Objectives And Goals Of Central Banks Finance Essay
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Published: Mon, 5 Dec 2016
Every central bank is responsible of implementing a monetary policy which aims at ensuring economic growth, low inflation and currency stability and to do that lowering inflation is the best way for enhancing economic growth and development.
So eventually every year central banks with the help of the governments set indicative inflation target and try to maintain it within the target band.
In addition central banks need to ensure price stability and regulate the money flow in order to control inflation and this is done by 2 ways:
Inject the market with liquidity: By tradition, the Fed uses the produce-money-and-purchase approach (PMP): the Fed produces money in their computers and uses it to buy US Treasuries from the banking system. In exchange for the US Treasuries, the Fed creates money on the account that the selling bank holds at the Fed. The ECB, in contrast, uses the produce-money-and-lend (PML) approach. It produces money and lends it to the banking system for one week or three months. The preferred collateral for these loans to banks is government bonds. As a result of PMP and PML, banks receive new base money. Or
Absorb extra funds by issuing treasury bills or central bank bills.
So to conclude, a compromise has to be found between decreasing interest rates and encouraging borrowing and increasing inflation.
When a bank finds itself in shortage of liquidity in order to meet fulfill its role, the central bank can lend additional funds to avoid bankruptcy of banks or other institutions deemed systemically important or ‘too big to fail’. Central Banks must be impartial in its lending process, that’s why Central Banks are independent.
Central banks can also require deposit insurance from commercial banks. Some central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank’s deposits. This is also a way of controlling money supply in the market.
The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market’s money supply and the central bank’s monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. Use of the discount rate can be restricted by making it unattractive when used repeatedly.
A third objective of central banks can also be added. It concerns long-term strategic objectives of financial sector development including the development of an effective payments system and secure the financial markets and transactions.
The major functions of central banks are the following:
Monetary Policy Implementation and Money Supply Control
Bank of Note issue
lender of last resort and government’s bank
interest rate interventions
Banker, agent and adviser to the government
banking supervision and regulation
The central bank can also be entrusted with other crucial functions like credit control, management of public debts, rediscounting of bills, and custodian of foreign exchangeâ€¦
Monetary Policy Implementation and Money Supply Control
The aim of an effective monetary policy is to create employment in the country, resist undue inflation and achieve a favorable balance of payment. Central banks implement a country’s chosen monetary policy by choosing the type of the currency and by determining the size and rate of growth of the money supply, which in turn affects interest rates.
Bank of Note issue
Earlier every bank’s notes lacked uniformity and were different from each other’s in color, size, value and even market goodwill. Hence the paper currency system was unstable, unreliable, and used to yield to gold and silver currencies. It was then necessary for a single bank to centrally issue currency notes for different reasons:
It brings uniformity in the monetary system
The central bank can exercise better control over the money supply in the country.
==> it increases public confidence in the monetary system.
Monetary management of the paper currency becomes easier. Being the supreme bank of the country, the central bank has full information about the monetary requirements of the economy and, therefore, can change the quantity of currency accordingly.
It enables the central bank to exercise control over the creation of credit by the commercial banks.
The central bank earns money by issuing currency notes and “selling” them to the public for interest-bearing assets, such as government bonds. Since currency usually pays no interest, the difference in interest generates income. In most central banking systems, this income is remitted to the government.
Granting of monopoly right of note issue to the central bank avoids the political interference in the matter of note issue.
Lender of Last Resort
The central bank is the lender of last resort in cases of banking insolvency or illiquidity, which means that it is responsible for providing its economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country’s banking system from failing by acting as a bank to commercial banks. By acting this way, central banks:
Increases the elasticity and liquidity of the whole credit structure of the economy,
Enables the commercial banks to carry on their activities,
Provides financial help to the commercial banks in time of emergency,
Enables the central bank to exercise its control over banking system of the country.
Interest rate Interventions
The central bank sets the official interest rate in order to manage both inflation and the country’s exchange rate and to ensure that this rate takes effect via a variety of policy mechanisms. Typically a central bank controls certain types of short-term interest rates. These influence the stock and bond markets as well as mortgage and other interest rates.
As the custodian of the cash reserves of the commercial banks, the central bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other with least use of cash. The clearing house function of the central bank has the following advantages:
It economies the use of cash by banks while settling their claims and counter-claims.
