CENTRAL BANKING AND THE MONETARY POLICY Dr. Mohammed Alwosabi

GENERAL INTRODUCTION Every country with an established banking system has a central bank. The central bank of any country can be defined as a government authority in charge of regulating the country’s financial system, controlling the quantity of money and conducting monetary policy. There is only one central bank for each country with few branches.

The central bank is a "bank" in the sense that it holds assets (foreign exchange, gold, and other financial assets) and liabilities. A central bank's primary liabilities are the currency outstanding, and these liabilities are backed by the assets the bank owns.

The central bank is the bank of government The central bank is the bank of government. It does not provide general banking services to individual citizens and business firms The central bank is the bank of the banks and acts as a lender of last resort to the banking sector during times of financial crisis The central bank has supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

There is no standard terminology for the name of a central bank, Many countries use the "Bank of Country" form (e.g., Bank of England, Bank of Canada, Bank of Russia). In other cases, they may incorporate the word "Central" (e.g. European Central Bank, Central Bank of Bahrain). The word "Reserve" is also used, primarily in the U.S., Australia, New Zealand, South Africa and India. Some are styled national banks, such as the National Bank of Ukraine.

THE MAIN ROLES OF CENTRAL BANK The central bank (CB) regulates and supervises depository institutions. The main roles of central banks are: To ensure monetary stability through monetary policy tools that keep inflation low and stable, and, hence, preserving local currency purchasing power and promoting economic activity To ensure financial stability and to have resilient and efficient financial system To have effective policy for risk management and control supervision

To issue and enforce anti-money laundering and fraud laws To enhance the economic development through institutional building and market infrastructure and through ensuring healthy competition and efficient financial markets To create a sound payments system through efficient means of transferring funds between parties and for commercial transactions To have a real time gross settlement system and check clearing system To play the role of economic and financial adviser to the government. To help in managing government borrowing

To represent the government in international agencies and meetings To strengthen cooperation with international financial community To manage the country's foreign exchange and gold reserves To issues new currency and withdraw damaged one To collect data and make economic forecasting and policy To review and approve annual accounts of all banks and conduct regular onsite inspection To evaluate and approve proposed mergers and expansions

Role of Central Bank – Islamic banking and finance In addition to the above-mentioned general roles, CB has a crucial role to supervise and monitor Islamic banking and finance. To ensure Shari’a compliance and to monitor Shari’a implementations by Islamic financial institutions, whether full-fledged or just Islamic banking windows To set up a Shari’a Supervisory Board (SSB) at the central bank level to approve the Islamic financial products and instruments developed by Islamic financial institutions To approve the appointment of CEOs and directors of Islamic financial institutions To monitors the compliance of Islamic banks to regulatory requirements

MONETARY POLICY AND ITS INSTRUMENTS Despite their names, central banks are not banks in the sense that commercial banks are. They are governmental institutions that are not concerned with maximizing their profits, but with achieving certain goals for the entire economy. The purpose of the central bank is to help achieve stable prices, full employment, and economic growth through the regulation of the supply of money and credit in the economy.

Changing the money supply and credit to achieve these goals is called monetary policy. Monetary policy is the management of the money supply for the purpose of maintaining stable prices, full employment, and economic growth.

The main monetary policy instruments available to central banks are (1) open market operation, (2) bank reserve requirement, (3) interest rate policy (discount rate). While capital adequacy is important, it is defined and regulated by the Bank of International Settlement (BIS), and central banks in practice generally do not apply stricter rules.

Open Market Operations (OMO) Through open market operations, a central bank influences the money supply in an economy directly. An open market operation is the purchase or sale of government securities by the central bank in the open market.

To reduce inflation, the central bank conducts a contractionary monetary policy using the open market operation. Central bank sells government securities  people pay money to buy government securities from the central bank  banks deposit decreases  banks reserves decrease  Loans decrease  money supply (Ms) decreases  AD decreases  AD curve shifts leftward.

To reduce unemployment, the central bank conducts an expansionary monetary policy using the open market operation. Central bank buys government securities  people receive money from the central bank  banks deposit increases  banks reserves increase  Loans increase  money supply (Ms) increases  AD increases  AD curve shifts rightward.

Discount Rate The discount rate is the interest rate the central bank charges the commercial banks and other depository institutions when they borrow reserves from it. To reduce inflation, the central bank conducts a contractionary monetary policy using the discount rate. It increases the discount rate  higher cost of borrowing reserves  banks borrow less reserves from central bank  but with a given required reserves banks decrease their lending to decrease their borrowed reserves  Loans decrease  money supply (Ms) decreases  AD decreases  AD curve shifts leftward.

