Role of Central Banks

A Central Bank (referred to as the Federal Reserve System in the United States), also known as the Reserve Bank of the government is separate from the country's ministry of finance. It's still referred to as the government's bank because it manages buying and selling of government bonds and other instruments. Most developed nations today have an "independent" central bank, that is one which operates under rules designed to prevent political interference. Functions of a central bank may include:

  • Implementing monetary policy: discussed in detailed
  • Determining Interest rates: discussed in detailed
  • Controlling a country's money supply
  • "Lender of Last Resort"
  • Regulating and supervising the banking industry
  • Managing country's foreign reserves and gold reserves
  • Controlling the nation's entire money supply

Central banks maintain the supply of money in the economy through measures called "open market operations". When a central bank buys securities such as bonds it infuses money into the market, which in turn means printing money to acquire a certain instrument. Conversely, selling of securities lowers the money supply.

The main open market operations are:

  • Temporary lending of money in exchange for collateral securities (also known as the "repo" market). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month) are auctioned off.
  • Buying or selling securities on a case by case basis
  • Foreign exchange operations such as forex swaps

These operations influence the foreign exchange market and hence the exchange rate of all currency pairs of that currency.

"Lender of Last Resort"

Central banks are also responsible for maintaining liquidity in the economy. When commercial banks go insolvent or cannot cover for their debt position (as seen in the 2009 financial crisis), the central banks prevent the financial system from collapsing. As a "lender of last resort" they protect depositors, avoid credit crisis and prevent widespread panic caused by financial institutions.

Fortunately or unfortunately we have had some experience of this in the 2009 with many bank, financial institutions going bust and the central banks running to their rescue. So you will remember this one.

Regulating and supervising the banking industry

In most countries a central bank through its subsidiaries and/or directly regulate and monitor the banking sector. In some countries like the United Kingdom regulatory responsibility lies with the UK Treasury, or an independent government agency. The regulatory body is in charge of verifying bank balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Managing country's foreign reserves and gold reserves

Central banks in most countries are required to hold a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks.

Today central banks also hold foreign reserves to manage the country’s world trade. Gold reserves are also maintained to secure the currency.

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