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Principles of Banking and Finance

Part 5

Introduction

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Introduction to Banking

Chapter 5

1. What are the mainfunctions of centralbanks?

2. What are the monetaryfunctions of a centralbank?

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I. Learning Objectives:

To understand the crucial role of central banks infinancial sector.

To describe the main functions of the central bank.

To understand the monetary policy functions ofcentral banks

To understand the arguments put forward by the

free banking theorists.

To discuss the arguments for and against anindependent central bank.

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II.Lecture/DiscussionDefinition of Some important TermsA. Main Functions of Central Bank:

It controls the issue of notes and coins (legal

tender).

It has the power to control the amount of credit-

money created by banks. It has control over non-bank financial

intermediaries that provide credit.

It uses relevant tools and instruments of monetary

policy in order to control: credit expansion,

liquidity, and the money supply of an economy.

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5. Oversees the financial sector in order to

prevent crises and act as a lender-of- a- last-

resort in order to protect depositors, prevent

wide spread panic withdrawal.

6. A central bank acts as the governments banker.

7. It acts as the official agent to the government in

dealing with all its gold and foreign exchange

matters.

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a. How does monetary policy work?

1. Monetary Policy- it is concerned with the

actions taken by central banks to influence the

availability and cost of money and credit by

controlling some measure of the money supply

and or level and structure of interest rates.

2. Fiscal Policy- relates to changes in the level

and structure of government spending and

taxation designed to influence the economy.

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3.Exchange Rate Policy

-involves the targeting of a particularvalue of a countrys currency exchangerate thereby influencing the flows within

the balance of payments.

4.4.Prices and Income Policy- is intendedto influence the inflation rate by means ofeither statutory or voluntary restrictionsupon increases in wages, dividends, and

or prices.

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5.National Debt Management Policy

-is concerned with the manipulation of the

outstanding stock of government debt

instruments held by the domestic private

sector with the objective of influencing thelevel and structure of interest rates and or

the availability of reserve assets to the

banking system.

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The Concepts and Functions of Money

1.Medium of Exchange

2.Unit of Account

3.Store of Value4.Standard of Deferred payment

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Monetary Policy Objectives

1. High Employment- to increase the

level of employed people.

2. Price stability- price of basic

commodities does not fluctuate.

3.Stable economic growth- to alleviate

the standard of living of the population.

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4. Interest Rate Stability- interest rate on

banks does not fluctuate to encourage

investors.5. Financial Market Stability- it is

influenced by the stability of interest rates

for it can lead to increase or decrease ofthe value of bonds and other investment

6. Stability in Foreign Markets the

foreign exchange rate does not change.

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Monetary Policy Functions of Central Bank:

1. Debt Securities and Open marketoperations These are represented by

government treasury bills/securities.

The central bank operates in the market andpurchases and sells govt debt to the non-

bank private sector. The government can

influence the portfolio of assets held by private

sectors.

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The open Market operations

Instruments or

Tools of

Monetary Policy

1. Open market

Operation

If the Central Bank sells government

securities, the money supply decreases.

If the Central Bank buys government

securities, the money supply increases.

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2.Loans to banks and the discount flow

Discount window- is often referred to asstanding facilities . It is the instrument that

allows eligible banking institutions to borrow

money from the central bank, to meet shortterm liquidity needs. By changing the discount

rate (the interest rate) that monetary authority

are prepared to lend to banking system, the

central bank can control the supply of moneyin the system.

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The Discount Window

Instruments or Tools of Monetary Policy

2. Discount

Window

The higher the discount rate, the lower

The amount of funds that banks will

decide to borrow.

The lower the discount rate, the higher

The amount of funds that banks will

decide to borrow.

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3.Reserve Requirements

Reserve requirement- is officially imposed toeffectively monitor the banks capacity tocontinue its operation and to protect thedepositors.

- By changing the fraction of deposits that banksare obliged to keep as reserves, the centralbank can control the money supply. Thisfraction is expressed in percentage calledREQUIRED RESERVE RATIO

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3.Reserve Requirement

Instruments or Tools of Monetary Policy

3. ReserveRequirement

The higher the required reserve ratio,

The lower the amount of funds available

to the bank.

The lower the rate, the lower required

reserve ratio, the higher the amount

of funds available to the bank

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Other Instruments of Portfolio Constraint

1.Special Deposits- these deposits are equalto a specified proportion of certain elements of

of banks deposits liabilities, are then frozen

at the bank and may not be used as part ofthe reserve asset base for lending purposes.

-The main objective of special deposits is to

remove excess liquidity from the system if

bank deposit growth is increasing too rapidly.

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2.Moral Suasion

- It refers to the range of informal requests andpressure that the authorities may exert overbanking institutions.

- The extent to which this is real power of theauthorities relative to direct controls is open toquestion, since much of the pressure that theauthorities would exert involves the institutionshaving to take actions that might not be in thebanks commercial interest.

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3.Direct Control

-It involves the authorities issuing directives inorder to attain particular immediate targets.

-Example: the monetary authorities might

impose controls on interest rates payable ondeposits, may limit the volume of credit

creation or direct banks to prioritize lending

according to various types of customer.

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4.The decline in use of Portfolio Constraints

These are widely used for following reasons:

a. Deregulation and increasing competition in

the provision of financial services and

products traditionally offered by banks havebroadened.

b. Disintermediation, primarily involving large

companies has undermined portfolio

constraints.

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c. Most countries now maintained a system of

foreign currency exchange control.

d. Portfolio constraints are regarded as

unfavorable to competition because they

place restrictions of one kind or another, on

the business freedom and growth of banksand other intermediaries falling within the

constraints.

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Why do banks need a Central Bank?

-Central bank can be thought as super-banks at the center of financial system.

-it is responsible for both macro functionssuch as monetary decisions and micro

functions like the lender of last resort (LOLR)

to banking sector.

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As LORL- Lender of Last Resort

It is the role of the central bank to providereserves to the bank experiencing serious

problems due to either a sudden withdrawal of

funds by depositors or to a situation where thebank has embark on highly risky operations

and thus cannot find liquidity anywhere else.

-The central bank will provide loan to an

illiquid bank to prevent it failure.

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Liquidity- it relates to the banks ability of tomeet short-term obligations (expected andunexpected) . It has something to do also withits ability to convert its assets into cash when

they fall due.Solvency- is the ability of the bank to

ultimately meet its all obligations. It meansthat the value of assets are greater thanliability.

Relationship between Liquidity & Solvency

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Should Central Bank be Independent?

Central Bank Independence-it can be defined as independence from

political influence and pressures in the

conduct of its functions, in particular monetarypolicy.

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2types of Banks Independence:

1.Goal Independence- ability of the centralbank to set its own goals for monetary policy

like: low inflation, and high production levels.

2.Instrument Independence- ability of the

central bank to independently set the

instruments of monetary policy to achieve

these goals.