It reduces the withdrawals of cash and these enable the commercial banks to create credit on a large scale.
It keeps the central bank fully informed about the liquidity position of the commercial banks.
Banker, agent and adviser to the governments
First As a banker to government, the central bank performs the same functions for the government as a commercial bank performs for its customers. It maintains the accounts of the central as well as state government; it receives deposits from government; it makes short-term advances to the government; it collects cheques and drafts deposited in the government account; it provides foreign exchange resources to the government for repaying external debt or purchasing foreign goods or making other payments; Second as an Agent to the government, the central bank collects taxes and other payments on behalf of the government. It raises loans from the public and thus manages public debt. It also represents the government in the international financial institutions and conferences; and finally As a financial advisor, the central bank gives advice to the government on economic, monetary, financial and fiscal matters such as deficit financing, devaluation, trade policy, foreign exchange policyâ€¦
Banking Supervision and Regulation
In some countries a central bank controls and monitors the banking sector. It examines the banks’ balance sheets and behavior 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.
The subprime crisis
Markets Pre-Crisis Situation
Following the 2000 burst in the dotcom bubble, investors lost confidence in the equity markets and concentrated their investments in government bonds, and secure assets. However, this lack of confidence started to turn around at the end of 2003, fueled by:
â€¢ The rise of real estate prices
â€¢ improving figures of world economy and in particular the U.S. economy
â€¢ the intervention of the Federal Reserve, helping banks by providing liquidity at particularly easy conditions (this liquidity injection by the Federal Reserve did not solve the problem, but only postponed it to blow up again in July 2007 in the form of the subprime crisis)
â€¢ The short memory of investors
To fully understand the origins and the impact of the current crisis on the world economy, it is crucial to understand the subprime loans and their use in the credit derivatives and structured products world.
The term subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates due to various risk factors, such as income level, size of the down payment made, credit history and employment status. Subprime loans are considered risky for both the borrower and the lender. It’s risky for the lender because borrowers usually have lower incomes and a poor record of paying debt which increases their default probability. It is also risky for borrowers. To offset the risk of defaults, lenders will charge high rates of interest to offset the risk. The high interest rates however are strenuous for borrowers which further increases their likelihood of default. Two aspects of the subprime loans could give us a clearer image of the causes of the crisis. First, borrowers not being able to pay the interest rates on their mortgages have used the continuing rise in the value of their real estate to refinance their debt, thus taking on a higher debt. Second, every couple of years the interest rates on the subprime loans is reset in a way to take into account, the moves that have taken into the market.
The final piece of the puzzle is the understanding of how these local loans issued by local brokers have made their way into the hands of Wall Street firms. Brokers match prospective borrowers with lenders who further lure borrower with exotic mortgages such as “no doc” mortgages, which do not require any evidence of income or savings. Bing banks and wholesale lenders buy the debt, repackage them and sell them to investment banks. These investment houses further repackage these loans in mortgage backed securities (MBS) and collateralized debt obligations (CDO). These structured products very often yield high rates of return and are sold to pension funds, hedge funds and institutions.
It all started out in the end of 2006 and the beginning of 2007, when the rise of real estate that started in 1997 showed sign of slowing down. Not being able to refinance their debt, subprime borrowers found themselves in default, and faced foreclosure. In March 2007, General Motors announced that earnings plunged 90% during the first 3 months. The reason was due to losses at its mortgage loan subsidiary GMAC. UBS said that it will shut down its Dillon Read Capital Management arm after the hedge fund lost 150 million Swiss Francs on subprime investments. Finally, on June 21st 2007 data was released showing the record number of foreclosure, with biggest increase in the subprime sector. These signs are the start of a crisis that would cost investors, banks and almost all financial institutions enormous losses, thus forcing central banks around the world to intervene in order to maintain the grip on the financial system.
Timeline of the subprime crisis:
2001: Crises of confidence on the American Stock Exchange (Internet bubble, terrorist attacks of September 2009). The Fed lowered interest rates.
2002-2004: Invention of the subprime, low loan rate credit for 2 years, then variable rate based on the market rate: for households that have a high risk of non-repayment. if they can’t reimburse it, their properties are seized by the bank.
