Central banks are relatively new inventions. The nineteenth-century American President Andrew Jackson even once cancelled America's central bank (in 1833) because he did not think that it was very important. But things have changed since. Central banks today are the most important feature of the financial systems of most countries of the world.
Central banks are bizarre hybrids. Some of their functions are identical to the functions of regular, commercial banks. Other functions are unique to the central bank. On certain functions, it has an absolute legal monopoly.
Central banks take deposits from other banks and, in certain cases, from foreign governments which deposit their foreign exchange and gold reserves for safekeeping (for instance, with the Federal Reserve Bank of the USA). The Central Bank invests in the foreign exchange reserves of the country while trying to maintain an investment portfolio similar to the trade composition of its client - the state.
The Central bank also holds onto the gold reserves of the country. Most central banks have lately tried to get rid of their gold, due to its ever-declining prices. Since gold is registered in their books in historical values, central banks are showing a handsome profit in this line of activity. Central banks (especially the American ones) also participate in important, international negotiations. If they do not do so directly - they exert influence behind the scenes.
The German Bundesbank virtually dictated Germany's position in the negotiations leading to the Maastricht treaty. It forced the hands of its co-signatories to agree to strict terms of accession into the Euro single currency project. The Bundesbank demanded that a country's economy be totally stable (low debt ratios, low inflation) before it is accepted as part of the Euro. It is an irony of history that Germany itself is not eligible under these criteria and cannot be accepted as a member of the club whose rules it has assisted to formulate.
But all these constitute a secondary and marginal portion of the central bank's activities.
The main function of a modern central bank is the monitoring and regulation of interest rates in the economy. The central bank does this by changing the interest rates that it charges on money that it lends to the banking system through its "discount windows". Interest rates are supposed to influence the level of economic activity in the economy. This supposed link has not been unequivocally proven by economic research.
Also, there usually is a delay between the alteration of interest rates and the foreseen impact on the economy. This makes the assessment of the interest rate policy difficult. Still, central banks use interest rates to fine-tune the economy. Higher interest rates - lower economic activity and lower inflation. The reverse is also supposed to be true. Even shifts of a quarter of a percentage point are sufficient to send the stock exchanges tumbling together with the bond markets.
In 1994 a long-term trend of increase in interest rates commenced in the USA, doubling interest rates from 3 to 6 per cent. Investors in the bond markets lost 1 trillion (=1000 billion!) USD in 1 year. Even today, currency traders all around the world dread the decisions of the Bundesbank and sit with their eyes glued to the trading screen on days on which announcements are expected.
Interest rates are only the latest fad. Prior to this - and under the influence of the Chicago school of economics - central banks used to monitor and manipulate money supply aggregates. Simply put, they would sell bonds to the public (and, thus absorb liquid means, money) - or buy from the public (and, thus, inject liquidity). Otherwise, they would restrict the amount of printed money and limit the government's ability to borrow.
Even prior to that fashion there was a widespread belief in the effectiveness of manipulating exchange rates. This was especially true when exchange controls were still being implemented and the currency was not fully convertible. Britain removed its exchange controls only as late as 1979. The USD was pegged to a (gold) standard (and, thus not really freely tradable) as late as 1971.
Free flows of currencies are a relatively new thing and their long absence reflects this widely held superstition of central banks. Nowadays, exchange rates are considered to be a "soft" monetary instrument and are rarely used by central banks. The latter continues, though, to intervene in the trading of currencies in the international and domestic markets usually to no avail and while losing their credibility in the process.
Ever since the ignominious failure of implementing the infamous Louvre accord in 1985 currency intervention is considered to be a somewhat rusty relic of old ways of thinking.
Central banks are heavily enmeshed in the very fabric of the commercial banking system. They perform certain indispensable services for the latter. In most countries, interbank payments pass through the central bank or through a clearing organ which is somehow linked or reports to the central bank. All major foreign exchange transactions pass through - and, in many countries, still must be approved by - the central bank.
Central banks regulate banks, licence their owners, supervise their operations, and keenly observe their liquidity. The central bank is the lender of last resort in cases of insolvency or illiquidity.
The frequent claims of central banks all over the world that they were surprised by a banking crisis looks, therefore, dubious at best. No central bank can say that it had no early warning signs or no access to all the data - and keep a straight face while saying so. Impending banking crises give out signs long before they erupt. These signs ought to be detected by a reasonably managed central bank. Only major neglect could explain a surprise on behalf of a central bank.
