetary system as well as a detailed examination of the ways in which the Bank of England should act to counteract fluctuations in the value of the pound.
Until the mid-nineteenth century, commercial banks were able to issue their own banknotes, and notes issued by provincial banking companies were commonly in circulation. Many consider the origins of the central bank to lie with the passage of the Bank Charter Act of 1844. Under this law, authorisation to issue new banknotes was restricted to the Bank of England. At the same time, the Bank of England was restricted to issue new banknotes only if they were 100% backed by gold or up to £14 million in government debt. The Act served to restrict the supply of new notes reaching circulation, and gave the Bank of England an effective monopoly on the printing of new notes.
The Bank accepted the role of 'lender of last resort' in the 1870s after criticism of its' lacklustre response to the Overend-Gurney crisis. The journalist Walter Bagehot wrote an influential work on the subject Lombard Street: A Description of the Money Market, in which he advocated for the Bank to officially become a lender of last resort during a credit crunch (sometimes referred to as "Bagehot's dictum"). Paul Tucker phrased the dictum as follows:
Central banks were established in many European countries during the 19th century. The War of the Second Coalition led to the creation of the Banque de France in 1800, in an effort to improve the public financing of the war.
Although central banks today are generally associated with fiat money, the 19th and early 20th centuries central banks in most of Europe and Japan developed under the international gold standard, elsewhere free banking or currency boards were more usual at this time. Problems with collapses of banks during downturns, however, lead to wider support for central banks in those nations which did not as yet possess them, most notably in Australia.
The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve Act in the Senate and its signing by President Woodrow Wilson on the same day, December 23, 1913. Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of the Great Depression in 1934. By 1935, the only significant independent nation that did not possess a central bank was Brazil, which subsequently developed a precursor thereto in 1945 and the present central bank twenty years later. Having gained independence, African and Asian countries also established central banks or monetary unions.
The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms, which accelerated in 1989 when the country adopted a generally capitalist approach to its export economy. Evolving further partly in response to the European Central Bank, the People's Bank of China has by 2000 become a modern central bank. The most recent bank model, was introduced together with the euro, involves coordination of the European national banks, which continue to manage their respective economies separately in all respects other than currency exchange and base interest rates.
There is no standard terminology for the name of a central bank, but many countries use the "Bank of Country" form (for example: Bank of England (which is in fact the central bank of the United Kingdom as a whole), Bank of Canada, Bank of Mexico; But the Bank of India is a (government-owned) commercial bank and not a central bank). Some are styled "national" banks, such as the National Bank of Ukraine, although the term national bank is also used for private commercial banks in some countries. In other cases, central banks may incorporate the word "Central" (for example, European Central Bank, Central Bank of Ireland, Central Bank of Brazil); but the Central Bank of India is a (government-owned) commercial bank and not a central bank. The word "Reserve" is also often included, such as the Reserve Bank of India, Reserve Bank of Australia, Reserve Bank of New Zealand, the South African Reserve Bank, and U.S. Federal Reserve System. Other central banks are known as monetary authorities such as the Monetary Authority of Singapore, Maldives Monetary Authority and Cayman Islands Monetary Authority. Many countries have state-owned banks or other quasi-government entities that have entirely separate functions, such as financing imports and exports.
In some countries, particularly in some Communist countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the Soviet Union's Gosbank (state bank). In other countries, the term national bank may be used to indicate that the central bank's goals are broader than monetary stability, such as full employment, industrial development, or other goals.
Functions of a central bank may include:
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, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the International Monetary Fund), currency board or a currency union. 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, when many currencies are fiat money, the "promise to pay" consists of the promise to accept that currency to pay for taxes.
A central bank may use another country's currency either directly (in a currency union), or indirectly (a currency board). In the latter case, exemplified by Bulgaria, Hong Kong and Latvia, the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency.
The expression "monetary policy" may also refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority.
Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. Unemployment beyond frictional unemployment is classified as unintended unemployment.
For example, structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment. Macroeconomic policy generally aims to reduce unintended unemployment.
Inflation is defined either as the devaluation of a currency or equivalently the rise of prices relative to a currency.
Since inflation lowers real wages, Keynesians view inflation as the solution to involuntary unemployment. However, "unanticipated" inflation leads to lender losses as the real interest rate will be lower than expected. Thus, Keynesian monetary policy aims for a steady rate of inflation.
Economic growth can be enhanced by investment in capital, such as more or better machinery. A low interest rate implies that firms can loan money to invest in their capital stock and pay less interest for it. Lowering the interest is therefore considered to encourage economic growth and is often used to alleviate times of low economic growth. On the other hand, raising the interest rate is often used in times of high economic growth as a contra-cyclical device to keep the economy from overheating and avoid market bubbles.
Interest rate stability
Financial market stability
Foreign exchange market stability
Conflicts among goals:
Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.
Similar to commercial banks, central banks hold assets (government bonds, foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding). Central banks create money by issuing interest-free currency notes and selling them to the public in exchange for interest-bearing assets such as government bonds. When a central bank wishes to purchase more bonds than their respective national governments make available, they may purchase private bonds or assets denominated in foreign currencies.
