The Role of the Central Bank - Essay Example

Executive summary The role of the central bank varies from each economic zone to another. In various economies, the role of the central bank has been that of a supervisor to the lending institutions in the same economy. In many countries, the role that is dominantly played by the central bank is to control the commercial banks of the country. In adverse circumstances or economic meltdown, the central bank will act as the last cushioning body for the banks to remain liquid. That is, the bank will act as a lender to these commercial banks to remain solvent and continue operation. In many economic set-ups or regional corporations that have a central bank, the main task of the bank is to ensure that each member’s rate has a considerable level of stability in the pricing of basic commodities by reducing interest rates. Other tasks include the ability of the central bank to act as a central reserve for the currency of the jurisdiction or country and to produce the legal tender used by the same country. Introduction Central banks perform several functions. They provide settlement services to large-value payments, act as lenders for the last resort, play a role to oversee banks for the sake of financial stability and monetary policy implementation. These jobs and their operations mode have repeatedly been redefined in order to decide on one specific financial and monetary crisis. In fact, all main stages in central bank functions shaping have been responses to financial and monetary crises. The Composition interpretation and the analysis of these crises are necessary to understand the functions that central banks need to implement and incarnate for a monetary economy to flourish. The origin of central banks as bankers’ banks was in 19th century England. Two conflicting theoretical conceptions of money, the banking principle and the currency principle, implied totally different roles of central banks. The central banks function is to put into effect convertibility of its bills into gold and to be flexible. Such flexibility is more consistent with the principle of banking, whereby money is a debt that financial intermediaries issue as the counterpart to their credit operations. Thus, it is the way of payments of debts issued by competing banks, payment between banks call for a superior bank to settle interbank transactions. This is mainly the role of the money given out by the central bank, money that is designed as legal tender for all debts. Nevertheless, the law cannot impose the trust of the economic agents in central bank money. It is fundamentally to protect this trust that central banks have developed their functions. The central bank supervises the banks to make sure the honesty of the payment system and avoid liquidity crises. In the event of liquidity crises, central banks are ready to lend in the last resort. They carry out monetary policies that result to a nominal anchor to the economy through stabilizing the unit of account. European Central Bank The European Central Bank (ECB) is an independent supranational monetary institution. It represents the core of the Euro-system and ESCB. The (ECB) headquarter is in Frankfurt, Germany. The main objective of the ECB is to support the economic activities and policies of the European Union and maintain price stability without discrimination to its primary objective. All the remaining objectives are not as important as compared with the primary objective, hence should not be in conflict with the primary objectives. ECB primary objective is drawn from the European Union main economic policy and the needs of the economic zone. The task of ECB are the following includes; defining Euro-system policies, monitoring, deciding and co-coordinating the monetary policy operations, adopting legal acts, to ensure the consistency in caring out of decentralized operations by national central banks, planning, coordinating and monitoring the euro banknotes issuance, interventions on the foreign exchange markets, European and international co-operation, monitoring financial risks and finally fulfilling advisory functions to institutions, national authorities and Community. The European Central Banks is characterized by the following bodies in its decision making council. They include; the General Council, the executive board and the Governing Council. These bodies are also tasked with the management of the ESCB and the Euro-system. Each of the three management organs is charged with a specific responsibility (Smits, 5). The General Council of the ECB The General Council is the decision-making body in ECB. It is composed of thirty persons; the ECBs President and his/her deputy, and the governors of the national central banks of all 28 EU Member States.  It is worth noting that this body is transition is nature and will be dissolved once governing council is formed. The Governing Council of EBC This is the executive board of the European central bank. The bank due to the structuring of operations is organized as a private corporation. This implies that it will have an executive Board of Directors as any other formal organization, and officers that are in charge of its day to day running. The board is tasked with the responsibility of making major decisions that are floated to them by the officers managing the firm on a daily basis. The governing council has six members and is the highest decision-making organ of the bank. The Executive Board of the ECB This is an operational decision-making body of the Euro-system and ECB, which manages day-to-day business. It is composed of the ECBs President, Vice-President and four other members. The ECB has 18 organizational units. This is divided as eleven main business areas and seven ancillary business areas. In addition, the employees of the ECB come mainly from its member states. In European Central Banking, the national central banks (NCBs) of the Euro system implement the monetary policy which is always decided by the Governing Council of the European. Central Bank (ECB). While in Central Bank of Golf cooperation Council, the decisions relating to monetary are discussed by the Central Bank Commission and then handed over to the Governor for implementation. The ECB is characterized by two pillars that form its strategy: economic analysis and monetary analysis. Economic analysis is always based on a greater range of leading indicators such as the outlook for risk to price stability and price developments. Furthermore, the ECB sets a target for inflation as (a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) in the European Union over the medium term below, but close to 2%). In terms of foreign exchange, the main economic foundation for a single European currency was to deepen economic integration within its members by improving price transparency, the reduction of the costs of cross-border commerce, encouraging cross-border