The role and functions of a central bank: A quick peek into history
Mirza Azizul Islam | Financial Express December 13, 2019
A Central Bank is the term often used to describe the authority responsible for policies that affect a country’s supply of money and credit. It has become a symbol of a country’s sovereignty in the arena of money and finance.
The Central Bank, in one form or another, has a long history. It dates back at least to the seventeenth century (1668) when the Swedish Riksbank, the first institution recognised as a Central Bank, was established. It was charged with the responsibility of lending funds to the government and acting as a clearing house for commerce. A few decades later, the most famous central bank of the era, the Bank of England was founded in 1694 to purchase government debt. The central bank of France, Banque De France, was established in 1800 to stabilise the currency after the hyperinflation during the French Revolution. A severe financial crisis that hit the United States in 1907 led to the creation of the country’s central bank, the Federal Reserve, in 1913. It was mandated to provide a common currency which would respond to the changing seasonal, cyclical and secular needs of the economy and to serve as a lender of the last resort.
OBJECTIVES AND FUNCTIONS: Based on diverse experiences, both positive and negative with respect to economic growth, inflation and financial sector stability as well as in response to change in intellectual perceptions, the central banks have been entrusted with multiple responsibilities.
- Conduct of monetary policy so as to control money supply and influence inflation and interest rates
- Development and supervision of financial market institutions and their prudential regulation
- Performing the role of a lender of last resort.
- Use of directed credit to cater to the financial needs of socially desirable sectors which do not benefit from the usual channels of transmission of monetary policy
- Implementing exchange rate policy
These functions find reflection in the Bangladesh Bank Order No. 127 of 1972. It is worth noting that these functions are not necessarily mutually complimentary. The performance of one function, in some cases, may undermine the implementation of another. The subsequent paragraphs deal with the challenges faced by the central banks, with some references to Bangladesh.
CONDUCT OF MONETARY POLICY: To set the stage for the analysis, two quotations from two outstanding Nobel-laureate economists are cited below. The first one is from Milton Friedman who is known to be a staunch monetarist. In an article published in 1955 he wrote:
“There seems little doubt that a large change in the money supply within a relatively short period will force a change in the same direction in income and prices…..But when the money changes are moderate the other factors come into their own….there are thus definite limits to the possibility of any fine control of the general level of prices by a fine adjustment of monetary change…”
The second quotation is from Paul Samuelson who wrote in a 1967 article:
“In the debate what should a central banker watch, should he watch the money stock or should he watch the interest rate structure….I think when the Good Lord gave us two eyes, He had a purpose in that. He didn’t want us to watch just one thing, He wanted us to watch both of these things”.
The messages that come out from these quotations are:
- It requires large changes in money supply within a short period to have an effect on income and price level. The effect of small changes in money supply is likely to be swamped by other factors.
- Monetary policy should exert control over both stock of money and interest rate. It is generally held that the transmission channel is from money supply to interest rate and then to flow of credit to and investment by the private sector. Higher money supply leads to lower interest and thereby promotes growth through investment.
It goes to the credit of the Bangladesh Bank that in its Monetary Policy Statements due recognition is usually given to both broad money and interest rates as intermediate targets with a view to ensuring sustainable growth and moderate inflation. This is consistent with Samuelson’s prescription, but raises two questions:
- To what extent can Bangladesh Bank exercise control over broad money?
- How does broad money affect interest rate?
CONTROL OVER MONEY SUPPLY: With regard to the first question, control over money supply, a large chunk of broad money comprising net foreign asset and credit to the public sector remains outside the control of Bangladesh Bank. Net foreign asset is determined by exports, remittances and inflow of foreign capital-none of these elements can be effectively controlled by Bangladesh Bank. Similarly, the central bank cannot exercise any control over government borrowing and little, if at all, borrowing by other public sector entities some of which receive government guarantee. The incapacity explained above constitutes a major challenge for monetary policy in Bangladesh.