One sure sign is the number of times that a bank chooses to borrow using the discount windows. Another is if it offers interest rates which are way above the rates offered by other financing institutions. There are many more signs and central banks should be adept at reading them.
This heavy involvement is not limited to the collection and analysis of data. A central bank - by the very definition of its functions - sets the tone for all other banks in the economy. By altering its policies (for instance: by changing its reserve requirements) it can push banks to insolvency or create bubble economies which are bound to burst. If it were not for the easy and cheap money provided by the Bank of Japan in the eighties - the stock and real estate markets would not have inflated to the extent that they have. Subsequently, it was the same bank (under a different Governor) that tightened the reins of credit - and pierced both bubble markets.
The same mistake was repeated in 1992-93 in Israel - and with the same consequences.
This precisely is why central banks should not supervise the banking system.
When asked to supervise the banking system - central banks are really asked to draw criticism on their past performance, their policies and their vigilance in the past.
To further explain this statement:
In most countries in the world, bank supervision is a heavy-weight department within the central bank. It samples banks, on a periodic basis. Then, it analyses their books thoroughly and imposes rules of conduct and sanctions where necessary. But the role of central banks in determining the health, behaviour and operational modes of commercial banks is so paramount that it is highly undesirable for a central bank to supervise the banks.
Supervision by a central bank means that it has to criticize itself, its own policies and the way that they were enforced and also the results of past supervision. Central banks are really asked to cast themselves in the unlikely role of impartial saints.
A new trend is to put the supervision of banks under a different "sponsor" and to encourage a checks and balances system, wherein the central bank, its policies and operations are indirectly criticized by the bank supervision. This is the way it is in Switzerland and - with the exception of the Jewish money which was deposited in Switzerland never to be returned to its owners - the Swiss banking system is extremely well regulated and well supervised.
We differentiate between two types of central banks: autonomous and semi-autonomous.
The autonomous bank is politically and financially independent. Its Governor is appointed for a period which is longer than the periods of the incumbent elected politicians so that he will not be subject to political pressures. Its budget is not provided by the legislature or by the executive arm. It is self-sustaining: it runs itself as a corporation would. Its profits are used in leaner years in which it loses money (though for a central bank to lose money is a difficult task to achieve).
Prime examples of autonomous central banks are Germany's Bundesbank and the American Federal Reserve Bank.
The Deutsche Bundesbank became the first central bank to be given full independence, leading this form of central bank to be referred to as the "Bundesbank model"
The second type of central bank is the semi-autonomous one. This is a central bank that depends on the political echelons and, especially, on the Ministry of Finance. This dependence could be through its budget which is allocated to it by the Ministry or by a Parliament (ruled by one big party or by the coalition parties). The upper levels of the bank - the Governor and the Vice Governor - could be deposed through a political decision (albeit by Parliament, which makes it somewhat more difficult).
This is the case of the Reserve Bank of New Zealand or People's Bank of China whose goals are set by the Government.
Such dependent banks fulfil the function of an economic advisor to the government. The Governor of the Bank of England advises the Minister of Finance (in their famous weekly meetings, the minutes of which are published) about the desirable level of interest rates. It cannot, however, determine these levels and, thus is devoid of arguably the most important policy tool. The situation is somewhat better with the Bank of Israel which can play around with interest rates and foreign exchange rates - but not entirely freely.
Now, the central bank is facing its most daunting task: facing the truth without fear and without prejudice. Bank supervision needs to be overhauled and lessons need to be learnt. The political independence of the bank needs to be increased greatly. The bank must decide what to do with TAT and with the other failing Stedilnicas.
They could be sold to the banks as portfolios of assets and liabilities. The Bank of England sold Barings Bank in 1995 to the ING Dutch Bank.
The central bank could - and has to - force the owners of the failing Stedilnicas to increase their equity capital (by using their personal property, where necessary). This was successfully done (again, by the Bank of England) in the 1991 case of the BCCI scandal.
The central bank could increase the reserve requirements and the deposit insurance premiums.
But these are all artificial, ad hoc, solutions. Something more radical needs to be done:
And bank supervision must be separated from the central bank and set to criticize the central bank and its policies, decisions and operations on a regular basis.
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