2002-2004: The low interest rate allows an increase in the real estate purchases, which leads to higher market prices
2004: higher Inflation due to rising in oil prices.
2004-2007: interest rates increased by the Fed.
2006: real estate prices went down
2007: Increase in foreclosures in the United States due to the non-repayment of subprime loans.
The crisis of 2008:
8 February 2007: HSBC global investment bank was the first to announce a liquidity problem due to the non-reimbursement of the subprime loans.
June 2007: Bear Stearns, the U.S. investment bank, closes two of their investment fund related to real estate market.
October 29, 2007: Merrill Lynch, the U.S. investment bank, announced $ 2 billion losses.
Few months later other banks (American Bear Sterns, the French Société Générale, UBS Switzerlandâ€¦)will announce identical losses.
March 16, 2008: Bear Stearns was saved from bankruptcy by JPMorgan with the help of the U.S. government.
13 July 2008: Henri Paulson announces the refinancing of Freddie Mac and Fannie Mae, the two funds that guarantee mortgages in the United States.
7 September 2008: Refinancing Fannie Mae and Freddie Mac by nationalizing them.
September 15, 2008: Bankruptcy, the first of a long list started by Lehmann Brothers. Merrill Lynch was saved by Bank of America.
September 16, 2008: AIG the American insurance went bankrupt.it was bought later by the U.S. government.
September 26, 2008: Bankruptcy of the first retail bank, Washington Mutual was bought by JPMorgan.
September 30, 2008: Dexia went bankrupt; refinanced later by the Belgian and French governments.
October 3rd, 2008: American Congress Voted for the Paulson rescue plan to save the financial market.
6 October 2008: The historical fall of the CAC40 and the Dow Jones, this continued throughout the week.
October 8, 2008: Major central banks have lowered their interest rates based on a mutual agreement.
October 12, 2008: European Union announced a bailout of the financial market.
October 15, 2008: The French Parliament voted for a bailout of the banks.
Quick remind of the banks’ losses:
% of total losses
bought by Bank of America
bought by Citigroup
Bank of America
bought by JP Morgan Chase
Royal Bank of Scotland
What the ECB did during the crisis : 2 big phases
The first phase of the turbulence
During the first phase of the turbulence on the capital markets, which lasted from August 2007 to mid-September 2008 and was characterized by a systemic shortage of liquidity, the ECB has amended the terms of the provision of technical applying liquidity in normal times. It has, at the same time, fully utilizing the flexibility offered by its operational framework for the implementation of monetary policy.
First, the Eurosystem has adjusted the distribution of liquidity during the period of reserve in advance by providing liquidity, compared to what it does in normal times. Thus, at the beginning of the maintenance period, ECB systematically allocated volume of liquidity than the usual theoretical reference in its main refinancing operations, while still aiming for balanced liquidity conditions at the end of the maintenance period. In this way, the total supply of liquidity throughout the period remained unchanged. These measures tended to take into account changes in the profile of the liquidity demand made by the banks.
Second, the Eurosystem has also provided liquidity to the banking system through procedures open market that had been little or no use before the onset of turbulence. Particularly in response to the increased demand for bank financing in the longer term, the Eurosystem has significantly extended the average maturity of its loans to banks in the euro area. Accordingly, and to leave unchanged the total outstanding refinancing, the amount of liquidity provided through MROs in a week was reduced in corresponding proportions.
The second phase of the turbulence
In mid-September 2008, however, concerns about credit risk have greatly increased, tensions immediately propagated in the United States in the euro area, and the money market has virtually ceased to function. Therefore, the Eurosystem has intensified its efforts to allow solvent banks to continue their activities. And several additional measures were taken unprecedented in this direction.
Thus, in mid-October, the ECB adopted as quite exceptional, a tendering procedure fixed rate full allotment for all main refinancing operations and the weekly refinancing operations more long term, with maturities ranging from one week to six months. This procedure will remain in effect as long as necessary in light of the market situation.
It also increased the number and frequency of refinancing longer term by three months each additional refinancing operations, two for a term of three months and a period of six months, and introducing a special-term refinancing operation with a maturity corresponding to the duration of the period of reserve.
Meanwhile, the ECB has implemented a new series of exceptional measures to temporarily expand the list of assets eligible as collateral in credit operations by the Eurosystem.
