Dr. Mohammed Alwosabi

Dr. Mohammed Alwosabi ECON248 University of Bahrain

1

CENTRAL BANKING AND THE MONETARY POLICY

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, but 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.


2

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 developmental 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


3

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 open

market operation, bank reserve requirement, interest rate policy (discount

rate).


4

While capital adequacy is important, it is defined and regulated by the Bank

for International Settlements (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.


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


5

borrowed reserves Loans decrease money supply (Ms) decreases

AD decreases AD curve shifts leftward.


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.


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.


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.


6

For international banks, including the 55 member central banks of the Bank

for International Settlements (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,

o To increase commercial bank lending the central bank can lower

reserve requirements, lower capital requirements, lower the discount

rate, or buy government securities.

o 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.


7

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. Operational (Instrument) 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


8

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:

o a forum to promote discussion and policy analysis among central

banks and within the international financial community

o a center for economic and monetary research

o a prime counterparty for central banks in their financial transactions

o agent or trustee in connection with international financial operations

The BIS banking services are provided exclusively to central banks and other

international organizations. As its customers are central banks and

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 Special Administrative Region of

the People's Republic of China 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.


9

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 Netherlands, 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


10

steps to implement them through their own national systems, whether in

statutory form or otherwise.

Basel I

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 (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 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 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 II

Basel II is the second of the Basel Accords, which are recommendations on

banking laws and regulations issued by the Basel Committee on Banking

Supervision. 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.


11

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.

Basel II uses a three pillars concept:

1. The first pillar intends to link capital requirements for large,

internationally active banks more closely to actual risk. It deals with

maintenance of regulatory capital calculated for three major

components of risk that a bank faces: credit risk, operational risk and

market risk. Other risks are not considered fully quantifiable at this

stage.

2. The second pillar focuses on strengthening the supervisory process,

particularly in assessing the quality of risk management in banking

institutions and in evaluating whether these institutions have adequate

procedures to determine how much capital they need. It also provides

a framework for dealing with all the other risks a bank may face, such

as systemic risk, pension risk, concentration risk, strategic risk,

reputation risk, liquidity risk and legal risk, which the accord

combines under the title of residual risk

3. The third pillar focuses on improving market discipline through.

increasing the disclosure of details about the bank’s credit exposure,

its amount of reserves and capital, the officials who control the bank,

and the effectiveness of its internal rating system. This is designed to

allow the market to have a better picture of the overall risk position of


12

the bank and to allow the counterparties of the bank to price and deal

appropriately.

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.

Documents

Dr. Mohammed Alwosabi