Another challenge arises from the fact that the instruments available at the disposal of the Central Bank, namely variations in cash reserve/statutory liquidity requirements and operations in treasury bonds, cannot exert significant influence on the target variable, namely, money supply. The principal explanation is that the banks in Bangladesh, up until very recently, typically maintained large excess liquidity. In this situation, it would be futile effort to expand money supply through reduction in cash reserve requirement/statutory liquidity requirement or treasury bond operations because if demand conditions permitted, the banks would prefer to earn higher income by expanding credit anyway instead of maintaining excess liquidity. Similarly, reasonable increases in cash reserve requirement/statutory liquidity requirement or treasury bond operations would not be of much help in inducing banks to restrain credit since they can fall back upon excess liquidity.
THE NORMAL TRANSMISSION CHANNEL: DOES IT WORK IN BANGLADESH? With regard to the second question, that is, effect on money supply on interest rate, the normal transmission channel of monetary policy is that an increase in money supply would cause a reduction in interest rate, this would lead to increase in investment and thereby higher aggregate demand and higher GDP (gross domestic product). Along the way there may be some increase in inflation, depending on constraints on the supply side. Conversely, a reduction in money supply would cause an increase in interest rate, fall in investment and aggregate demand leading to lower inflation and possibly lower GDP. In the context of Bangladesh, policy stance favouring reduced money supply and thereby higher interest is out of question as acceleration of GDP growth remains the overriding development objective.
At any rate, the first link in the above mentioned chain of causation runs from money supply to interest rate. The experience in Bangladesh shows that this link does not work effectively. An examination of data shows that movements in interest rate (lending rate) were in the predicted direction in only few years. In most years, higher growth of broad money relative to the preceding year was accompanied by higher interest or a lower growth of money supply was accompanied by lower interest.
One reason for the breakdown of the link between money supply and interest rate most likely is that the financial system of Bangladesh does not operate under the principles of competition. The banks, particularly the private ones, collusively determine the lending rate with little regard for money supply conditions.
In the above scenario, it is no wonder that money supply has no discernible impact on inflation either. I have argued elsewhere that in an open, import-dependent economy like Bangladesh, domestic prices are largely determined by international prices. Hence, effectiveness of monetary policy in containing inflation is bound to be limited.
In the context of the role of interest rate, the analysis of relevant data suggests that a reduction in interest rate is likely to boost private sector credit and private sector investment is likely to be increased by higher flow of credit. There is, therefore, a plausible case for adoption of policies to reduce interest on loans and advances.
Then the question is what actions can be taken to reduce interest. A few suggestions in this regard may be considered:
- There are too many banks in Bangladesh. It can be reasonably assumed that in any business if the volume is low the businessmen will try to charge higher price in order to reach their revenue targets. This seems to characterise the banking system of Bangladesh. The scenario is one of too many banks, small volume of business for each and higher interest charged on loans and advances. The concerned authorities should, therefore, consider how the number of banks can be reduced by implementing mandatory mergers.
- Though there are too many banks they do not operate competitively, as noted before. Some bankers privately admit that they fix a ceiling rate of interest for deposits and a floor rate of interest for advances through their Associations. The Central Bank may, therefore, consider whether an upper limit should be fixed for loans and advances. This move is likely to be opposed by multilateral institutions such as the World Bank and the International Monetary Fund (IMF) as this would tantamount to restoration of administered interest rate regime. But even the staunchest neoclassical economists would admit that when a market does not function competitively, there is a strong case for price fixation by government authorities, However, the implementation of this policy would require strong monitoring to ensure that the ceiling is not subverted by adopting unfair means such as charging higher processing fee or bribes to process loan applications.
- Efforts should be strengthened to recover non-performing loans (NPLs) and deal with the underlying causes. Bangladesh Bank should take the initiative to bring about legal reforms needed to penalise the defaulters quickly and visibly.