The European Central Bank remits its interest income to the central banks of the member countries of the European Union. The US Federal Reserve remits all its profits to the U.S. Treasury. This income, derived from the power to issue currency, is referred to as seigniorage, and usually belongs to the national government. The state-sanctioned power to create currency is called the Right of Issuance. Throughout history there have been disagreements over this power, since whoever controls the creation of currency controls the seigniorage income.
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 for example announces its interest rate at the meeting of its Governing Council; in the case of the U.S. Federal Reserve, the Federal Reserve 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 Federal Reserve, they are the local Federal Reserve Banks; for the ECB they are the national central banks.
Although the perception by the public may be that the "central bank" controls some or all interest rates and currency rates, economic theory (and substantial empirical evidence) shows that it is impossible to do both at once in an open economy. Robert Mundell's "impossible trinity" is the most famous formulation of these limited powers, and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain free capital movement. Since most Western economies are now considered "open" with free capital movement, this essentially means that central banks may target interest rates or exchange rates with credibility, but not both at once.
In the most famous case of policy failure, Black Wednesday, George Soros arbitraged the pound sterling's relationship to the ECU and (after making $2 billion himself and forcing the UK to spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies and argued that no one should be able to do what he did.
The most complex relationships are those between the yuan and the US dollar, and between the euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially removed from circulation in 2004 and replaced by the convertible peso.
The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.
To enable open market operations, a central bank must hold foreign exchange reserves (usually in the form of government bonds) and official gold reserves. It will often have some influence over any official or mandated exchange rates: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").
By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required.
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, 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 (perceived) 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 (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, 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.
"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." – Henry C.K. Liu. Liu explains further that "the U.S. central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market ... a fiat money system set by command of the central bank. The Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of central banks in general.
A typical central bank has several interest rates or monetary policy tools it can set to influence markets.
These rates directly affect the rates in the money market, the market for short term loans.
Through open market operations, a central bank influences the money supply in an economy. Each time it buys securities (such as a government bond or treasury bill), it in effect creates money. The central bank exchanges money for the security, increasing the money supply while lowering the supply of the specific security. Conversely, selling of securities by the central bank reduces the money supply.
Open market operations usually take the form of:
All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the People's Bank of China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus the renminbi and the yen.
All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords) 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 reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.
Historically, bank reserves have formed only a small fraction of deposits, a system called fractional reserve banking. Banks would hold only a small percentage of their assets in the form of cash reserves as insurance against bank runs. Over time this process has been regulated and insured by central banks. Such legal reserve requirements were introduced in the 19th century as an attempt to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other overextended banks. See also money multiplier.
As the early 20th century gold standard was undermined by inflation and the late 20th century fiat dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China retains (and uses) more powers over reserves because the yuan that it manages is a non-convertible currency.
Loan activity by banks plays a fundamental role in determining the money supply. The central-bank money after aggregate settlement – "final money" – can take only one of two forms:
The currency component of the money supply is far smaller than the deposit component. Currency, bank reserves and institutional loan agreements together make up the monetary base, called M1, M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part of the money supply in 2006.
To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.
In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral.
In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as the UK Treasury, or an independent government agency (for example, UK's Financial Conduct Authority). It examines the banks' balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".
Many countries such as the United States will monitor and control the banking sector through different agencies and for different purposes, although there is usually significant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and other types of financial institutions may be subject to different (and occasionally overlapping) regulation. Some types of banking regulation may be delegated to other levels of government, such as state or provincial governments.
Any cartel of banks is particularly closely watched and controlled. Most countries control bank mergers and are wary of concentration in this industry due to the danger of groupthink and runaway lending bubbles based on a single point of failure, the credit culture of the few large banks.
In the 2000s there has been a trend towards increasing the independence of central banks as a way of improving long-term economic performance. However, while a large volume of economic research has been done to define the relationship between central bank independence and economic performance, the results are ambiguous.
Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust"), as politicians may be tempted to boost economic activity in advance of an election, to the detriment of the long-term health of the economy and the country. In this context, independence is usually defined as the central bank's operational and management independence from the government.
The literature on central bank independence has defined a number of types of independence.
It is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England (1997) and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect. Even the People's Bank of China has been accorded great latitude due to the difficulty of problems it faces, though in the People's Republic of China the official role of the bank remains that of a national bank rather than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under pressure". The People's Bank of China's independence can thus be read more as independence from the USA which rules the financial markets, than from the Communist Party of China which rules the country. The fact that the Communist Party is not elected also relieves the pressure to please people, increasing its independence.
Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the Board of Governors of the U.S. Federal Reserve are nominated by the President of the U.S. and confirmed by the Senate. The Chairman and other Federal Reserve officials often testify before the Congress.
International organizations such as the World Bank, the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence. The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and increased transparency in the policy-making process. The IMF's Financial Services Action Plan (FSAP) review self-assessment, for example, includes a number of questions about central bank independence in the transparency section. An independent central bank will score higher in the review than one that is not independent.
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