A Central Bank is an institution or authority predominantly responsible for printing and issuance of currency, to control and regulate the supply of money and interest rates in a state and at times to act as a lender (Lender of the last resort) to the banking sector. It also acts as an overseer by supervising the other financial institutions especially the commercial banks in a state. The central bank often vested with the responsibility of formulating the monetary policy in a country. Almost every state in modern age has established a central bank which regulates its monetary policy and responsible to issue the currency and execute several others responsibilities to be discussed in succeeding paragraphs.
In United Kingdom, for instance, the Bank of England with its headquarters located in London acts as central bank of the kingdom. The foundation of the Bank of England was laid in 1694 and since then it went through various swings including its nationalisation in 1946 and yet again its independence in 1997 however it has indisputably been standing at the centre of the UK's financial system retaining a pivotal position. The Bank of England is viewed as one of the model central banks of the world and of course the first ever bank of its kind. Its realm of operation is not limited to the England only, as its name may suggest, but it extends to the whole of United Kingdom.
In United States, the role of central bank has been shifting from one bank to the other. Bank of North America, for instance, remained the de facto central bank until 1791 when it was succeeded by the First Bank of the United States. However unlike the conventional Central Banks in other countries, the United States, in response to a sequence of financial crisis, replaced the conventional Central Banking and brought into effect a quite distinct substitute with the establishment of the Federal Reserve System in 1913 by virtue of the Federal Reserve Act. The Federal Reserve System operates through Board of Directors appointed by the presidency, the Federal Open Market Committee (FOMC), a number of privately owned banks and regional Federal Reserve Banks. The events like Great Depression became chief factors leading to the expansion of the role of this institution. Its functions now include regulating and supervising commercial banks, maintaining the stability of the monetary system and formulating the monetary policy, affording financial support to commercial banks and the government or other depository institutions.
Importance of a Central Bank
The importance of the central banking system can be assumed from the fact that there were only few countries prior to the World War-I who had established their central banks, however, after the World War new financial crisis obliged the other countries to revisit their monetary systems and thus many countries either reshuffled and rationalized their existing central banking system or created new central banks. The central bank in any modern economy plays a very significant role since it is a highest financial and monetary management institution of a country. No need to go too far; just have a look at the Bank of England, the first ever central bank created by any country of the world. The Bank of England unceasingly strengthened the UK's banking sector and it will not be an exaggeration to say that credit goes to the Bank of England that City of London is now one of the world's top financial centres.
Central Banks in Developing Countries
The sphere of the responsibilities shouldered by the central banks in developing or least developed countries is not however limited to the so-called conventional primary functions at macroeconomic level like managing monetary policy, issuance of currency notes etc., but they rather extend to micro level including the development of capital market and other important constituents and also to provide a fuller assistance in promoting the country's resources and help in the economic growth.
FUNCTIONS OF A CENTRAL BANK
As discussed above a central bank performs multiple functions and operates in the broader macroeconomic financial system as well functions of micro level different from country to country and at the end of the day plays a significant developmental and progressive part. Broadly speaking central banks in many countries perform both traditional functions as well as promotional functions to realize their macroeconomic objectives. Some of the important activities of a central bank are briefly illustrated hereunder:
Advisor to Government on Monetary, Economic and Fiscal Policies
Central Bank in a country is normally entrusted with the responsibility to formulate monetary and credit policy of the country and to advise the government on monetary issues and other economic affairs. It helps a government in the endeavours to reduce unemployment and resist undue inflation in the country. Central bank is usually responsible to implement a country's monetary and fiscal policy and it may involve determining what type of currency the country may have, whether a gold-backed currency (not allowed for IMF member countries) or fiat currency etc. essentially in the form of a standardized currency or promissory notes and bonds etc. The central bank strives and helps to prevent the country's banking system from deteriorating however the foremost and important objective of the central banks is to afford price stability by clamping the inflation.
"In countries with fiat money, expression 'monetary policy' may refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority".
Issue Banknotes
The leading and primary function of any central bank is to issue and regulate the supply and circulation of currency notes. A central bank in a country is the only authorized body to do so, thus it enjoys monopoly over issuance of currency. It usually does this by keeping reserve against the money issued. Though most of the transactions in day to day life are carried out through cheques, debit or credit cards etc. and use of cash is minimized yet the role of currency notes can never be overlooked.
Exchange Rate Management
One of the major functions of a central bank is to maintain the external value of the currency and keep the exchange rate at a decent level and prevent it from recurrent fluctuations. The keeping of exchange rate at an appropriate level helps maintain the constancy in foreign exchange market and competitiveness of exports and in order to achieve this, central bank regulates foreign exchange reserves besides other measures in this regard.
Banker to other banks and Government
Central bank acts as a banker to other banks and holds accounts with other International bodies like World Bank and IMF. It helps the member banks in time of crises as a "lender of the last resort".
It also acts as banker and financial agent to the government by collecting and paying transactions for government. The central bank receives income in shape of taxes etc. on behalf of government and keeps account of its treasures free of interest. It helps the government in borrowing money by issuing bonds and bills.
Supervision and Regulation
Central Bank act as supervisor and oversee the affairs of the other commercial banks and financial institutions by collecting information and take necessary actions. Central Banks monitor and control the commercial banks and often serve the purpose of a clearing house or mediator for the settlement of disputes and mutual obligations among commercial banks and other financial institutions. They regulate and supervise the financial system to protect the interests of the depositors as well to maintain the stability and soundness of the system. With the advancement of technology and onset of modern banking, things have become very complex and the supervisory role of central banks has become quite unavoidable in order to keep pace with rapidly changing financial conditions of the country. The detail scrutiny of the banking supervision and its repercussions in the light of Core Principles of the Basel Accords are discussed in the second part of this course work.