In addition, there are certain characteristic features of money and capital markets in many low-income developing countries, including Bangladesh, which tend to limit the efficacy of the conventional monetary policy in influencing interest rate. Among these are:
- Presence of a sizable non-monetised sector in the economy
- Narrow markets with few discountable commercial bills, corporate stocks and government securities,
- Unintegrated interest rate structure and a fragmented market in which interest rates prevalent in the informal markets or charged by NGOs (non-governmental organisations) are hardly sensitive to actions by monetary authority
However, these considerations by no means suggest complete abandonment of monetary policy. The facts that techniques of monetary policy are more flexible and quickly adaptable, increased monetisation takes place as an economy grows and problems of narrowness and fragmentation of money markets are alleviated over time provide rationale for adoption of monetary policy in judicious manner to promote growth and control inflation along with other instruments.
PRUDENTIAL REGULATION: Prudential regulations provide the framework for ensuring stability and soundness of the banking system. “Asymmetry of information” and “Moral hazard” are inescapable features of the banking system. These features find expression in multiple ways.
There is asymmetry of information between the depositors and the bank management. The latter are aware of the true state of the financial health of a bank, but the former are not. As a result, depositors may perk their deposits in any bank that they come across without scrutinising the solvency status of the concerned bank. This tendency may be reinforced by “moral hazard” based on the perception that if the bank runs into difficulty, the government will bail it out and therefore depositors need not be concerned about the security of their deposits.
There is also an asymmetry of information between the banks and the borrowers. The latter are much better informed of the potential risks and returns of their loan proposals. It is not easy to bridge this asymmetry even though banks may diligently screen the loan proposals. Hence banks may end up financing high-risk proposals some of which may fail. The tendency in this direction also may be reinforced by “moral hazard” on the part of the banks based on the perception that, in the event of any trouble, the government will bail them out. Such a perception may undermine due diligence by banks and exert strongly negative impact on the soundness of the financial system and real sectors of the economy. The Asian economic crisis of 1997-1998, the financial sector problems that occurred in the United States in 2008 and 2009 and the on-going debacle in several countries of Europe can be traced to asymmetry of information and moral hazard characterising the banking sector operations.
The above considerations provide strong justification for prudential regulation of banks. The need for such regulation is almost universally accepted though the details may differ from country to country. Besides, the emergence of unanticipated problems may give rise to new regulations.
LENDER OF LAST RESORT (LOLR): Considerations of bank solvency become highly relevant in managing central bank LOLR facilities and related payment system policies. Most central banks provide some form of credit facility, which can be used to provide liquidity and facilitate payments settlement for banks in distress. Central bank’s last resort lending will generally take the form of liquidity injections directed to a particular bank or set of banks and may need to be sterilised by reducing liquidity elsewhere, for example, through open market operations or other instruments.
The intent of central bank LOLR facilities is not to provide resources to insolvent institutions, but to provide temporary liquidity to sound institutions, typically at a penalty rate. To manage its LOLR facility, the central bank must know (on the basis of information from supervisors) which banks are approaching insolvency or are insolvent. In practice, however, both central banks and supervisors often have difficulty distinguishing illiquid but solvent banks from insolvent ones. This is even more difficult when most banks or the entire system is in distress. Experience shows that banks that have major or protracted liquidity problems invariably also are insolvent. In exceptional cases, the central bank may be called upon to lend to insolvent banks, for example, to buy time for the design of restructuring strategies when banks are viewed as “too big to fail” or when the lending is part of a systemic restructuring strategy. LOLR facilities must be managed with utmost caution, relying on careful monitoring of banking soundness.
DIRECTED CREDIT: Many developing countries have followed a policy of directed credit to selected sectors, often at subsidised rates, with a view to accomplishing certain development objectives which included industrialisation, employment creation, increase of food production, export promotion etc. Directed credit can, therefore, be viewed as an instrument of non-price rationing or non-market allocation. The justification is that private sector may be unwilling to undertake investment in some desirable activities because of market failures. For example, private sector may not be interested to develop new export products or explore new markets because of uncertainties of returns. The country as a whole stands to gain from such activities. In the medium to long run, when returns actually start flowing in no more subsidised credit would be needed. Similarly, adoption of new technologies may be fraught with risks. It is generally agreed that private sector investment tends to be inadequate in areas characterised by the presence of positive externalities.