To reduce unemployment, the central bank conducts an expansionary monetary policy, using the discount rate. It decreases the discount rate  lower cost of borrowing reserves  banks borrow more reserves from central bank  banks increase their lending  Loans increase  money supply (Ms) increases  AD increases  AD curve shifts rightward.

Reserve Requirements Another significant power that central banks hold is the ability to establish reserve requirements for other banks. All depository institutions in the country are required to hold a minimum percentage of deposits as reserves (cash or deposited with the central bank). This minimum percentage is known as a required reserve ratio.

To reduce inflation, the central bank conducts a contractionary monetary policy using the required reserve ratio. It requires depository institutions to hold more reserves, which results in increasing the reserves and thus reducing the amount they are able to lend  Loans decrease  money supply (Ms) decreases  AD decreases  AD curve shifts leftward.

To reduce unemployment, the central bank conducts an expansionary monetary policy using the required reserve ratio. Required reserves decrease  loans increase  Ms increase  AD increase  AD curve shifts rightward.

Capital requirements All banks are required by the central bank to hold a certain percentage of their assets as capital. For international banks, including the 55 member central banks of the Bank of International Settlement (BIS), the minimum capital requirement is 8% of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy.

Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when a bank cannot extend another loan without acquiring further capital on its balance sheet.

In conclusion, To increase commercial bank lending the central bank can lower reserve requirements, lower capital requirements, lower the discount rate, or buy government securities. To decrease commercial bank lending the central bank can raise the reserve requirements, raise the capital requirements, raise the discount rate, or sell government securities.

CENTRAL BANKS INDEPENDENCE Although central banks are part of the government, they usually have much more independence than other government agencies. The literature on central bank independence has defined a number of types of independence. The most important ones are:

Goal independence: The central bank has the ability to set its monetary policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government authority. The setting of common goals by the central bank and the government helps to avoid situations where monetary and fiscal policy are in conflict; a policy combination that is clearly sub-optimal.

Instrument (Operational) independence: The central bank has the ability to determine the best way of achieving its policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence. Management Independence: The central bank has the authority to run its own operations (appointing staff, setting budgets, etc) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. International organizations such as the World Bank, the BIS and the IMF are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence, and from the connection between increased independence for the central bank and increased transparency in the policy-making process.

THE BANK FOR INTERNATIONAL SETTLEMENTS (BIS) The Bank for International Settlements (BIS) is an international organization, which fosters international monetary and financial cooperation and serves as a bank for central banks. The BIS fulfils this mandate by acting as: a forum to promote discussion and policy analysis among central banks and within the international financial community a center for economic and monetary research a prime counterparty for central banks in their financial transactions agent or trustee in connection with international financial operations

The BIS banking services are provided exclusively to central banks and other international organizations. The BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities. The head office of BIS is in Basel, Switzerland and there are two representative offices in the Hong Kong and in Mexico City. Established on 17 May 1930, the BIS is the world's oldest international financial organization.

The BIS unit of account is the IMF special drawing rights, which are a basket of convertible currencies. The reserves that are held account for approximately 7% of the world's total currency. The BIS carries out its work through subcommittees, the secretariats it hosts, and through its annual General Meeting of all members. The BIS' main role is in setting capital adequacy requirements. BIS requires bank capital/asset ratio to be above a prescribed minimum international standard, for the protection of all central banks involved.

Another role for BIS is make reserve requirements transparent. The BIS also comments on global economic and financial developments and identifies issues that are of common interest to central banks. The BIS carries out research and analysis to contribute to the understanding of issues of core interest to the central bank community, to assist the organization of meetings of Governors and other central bank officials and to provide analytical support to the activities of the various Basel-based committees.

BASEL ACCORDS The Basel Committee on Banking Supervision is an institution created in 1974 by the central bank Governors of the Group of Ten nations (Belgium, Canada, France, Germany, Italy, Japan, the Netherlans, Sweden, Switzerland, the United Kingdom, and the United States). Its membership is now composed of senior representatives of bank supervisory authorities and central banks from the G-10 countries, and representatives from Luxembourg and Spain. It usually meets at the Bank for International Settlements in Basel, where its 12 member permanent Secretariat is located.

The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise.

Basel I is the term which refers to a round of deliberations by central bankers from around the world, and in 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord. It was enforced by law in the Group of Ten (G-10) countries in 1992, with Japanese banks permitted an extended transition period. Basel I primarily focused on credit risk. Banks with international presence are required to hold as capital at least 8 % of the risk-weighted assets.

Basel I is now widely viewed as outmoded, and a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries. Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the BCBS. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

Several countries started to implement Basel II in 2008. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.

Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Although Basel II makes great strides toward limiting excess risk taking by internationally active banking institutions it increased complexity compared to Basel I, which raised the concerns that it might be unworkable.