Central banks: What they are and what they do

A Central Bank can be generally defined as an institution whose main objectives lie in managing a state’s currency, money supply, and interest rates. Central Banks are also known as Reserve Banks, Monetary Authorities or, in the case of the US, the Federal Reserve (aka “Fed”). The Central Bank usually also prints the national currency, which usually serves as the state’s legal tender.  In the early 20th century, a state’s legal tender meant that money could be exchanged for precious metals in some fixed amount, but this does not hold since the abandonment of the Gold Standard in the 1930s. Now, most currencies are fiat money, meaning that the “promise to pay” consists of the promise to accept that currency to pay for taxes in that country. In the broader sense, the Central Bank enforces the use of that specific currency within its jurisdiction, making sure that at all commercial banks accept the currency when the public presents them with it. For example, commercial banks in the Euro Area should accept any euros brought to them by any of their customers, provided of course that they meet some criteria (not counterfeit, not stolen, etc.). This also indirectly ensures that all citizens within that state would be happy to receive the specific currency for the work and services they provide.

The first Central Bank to be established with ongoing operations was the Swedish Riksbank, which was set up in 1668. However, the bank did not have a monopoly over the issuance of bank notes until the early 20th century. Bank of England, which was established in 1694, defined the model on which most modern central banks have been based. Motives for the establishment were not so pure though: the Kingdom of England wanted to obtain a loan to finance the ongoing Nine Years’ War with France, but its credit position was too low to be able to borrow. In order to agree to the provision of the loan, the lenders proposed that they were incorporated as The Governor and Company of the Bank of England with long-term banking privileges including the issue of notes. The lenders would give the cash to the government and also issue notes against the government bonds, which could be lent again. Consequently, the Central Bank’s first functions were to act as the government’s banker and trustee, in particular when it came to raising money. In their function as a trustee, Central Banks often, bought government bonds themselves, an action also known as monetary financing, and which is still used by some countries today.

Still, the  Bank of England did not have many of the objectives and powers modern Central Banks do. Power over the value of the national currency and monopoly over the distribution of banknotes, evolved slowly through the 18th and 19th centuries. The most important benefit of having a monopoly over the supply of money is that it essentially means that a Central Bank cannot run out of money as it can, theoretically, issue (print prior to the digital era) any amount of money to satisfy its needs. Naturally, an uncontrollable increase in the amount of money would come at the cost of higher inflation, hence cancelling out any benefit from more money in the economy. Following the British example, Central Banks were established in many European countries during the 19th century.

A result of its unlimited ability to create money is that the Central Bank cannot, at least in theory, run out of liquidity. This was not always the case, as when the Gold Standard presided over the world, Central Banks had to obey a law stating that a specific percentage of the existing money had to be backed with Gold. This was very impractical given that in times of distress either the percentage would have to be lowered in order to issue more money, or the Central Bank would see its reserves depleted if enough citizens requested an exchange of their money for Gold. As a result, the Central Bank’s ability to affect the money supply could be severely diminished, given that runs to get gold in return for money usually happened during recessions, when the economy needed the money the most. This led to higher unemployment and a severe and persistent decrease in prices (deflation) which can be very harmful if it persists for a long period of time. As such, the Gold Standard was abandoned, allowing the Central Bank to potentially create unlimited liquidity and use it when it sees fit.

This leads to another important role of the Central Bank which is to act as the ‘lender of last resort’.  The term was popularized by journalist Walter Bagehot and suggests that during periods of distress Central Banks should lend early and without limit, against good collateral, and at high rates, to firms which are solvent, in order to avert panics. To understand why this is required, we need to have a glimpse of how commercial banks operate. In general, commercial banks provide loans and obtain deposits from the public, and also provide other sorts of financial services. Given that the money is lent out, banks only have a limited availability of cash to cover for potential deposit withdrawals. In times when many withdrawal requests could come at the same time, but the commercial bank does not have the available funds to satisfy all of these needs, it usually borrows either from other banks, the Central Bank itself, or from other financial institutions (e.g. investment funds, etc.) for short periods of time, so as not to cease withdrawals and enter a state of default. This is why the Central Bank is also usually referred to as the “Bank of Banks”.

However, during periods of financial crises, it could be the case that withdrawal requests increase while the interbank market dries up. During these periods of time, the Central Bank assumes the role of a liquidity provider to financial institutions which are unable to obtain sufficient liquidity to maintain their operations, but are judged to be in a position to be able to continue with their operations. This allows the Central Bank to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next as a result of bank illiquidity.  Central Banks also use an additional tool to avoid panics, by providing what is known as deposit insurance, i.e. guarantee an amount of deposits in the case that the commercial bank fails. As such, depositors should not feel the rash to withdraw their funds in the case when a commercial bank faces problems. The lender of last resort role and the deposit insurance tool assisted the US Fed to avoid a systemic crash of the economy during the 2008-2009 crisis.

As already suggested, Central Banks also have the ability to control the supply of money (and indirectly other macroeconomic developments such as inflation and GDP growth) through the manipulation of interest rates, a theme examined in a series of articles here. Prior to abandoning the Gold Standard, where any increase in the amount of currency needed to be met with an increase in the level of goldreserves according to a predetermined percentage, Central Banks had a stronger grip over a country’s money supply. Nowadays, the power of monetary policy is affected by the strength of the transmission channels through which it affects the economy.

Finally, in a theme which has resurfaced since the 1990s, Central Banks are the official licensors and supervisors of commercial banks. While this does not refer to the micro-managing of commercial banks, i.e. in interfering regarding whether Mr and Mrs X obtain a loan, the Central Bank monitors the overall lending behaviour of commercial banks, as well as their capital buffers and requirements. The reason behind this monitoring is to ensure financial stability, since financial crises can be much more harmful to the economy compared to economic downturns.

Notice that in order to proceed as they see fit, Central Banks need to be independent from political developments so that their interference in the economy is objective and not driven by any political agenda. The idea is that if Central Banks are affected by politics then they may not act in the best interest of the economy but could take steps to assist the agenda of politicians which could hurt the economy in the long run. As such, independence is highly valued by investors and is indeed the case in the majority of developed countries, with the recent examples of BoE and Fed acting against what the UK Prime Minister and the US President would prefer.

In a nutshell, Central Banks have the following functions:

  1. Banker and Trustee to the government

  2. Issue and control the quantity of banknotes

  3. Bank for commercial banks

  4. Control the money supply through monetary policy

  5. Lender of last resort

  6. Financial oversight

Disclaimer: Nothing in this communication contains, or should be considered as containing, an investment advice or an investment recommendation or a solicitation for the purpose of purchase or sale of any financial instrument.