Governments may prefer directed credit at subsidised rates as an alternative to providing direct subsidies out of the budget for political reasons. Politically, it may be difficult to make direct subsidy proposals acceptable to the Parliament. The leaders in the governments may also feel that tax-paying citizens would consider such subsidies as unjustified use of tax revenues for the benefit of some vested interests.
Another justification for preferring directed credit over budgetary subsidies is the presumption that banks which provide such loans are likely to exercise effective control over the utilisation of funds as they have a direct stake in the success of the recipient enterprises. The failure of the concerned projects would jeopardise the recovery of loans. It would be unrealistic to expect government officials administering subsidies to exercise effective control since they do not directly stand to gain (lose) from the success (failure) of the projects.
It appears that very few countries could successfully use directed credit as a tool for accomplishing their development objectives. There are also some inherent limitations of this approach. The choice of firms and sectors may be arbitrary in the absence of well-articulated criteria. The entities receiving such benefits may choose a path of excessive leverage leading to fragility of their financial health. Banks may incur losses and, in some instances, may be forced to throw good money after bad money.
Many analysts are of the view that Japan and republic of Korea are among the few countries which successfully used directed credit as a tool of industrial development and export promotion. The emerging trend in financial sector liberalisation has been characterised by abolition or reduction of the use of directed credit. The received wisdom is that such practice should be linked to explicit performance criteria. The successful firms should be rewarded; the unsuccessful ones should be cut off. Strong governance institutions are needed for monitoring performance.
BANGLADESH SCENARIO: Bangladesh has introduced over the years a host of measures which fall directly or indirectly, in the category of prudential regulation. The important ones are listed below:
- Ceilings on disbursement of loans to a single party
- ‘Fit and proper’ test for Chief Executives and Advisors of private banks
- Requirement of Audit Committees in banks
- Imposition of capital Adequacy requirement as per Basel II and announcement of intention to adopt Basel III
- Promulgation of stress testing guidelines
- Instruction to establish separate risk management unit in banks
- Cash reserve and statutory liquidity requirement
- Limits on banks’ investment in stock markets and the requirement to operate merchant banks by constituting separate legal entity
- Introduction of CAMELS (Capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risks ratings)
- Requirement of provision against bad loans
However, the ever-increasing volume of non-performing loans despite generous rescheduling and restructuring casts a gloomy shadow on the effectiveness of prudential regulations.
In Bangladesh it has been a common practice to influence allocation of credit. In most cases, efforts have been made to enhance the flow of credit to certain activities; sometimes credit to certain others has been discouraged. In the former cases, administrative pronouncements have been backed up by refinance facilities for banks at concessional interest rates. Some of the pronouncements of the central Bank which are in the nature of directed credit are noted below:
- Fixation of the target for agricultural/rural credit
- A scheme titled “Solar Energy, Bio-gas and Effluent Treatment Refinance Scheme” was set up by Bangladesh Bank
- A “Refinancing Scheme for Small Entrepreneur” was instituted
- A refinancing scheme was introduced to provide credit at the existing bank rate for adoption of Hybrid/Hoffman Kiln equivalent technology by brick field owners
- Group loans were introduced for women entrepreneurs and interest rate for such loans would be maximum 10 per cent
Bangladesh Bank should continuously monitor compliance with directed credit requirements and evaluate impact on cherished objectives.
EXCHANGE RATE MANAGEMENT: In most countries with floating exchange rate regimes, central banks do intervene in foreign exchange market from time to time in order to achieve broader macro-economic goals. Bangladesh has been no exception to this widespread practice. In reality the issue relates to the need for depreciation often demanded by exporters.
The case for depreciation rests on the ground that if exporters are facing hardship due to developments in the global economy, they need to be compensated and depreciation would be an effective tool to provide such compensation. In this context it should be noted that depreciation does not change the price of export in terms of foreign currency. What it does is to raise the price in terms of domestic currency. In consequence, domestic consumption of the export commodity is reduced, also the producers are enabled to move up along the supply curve. The combined result is to increase the volume of exports. The exporters earn greater revenue, proportionate to the increase in the volume of exports and the magnitude of depreciation.