mergers, increasing competition, and eliminating exchange rate risk. In the exchange rate both European Central Bank and Central Bank of Gulf Cooperation share a common goal of trying to stabilize their currency and try their level best to strengthen it. Before monetary union, the main agenda was on the rates at which the existing national currencies would be turned into Euros. After January 1, 1999, the interest quickly changed to the value of the euro in relation to other non-European currencies, mainly the U.S. dollar. In relation to payment system, all central banks carry out oversight of instrument and payment systems which was fully decentralized. The payment system is also seen as a similarity between both the Central Bank of Golf Cooperation Council and the European Central Bank. This is so as both the banks play a role on the oversight of the payment system. The payment system consisted of real-time gross settlement systems of the NCBs, the payment mechanism of the interlinking and the European Central Bank. Concerning other central banks, a real-time gross settlement (RTGS) system existed in most central banks. As far as security clearing and retail payments are concerned the ESCB does not participate as operator but restricts its authority to check on the smooth operation of settlement system and retail payment. Proposal for a gulf corporation council central bank Should the gulf corporation form a central bank, its structure and functions would borrow heavily from existing central banks in the six nations. The central bank will also derive most of its objectives from the kind of banking that is advanced in the Islamic culture of banking. In order to form this central bank, issues like currency and market have to be resolved beforehand. Bringing off all the six countries together will call for the need of a common market. This will call for the use of a single currency. This single currency will have lots of benefits; Single currency wills established an environment of a stable price in the Gulf area, exerting a moderating effect on wage-setting and price. As a result, inflation risk and inflation expectations premier will be kept stable and low. Even in the very challenging present environment, it will be hard to jeopardize price stability. Single currency will enable Payments to be made with the same money in all the six countries, making travelling across these countries easier. Transparency in price is good for trade because easier price comparisons enable the trader to buy from the cheapest supplier in the Gulf area. Therefore, price transparency brought about by a single currency will help the Central Bank of Gulf Cooperation Council to keep inflation under control. Increased competition will make the available resources to be used efficiently, spurring intra-gulf area trade and thereby supporting growth and employment. The launch of the Gulf Cooperation currency will eliminate foreign exchange transaction costs hence improves on the savings. Within the Gulf area, there are some transactions will be removed; a) Keeping numerous currency accounts that make management of accounts more difficult. b) Eliminate buying and selling of foreign currencies on the foreign exchange markets. c) Eradicate cross-border payments in foreign currencies, which involves high fees; protecting oneself against difficult exchange rate movements. With the introduction of the Gulf Cooperation Council currency, exchange rate fluctuations and risk in foreign exchange within the Gulf area will disappear. These exchange rate costs and risks prevent trade and competition across borders. In terms of structure and management, the proposed gulf corporation council central bank will adopt the structure of the Twenty-first century Corporation. This implies that it will have two organs in its management: the board of directors or governors and the officers who are in charge of its daily running. The board which will be the highest decision-making organ of the Bank will also be in charge of the implementation of the central banks policies in the member states and development of the policies that foster economic growth. Each of the member state’s central banks then will have to hold a share in the central bank. The central bank will then act as the bank of these constituent central banks. Objectives and functions for Gulf Cooperation Council central Bank It is worth noting that the proposed gulf corporation council central bank will borrow much of its structural and operational functions from existing central banks of similar kind. The objectives however will have to be set based on the specific requirements of the economic zone and the policies that form the backbone of the corporation. The most important objectives and functions of the Gulf Cooperation Council will be categorized in to the following main functions of the central bank. Monetary policy objectives Price stability is the main dominant monetary policy objective specified in legislation. It means low inflation. It is evidenced that the economy performs well when there is low inflation and is expected to be low. In this condition Interest rates are also low. This environment allows an economy to achieve its potential growth and fosters high employment. In this aspect, the central bank proposed borrows heavily on the functions that are performed by other central banks such as the European central bank. Financial stability objectives Financial stability is a situation whereby the financial system, for example; the financial institution and key financial markets system is resistant to economic shocks and is fit to smoothly fulfill its basic functions. A financial system that is stable creates a good environment for investors and depositors, encourages effective functioning of markets and efficient financial intermediation, and hence, promotes economic growth and investment. Financial system stability means the financial system effective functioning and the absence of currency, banking and balance of payments crisis. The Functions Issue of Bank Note: The central bank exclusively monopolizes the note issue. The advantages of giving the central bank the monopoly to print and issue note are: to bring uniformity in the monetary system of note circulation and issue and to provide better control of money supplied in the country. Hence increasing the confidence of the public in the monetary system Monopoly makes monetary management of the paper currency easier. Considering that it is the supreme bank of the nation, the central bank has all the information about the economy monetary requirements and, thus, can change the amount of currency accordingly. It enables the central bank to control the creation of credit by the commercial banks. The central bank also attains its profit from the paper currency issue. Giving of monopoly right of issuing the note to the central bank prevents the political meddling in the