Introduction
Banking plays an
integral role in countries all over the World today. Based on the underlying
principle of trust amongst people and institutions, banking plays a vital purpose
in the everyday functioning of people, businesses and governments. The starting
of banks can be traced to the Venice, where the first regular institution
resembling what we may call a Bank, was established nearly seven hundred years
ago.[1]
The early banks were primarily engaged in the limited function of money
changing. Over the next century or two, other banking functions evolved. Banks
began to receive objects of entrustment, the “depositor” of the object expecting
its return on demand. In addition, banks began to grant credit, often to
merchants, for a share of a venture’s profits. Further, because of the increase
in foreign commerce, bankers began to establish agents in various locations.[2]
The rapidly increasing role of banks in the economy and life of people prompted
the need for the regulation of this industry. The massive importance that the
banking industry was gaining made the government step in to make laws in
relation to banking.
Central banking is a
relatively recent concept whereby certain banks were given special privileges. The
first central banks originated from the banks of issue, founded because of an
urgent need by the governments for credit and domestic control over monetary
matters.[3]
However, the forerunners of modern central banks were not born of the need for
monetary services or a lender of last choice.[4]
Wars and revolutions of independence create financial turmoil for governments
and the founding of central banks has commonly followed on heels of such
events.[5]
In fact, all such central banks in existence before 1850 were chartered in the
context of war. For banks chartered after a war the context was usually very
high inflation generated by governments’ overissue of paper currency to meet
wartime expenditures.[6]
The importance of a central
bank was further articulated at the International Financial Conference in
Brussels in 1920, where it was suggested that a central bank was necessary for
a state to fulfill its economic potential.[7]
The majority of the modern day countries have already established central banks
or similar statutory authorities. During the initial phases, the central banks
were majorly given the power to issue currency. Later, many other monitoring
and controlling powers were given to the central banks. They were given the
charge to regulate the domestic monetary market and were made the single
authority that played a key role in the development of any nation. The everyday
changing nature of banking is also changing the role and functions of the
central banks. These banks are in the driver’s seat in the major economies of
the World and are taking proactive role in shaping the global economy.
Role
of Central Banks
Central Banks
around the World are the primary institutions to control economic growth,
control inflation and provide fiscal stability in the State. These banks are
statutory bodies that play a pro-active role in the economy and their decisions
have a vital impact in the financial markets. Although it must be noted that
the creation of central banks is no guarantee against financial crisis, their
quick and committed fulfillment of their powers and functions should have an
important impact on financial markets, with resulting benefits for customer
bankruptcies and commercial failures and limits.[8]
Although many ancillary roles are played by the central banks, the following
can be characterized as the major roles that majority of the central banks play
throughout the Globe:
Ensuring Financial Stability:
It can be argued
that banking depends upon trust. Trust is so essential to the banking industry
that once the inter-related trust amongst the people and banks/institutions is
broken, the entire financial system collapses. An example highlighting the
importance of trust could be that of a bank run. Simply put, bank run is when
due to the instability created in the system, people loose the trust that the
bank in which they have deposited their money would get bankrupt and they rush
to the banks to get their money out of it. Bank runs are dreaded in any
financial system as it could lead to the collapse of a bank, which in turn
could lead to failure of the whole system.
Each bank is of
systemic importance in any nation and to prevent this kind of failure, the central
banks step in and act as the lender of last resort. This means that in emergency
conditions, the central bank brings out the bank that is on the verge of
bankruptcy to save the entire system so that the trust of people is maintained
in the financial system. It does this by using reserves of cash and marketable
securities to meet the resulting demand.[9]
One of the famous examples of recent times was the case of Lehman Brothers in
2008.[10]
It is important to note that this does not mean that the central banks seek to protect
individual organizations. The goal of this policy is to protect the stability
of the whole financial system, through particular players if need be. In
addition to being the lender of last resort, to support financial stability,
bankers do macroeconomic surveillance, prudential regulation and supervision.[11]
Regulating Monetary Policy:
Central banks
also play a major role in managing the money and controlling inflation.