SUPERVISION BY CENTRAL BANKS
As discussed in the foregoing paragraph that the advancement of technology and modern banking has made things very intricate and the supervisory role of central banks has become quite indispensible in the given situation which might give birth to various issues. In order to minimize the existing problems and increase the effectiveness of the supervisory system in banking sector, a lot of measures have been taken by the international communities. The establishment of Basel Committee in this regard is the most eye-catching example.
The Basel Committee
The Basel Committee on Banking Supervision is an organization established in 1974 by governors of the central banks of G-10 nations with its central secretariat located in Basel Switzerland. It has 12 permanent members whereas number of non-permanent members varies. The idea behind the establishment of this institution was to attain an effective supervision system by formulating guidelines to the member countries and set up comprehensive supervisory standards.
Brief Summary of the Core Principles of Effective Supervision
The Basel Committee on Banking Supervision, in order to achieve its objectives, adopted and published accords comprised of recommendations and regulations on banking laws and the supervisory standards and principles to be followed by the member countries. Let's have a quick look of few of them.
The core principles provide an outline the conditions to be followed in order to realize the effective supervisory system. It suggests and requires all the stakeholders to have an unequivocal line of objectives and obligations and hold all necessary resources with freedom of action well before embarking upon the effective supervision. The constitution and structure of the subject banking organizations and their corporate affiliations should be well-defined, not exposing them to any risks. And as far licensing of the activities and nomenclature of the institutions is concerned, the arrangements in this regard should also be clearly demarcated whereas the licencing authority ought to have the unhindered powers to either reject or accept the submissions by the institutions that do not fulfil the set criterions.
The core principles further lay down standards with regard to the adequacy of the capital, evaluation of banking organizations' policies and mechanism related to the loans, market risks and risk management process and the quality of assets. The principles further require the banking organizations to have an efficient and demarcated arrangement of the separation of functions within the organizations and policies related to their customers. Eyeing farther, the core principles urge on the banking organizations to have proficient system of information both interstate and cross border and also to have a proper system of maintaining of their record.
Possible Legal Issues
The first likely issue to be confronted before setting off for the effective supervision is to draw an acceptable structure of the legal provisions required by the Basel Committee as a prerequisite. This framework has to be clear and certain with regard to the extent of the powers and authority of the banking organizations as it might give rise to the question of immunities and legal protection to the supervising authority and also to the uncertainty of the privacy protection to the supervisors while they are communicating and carrying out correspondence of information.
The second set of concern might be a kind of authority vs. self-governance issues, related to the activities prohibited or permitted to the banking organizations and with regard to the criteria of issuance of license to carry out any particular activity. It may give rise to the conflict of freedom of decisions and other affairs between supervisors and the banking institutions like as to which and to what extent and limit they can undertake these activities. The banking organizations might take it as the invasion on their autonomy and liberty and might accuse the supervisors for being dictatorial under in the name of authority.
Similarly in Islamic banking, for instance, which is supposedly a conventional kind of banking, the issue may emerge as to what extent any proposed or licensed activity has binding effect on it since principally the Islamic banking is inspired by the Quran and Sunnah and supposed to be governed by the injunctions of the sharia law, thus it may give rise to a likely conflict between the apparently two divergent systems of the banking.
Another issue likely to spring up is whether the capital with a particular organization is adequate or inadequate and also the quality of assets as envisaged by the authors of the Core Principles. Banks, by virtue of the Core Principles, are required to set a 'prudent minimum capital adequacy' and quality of assets and the adequacy of loan loss provisions and loan loss reserves, which statement is quite vague and absurd and may possibly be interpreted in one way or other and all the descriptive things like 'risk assessment' and 'ability to absorb the losses' connected to it are subjective type which cannot be proved directly. Yet in another principle a same kind of unclear criteria has been applied that is 'at arm's length basis' apparently a measure proposed to lessen the risk of lending, however this thing may lead to the issue of mistrust between the banking organizations and their customer companies and individual.
The other probable issue is related to the transfer of information from the banking organizations to the supervisors and vice versa. The supervisors might insist to pass on various types of information while the banking organizations might be cautious to pass every kind of information; considering it to be invasion on their privacy. Same is the case with supervisors, they would also demand for a secure and protected information exchange system to avoid any kind of invasion whatsoever on their privacy with regard to their supervision related information. The state of affairs might lead to the frequency of litigation between them in the name of 'privacy invasion' and 'privacy protection'.
In case of cross-border banking a sword of conflict of laws, between the host country and operating country, is always hanging over the banking organizations. Though provision of having a consolidated supervision system might minimize the hazards however in the event of clash between the rules of banking of both countries the banking organizations have to suffer a lot. The question which country's rules would prevail might be decided in litigation.
CONCLUSION
To put in nutshell, a Central Bank is an institution which helps to regulate the monetary, economic and fiscal policy of a country and also responsible to issue and circulate the money. The central banks beside their traditional primary functions discharge a wide range of other secondary functions in order to successfully achieve the primary functions. As for as the supervisory functions of the central banks are concerned, guideline like Core Principles is in place for the central banks by following which they can with smooth and effective manner supervise the other banking institutions. However there are still a number of loopholes in the system particularly in Basel Accords which are required to be rectified as they may lead to conflicts between the supervisor-institutions and other banking organizations.
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