matter of note issue. By performing this duty, the proposed central bank for the gulf corporation will have little or no political influence. Banker to the Governments: As a banker to the government, the central bank delivers the same functions to the government as a commercial bank delivers to its customers. These include: a) It keeps the government account as well as the central accounts. b) It makes short-term advances to the government. c) It receives government deposits. d) It receives cheques and drafts deposited in the government account. e) It provides the government with foreign exchange resources for purchasing foreign goods, repaying external debt or making other payments. In the case of the gulf corporation council, the central bank will act as a collective bank that helps the nations perform their transactions faster. It will also be a perfect bank to help the states in this council deal with cross-border transactions that involve other economic locks like the United States or Asian countries. Agent to the Governments: As an Agent to the government, the central bank collects payments and taxes on behalf of the government. It increases loans from the public and hence manages public debt. It also represents the government in the conference and international financial institutions. Adviser to the Governments: As a financial adviser to the countrys government, the central bank advises the government on financial, economic, fiscal and monetary, matters such as devaluation, deficit financing, trade policy and foreign exchange policy. These functions are typical to any central bank. In the case of the gulf corporation council central bank, the function will be delivered through the states central banks. The council’s central bank will offer the advisory function by engaging the individual member state central banks. This will be aimed at encouraging the even development within member states as expressed in the council’s objectives. This is not easy to realize because the structuring of the proposed bank. In the European central bank, the implementation of the policies and the adoption of the Euro as a currency by the member states led to the inclusion of a third organ in the structure of the bank. The task of this organ was to oversee the transition of all member states to the new currency of the Euro-zone. Acts as Bankers Bank: The central bank performs the role of the bankers bank in three ways: First it is the custodian of the cash reserves: As the keeper of the commercial bank cash reserves, the central bank maintains the cash reserves of the commercial banks. Each commercial bank has to keep some part of its cash balances with the central bank as deposits. The commercial banks can use. These cash reserves during emergency. In this case, the council’s central bank will treat the member state’s central banks as the commercial banks. The cash that it will hold is in the currency that is accepted by the council. Some of the advantages of centralization of cash reserves in the central bank are: I. Centralized cash reserves stir confidence of the public in the country’s banking system. II. Centralized cash reserves offer the basis of an elastic and larger credit structure than if these amounts were distributed among the individual banks. III. Centralized reserves can be used in the most efficient manner during the time of financial emergency and seasonal strains. IV. Centralized reserves enable the central bank to provide financial accommodation to the commercial banks facing difficulties. This is by acting as the lender of the last resort. V. The centralized cash reserves system allows the central bank to persuade the creation of credit by the commercial bank by decreasing or increasing the cash reserves through the variable cash-reserve ratio technique. Vi. The central bank cash reserves can be used to promote national welfare. Lender of Last Resort: As the bankers bank and the supreme bank of the country, the central bank performs the role of the lender of the last resort. To mean, in case the commercial banks are not in a position to meet their financial requirement, they can approach the central bank for financial assistance. In addition, the central bank rediscounts commercial banks exchange bill and eligible securities. That is, it provides financial accommodation to the commercial banks. While treating the member states as the clients or the commercial banks, the proposed central bank is able to discharge this function effectively. The advantages of the central banks functioning as the last resort lender are: i. it increases the liquidity and elasticity of the whole economy credit structure. II. It allows the commercial banks continue with their activities even when having limited cash reserves. Iii. It provides commercial banks with financial help in times of emergency. IV. It allows the central bank to apply its control over the country’s banking system. The substantial control that the proposed central bank will have on the member states central banks enables the bank to easily monitor and control the financial markets of the region. This will make it easy for it to control the interest rates and reduce inflation in the member states economies. Clearing Agent: As a commercial bank cash reserve custodian, the central bank plays as the clearing house for these banks. Since the central bank has the account of all banks, the central bank is in a position to easily settle various banks claims against each other with little use of cash. The advantage of the clearinghouse function of the central bank includes: i. it minimizes the use of cash by banks while taking care of their claims and counter-claims. ii. It reduces cash withdrawals, and these allow the commercial banks to develop large scale credits. iii. It keeps the central bank well informed about the commercial bank liquidity position. While treating the member states as commercial banks, the central bank will be able to clear the debts owed between different nations effectively. Conclusion Countries coming together and forming a central bank is crucial. This central bank will lead to the formation of a common market that will help in the economic growth. Never the less it may also lead to the common currency among the countries involved. In the attainment of a common currency, the countries reduce the time taken to effect certain payments that involve cross-border transactions. The central bank of the corporation will also offer significant ease to the member states while dealing with other states outside the bloc. It is worth noting that the central bank will borrow significantly on the structure and functionality of the existing similar central banks. This will determine the level of success in delivering on its core objectives as defined by the member states. Works cited Rene Smits. The European central bank: institutional aspects. Wolter Kluwers publishers: 1997. Read More