According to Semler, earlier the role of central banks in controlling monetary
policy was limited as long as the exchange rates were fixed. After the
suspension of global gold standard and collapse of the Bretton Woods system of
pegged exchange rates, the role of central banks in this sphere has increased.[12]
Thus, it can be seen that in the present day World, central banks play a
leading role in money management and trying to stabilize the currency.
To manage the
monetary policy, the central banks use various tools such as having reserve
requirements for other banks, increasing or decreasing the interest rates etc.
For example- if the central bank feels the need to supply more money in the
market, it decreases the CRR (credit reserve ration) and the banks have more
cash with them to loan further and if they want to decrease the supply of cash,
the central bank increases the CRR for banks and they are left with less cash.
Similarly, in the short term, by increasing the interest rates, the central
bank ensures that people spend less and thus inflation is checked and by
reducing the interest rates it is ensured that people have more money which
leads to increase in inflation. Central banks all over are constantly entangled
in the inverse relationship of inflation and interest rates. It can be seen
that the monetary policy has a great effect on the market as well as the
day-to-day life of the people and it is one of the most important tasks which
are assigned to central banks.
Acting as Banker’s Bank
Apart from other
regulatory and supervisory jurisdiction that most of the central banks have
over other commercial banks in the country, they also act as the banker to these
other banks. This means that all the banks in the country are required to have
their accounts in the central bank and then the central bank acts as their
banker by providing them short term loans and other credit facilities. All
their reserve requirements are also deposited in their accounts with the
central bank.
Through this, the central bank has powers to
influence liquidity and interest rates discussed in the above section. In
addition to this, the central banks also act as clearing agents to other banks.
As the custodian of the cash reserves of the profit-making
banks, the central bank acts as the clearinghouse for these banks. Since all
banks have their accounts with the central bank, the central bank can easily
settle the claims of various banks against each other with least use of cash.[13]
Government’s Banker
In addition to
the other banks in the country, the central banks also usually cater to the
banking needs of the governments. The central banks has accounts of the
government and it advances loan to the governments as any other bank does to
the customer. Further, it collects and has deposits of the taxes collected from
various State or Central governments. The central banks also serve the purpose
of advising the governments on matters relating to the financial policy etc.
Sole Issuer of Currency
One of the first
roles assigned to the central banks was that of being the sole issuers of
currency notes. The central banks throughout the World are given monopoly
rights to issue bank notes and this was the distinctive feature that separated
these banks from other banks. Private banks are not allowed to issue notes. The
simple reason behind this is that if private banks were allowed to issue their
respective notes, there would be multiplicity of notes that would be cumbersome
and not best suited for regulation.[14]
It can be seen
that the central bank performs many important functions that are vital to the
functioning of the financial markets. Central banks are made independent and
powerful and one of the major reasons for doing this is to maintain the public
confidence in the system. This highlights the importance that trust has in
banking, which is further discussed in the next section.
Trust in banking
Colombo, in his article says,
the economy and the world as we know it simply could not function without a
certain degree of trust.[15]
Trust is the scope to which one party is willing to depend on somebody, or
something, in a given situation with a feeling of relative security, even
though negative consequences are possible.[16]
This general definition tends to point that ‘trust’ and ‘risk’ might be related.
Taking cue, it can be said that the banks are in the business of risk taking.
The every day transactions that bank do have certain degree of risk in them.
Banks try to mitigate these risks by various means in different situations. For
example, while giving a loan, the bank is taking a risk of default by the
borrower and it tries to mitigate the risk by taking security from the
borrower. The bank always has the possibility of default but it still provides
credit to the borrower based on the trust that he will be giving back the loan
(this trust is increased by the presence of security). If the banks had no
trust in the ability of the borrower to pay back the money, they would have not
been able to extend loan to anyone and therefore no commercial business would
be transacted. Similarly, from the other side, the depositor trusts that the
bank will give his money back to him when he demands and then he submits the
money. Thus the nature of banking business can be said to have its roots in the
presence of mutual faith.