The above analytical result can be realised only if certain conditions are met. First, the depreciation – induced domestic price increase causes a fall in the domestic consumption of the export commodity. In the case of garments exports, this is likely to be the case in a country like Bangladesh. With low per capita income, the demand for garments may be fairly price elastic. The second condition is that for the full realisation of the beneficial impact of devaluation, the supply curve has to remain unchanged. This is most unlikely scenario in Bangladesh. The garments industry is substantially dependent on imported inputs, including chemicals and fabric. Depreciation would cause an increase in the domestic price of these inputs. As a result, the supply curve would shift to the left undermining the increase in export volume relative to what would be the case if the supply curve remained unchanged. Furthermore, labour engaged in the garment industry may press the demand for higher wages more forcefully, leading to a further shift of supply curve to the left. The third condition is that the prices of garments remain unchanged in terms of foreign currency and that Bangladesh satisfies small country assumption meaning that the country can sell any volume at the existing international price. This condition is also most unlikely to be met in the present circumstances. The garments exporters frequently complain that they were facing pressures from the foreign buyers to reduce prices in terms of foreign currency. Depreciation might well add fuel to such pressures and if our exporters have to yield, a significant portion of the potential benefit of depreciation would be appropriated by foreigners.
The above analysis suggests that the beneficial impact of depreciation on garments exporters is at best uncertain. Those who clamour for depreciation pitch their argument primarily on depreciation of the currencies of competitor countries. In order to come to grip with the question of whether greater depreciation of the currencies of some competitor countries has cut into exports of Bangladesh, it would be worthwhile to examine whether export volumes of those countries have increased by a greater extent than those of Bangladesh. The experience in recent times has been that most of the increase in export earning has been generated by increase in volume. The explanation lies in the fact that labour cost in Bangladesh is much lower than in most of the competitor countries, outweighing the supposed advantage of competitor countries attributable to depreciation of their currencies.
At this stage, let me recall a couple of the well-known undesirable consequences of depreciation. It should be reiterated that depreciation increases the domestic price of most goods – imported machinery, raw materials, intermediate goods and final consumption goods (including those which are exported and domestically produced import-competing products). As a result, depreciation may stoke inflation.
Depreciation would also cause an adverse impact on Government finances. The subsidy requirements for food, fuel and fertiliser imported mostly by the Government would go up if the present price level is to be maintained. Furthermore, taka cost of external debt service will also increase.
Depreciation is a macro-economic policy tool which a country may need to deploy when it suffers from persistent imbalance in external accounts and the deficit cannot be financed within the limits of sustainable external debt service. With still healthy growth of exports and remittances that is not the situation in Bangladesh right now. In considering depreciation, the Government and the Central Bank should carefully weigh (i) the likelihood of increasing exports and remittances in the present global climate through depreciation (ii) the impact on inflation and (iii) consequences for the Government budget.
CONCLUDING OBSERVATIONS: I would like to conclude by posing a few questions which Bangladesh Bank may wish to ponder over:
- Should Bangladesh Bank have the authority to refuse credit to the Government and state-owned enterprises? This is connected with the issue of the independence/autonomy of Bangladesh Bank which I have not dealt with.
- Should Bangladesh Bank take the initiative for mandatory mergers to reduce the number of banks?
- Should there be an anti-trust/anti-monopoly law applicable to banks to prevent collusive interest rate fixation?
- Why have prudential regulations failed to keep non-performing loans within a reasonable level?
- What sort of reforms are needed in the Loan Courts Act and Bankruptcy Act to recover non-performing loans and penalise defaulters?
- Shouldn’t there be an objective review of the compliance record of directed credit and how can non-compliance be punished? Also what has been the impact of such credit on desired objectives?
The article is based on the Second AKN Ahmed Memorial Lecture delivered by the writer. Bangladesh Institute of Bank Management (BIBM) organised the A K N Ahmed Memorial Lecture for the second time styled as ‘Central Banking ‘ at its office at Mirpur in the capital on June 25, 2019.
Dr. Mirza Azizul Islam is a former Caretaker Government Adviser, Ministries of Finance and Planning, and presently a Professor
at BRAC University.