Similarly, in central
banking, trust plays even a major role. On the first place, the citizens are
ensured that an independent, powerful institution that is specialized in taking
care of the financial affairs governs them. It is always better that these
increasingly complex matters are not taken care of by the politicians and
therefore the confidence of the public in the financial system improves. The
citizens of any country would feel safe in using the banking facilities only if
they have faith in the whole system. They will not approach the banks if they
are not sure if their money would be returned to them. In case the bank fails,
the depositors have the belief that the central bank would insure them against
their risk and their money would be returned back to them.
More so, in central banking,
the essential role of credibility and reputation of central banks for the
conduct of monetary policy can be emphasized. It is seen that discretionary
monetary policy leads to an inflationary bias. That is to say that the
inflation rate will be higher than the one that is socially desirable. As
credibility and trust are closely connected, it is difficult to disentangle
them.[17]
More so, in the case on central banking, all the other commercial banks in any
country have trust that their interests are protected against any new comer, as
there would be no chance for the new comer to have any extra benefits in
presence of the central bank. Further, as discussed earlier, the presence of
central bank also prevents situations like bank runs.
Conclusion
Central banks have been at
the centre of economic affairs in countries since the pas few decades. However,
with growth of new avenues of trade and commerce, it is proving to be difficult
for central banks to regulate financial markets. Instead of bank notes, people
are relying more and more on e-transactions. In this scenario, only a
multi-national approach towards the problem can prove to be effective. Various
central banks have shown co-ordination in their conduct to tackle global
problems and it is to be seen what steps are taken in future to further the
co-operative efforts.[18]
Interestingly, the most important issue here will also be that of the trust
between various central banks of the World.
Dev Chaudhary
[1]
Richard Hildreth, The History Of Banks 9 (Augustus M. Kelley Publishers, 3rd
ed. 1971) (1837) [http://mises.org/books/History_of_Banks_Hildreth.pdf].
[2] Edward L. Symons Jr., The “Business Of Banking” In Historical
Perspective, 51 Geo. Wash. L. Rev.
676 1982-83.
[3] Dwight Semler, Focus: The Politics Of Central Banking, 3
E. Eur. Const. Rev. 48 1994.
[4] J. Lawrence Broz, The Origins Of Central Banking: Solutions To The
Free Rider Problem 7 (December 1969), dss.ucsd.edu/~jlbroz/origins_CBs_IO.pdf
[5] Semler, supra note
3, at 10.
[6] Broz, supra note
4, at 7.
[7] Sheri Berman &
Kathleen R. McNamara, Bank On Democracy:
Why Central Banks Need Public Oversight, 78 Foreign
Aff. 2 1999.
[8] Bernard Bekink &
Christo Botha, The Role Of A Modern
Central Bank In Managing Consumer Bankruptcies And Corporate Failures: A South
African Public-Law Angle Of Incidence 21 S.
Afr. Mercantile L.J. 74 2009.
[9] Douglas W. Arner &
Michael A. Panton & Paul Lejot, Central
Banks And Central Bank Cooperation In The Global Financial System 23 Pac. McGeorge Bus. & Dev. L.J. 1 2010-11.
[10] Lenders Of Last Resort,
Too Big To Fail, available at http://lenderoflastresort.weebly.com/too-big-to-fail.html.
[11] Arner & Panton & Lejot, supra note 8 at 22.
[12] Semler, supra note
3, at 23.
[13] Aparijita Sinha, What Are The Functions Of Central Bank?,
available at http://www.preservearticles.com/201012281868/functions-of-central-bank.html.
[14] Cheques can be issued
by different banks on their own but it is important to note that the Cheques
are only issued on the name of the beneficiary which is not so in bank notes.
The bank notes are payable to the bearer of the note.
[15] Ronald J. Colombo, The Role Of Trust In Financial Regulation 55
Vill. L. Rev. 577 2010.
[16] Audun Josang & Stephane Lo Presti, Analyzing The Relationship
Between Risk And Trust 1 (2004), http://eprints.soton.ac.uk/258769/1/risktrust.pdf.
[17] Dirk Bursian & Sven Furth, Trust Me! I Am A European Central
Banker 5 (2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1932638.
[18] Jon Hilsenrath &
Jeffrey Sparshott, Central Banks Move To
Calm Fears, Wall St. J., Dec.
1, 2011.
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