Finally, the ECB has increased the supply of dollars in funding to its counterparties in conducting tenders fixed rate, full allotment and maturities from one week to three months, through swap agreements with the Federal Reserve System of the United States.
These measures, which reflect the important role of strengthening intermediation taken by the Eurosystem during this turbulent period helped ensure the continued access of solvent banks to liquidity despite the monetary market failure. In addition, they have helped to reduce tensions in some segments of the money market. For example, the difference between the rates of unsecured long-term Euribor rate and index swaps on a daily basis is significantly reduced, even if it remains at a level high, significantly higher than the levels observed prior to September 2008.
In practice, these measures imply that banks in the euro area can get as much euro liquidity they wish, through both our weekly operations as our futures, and this by using a wide range of assets as collateral. In total, the balance sheet of the Eurosystem increased by a total of approximately EUR 600 billion since the end of June 2007 until today, an increase in the size of 65%, the assets reflecting the sharp rise in the volume of liquidity provided and liabilities resulting from concomitant use banks to the deposit facility. These measures were effective to address the shortage of liquidity in the interbank market. They cannot, however, remove the heightened concerns regarding credit risk. In this regard, the money market conditions are not yet standardized and remain strongly affected by a high degree of risk aversion.
The increase in the intermediation role of the Eurosystem has proved a necessary measure to cope with the current money market malfunction, but it can, and should, be considered as a temporary measure. The Eurosystem would naturally resume interbank lending and traditional intermediation activity of banks. The recent decision of the ECB to reduce the corridor of standing facility rates to 200 basis points around the interest rate on the main refinancing operations aims to stimulate interbank activity. That ‘ s why we observe, in this context, a reduction in the demand for bank refinancing operations during our open market and a corresponding decrease in the use of the deposit facility. We see a parallel increase in the volumes underlying the calculation of the EONIA.
What the fed did during the crisis : 5 big phases
Phase 1: 2007 / mid-March 2008 |
From late spring, the Fed began to note that the growth in the U.S.is slowing down and targets need to be lowered. However, the inflation and underlying inflation are going up. The Fed believes that with this rate of inflation the Fed Funds rate should stay at 5.25%.
But in August 2007, the subprime crisis and tensions within the bank market appeared. On 10 August 2007, the Fed announced the first corrective measures to the problems, by injecting liquidity into the market via refinancing operations.
The liquidity crisis remains stable, and the Fed lowers the penalty on the discount rate. on August 17, Penalty decreased from 100 bp to 50 bp.
The Fed lost any hope of a possible economic growth so they lowered their key lending rate despite a strong inflation. The rate reaches the 3% after his 5.25% in only 6 months which is one of the fastest decline the USA ever had.
At the same time, the Fed put in place specific measures to facilitate access to liquidity for U.S. and international banks. Refinancing operations are going up. Then the Fed launches in December 12th the Term Auction Credit Facility (TAF). It consists in lending $ 60 billion within 28 days by accepting as collateral a large range of assets at a lower rate (discount rate). Line Swaps had been implemented with European banks.
Nevertheless, the crisis has continued to expand, hitting after the interbank market, the Mortgage Backed Securities (MBS) guaranteed by Government Sponsored Enterprise (GSE, primarily Fannie Mae and Freddie Mac), and the credit and equity markets.
From March 2008, the Fed further increases its liquidity loans with the creation of the Term Repurchase Transaction ($ 80 billion) and the TAF increased from $ 60 billion to $ 100 billion. Then they created the Term Securities Lending Facility (TSLF) which can lend up to $ 200 billion.
In 14 of March, the Fed saved the Bear Stearns bank which was one of the best news since the beginning of the crisis. It’s the first time that the Fed intervenes directly on the market, since 1929 and rescues a bank on behalf of the “Too big to fail”.
Disturbances become wider for that time, so the Fed decided to gives access to a last resort facility to the investment banks that remain. In addition, the penalty discount rate is reduced to 25 basis points against 100 bp before the crisis. Finally, the Fed decides to lower its key lending rate, from 3% to 2.25% in March and 2% in May.
Then follows minor adjustments to the lending facilities (TAF increased to $ 150 billion, with an extend in the loans maturity, larger swap lines with other central banks). The Fed believes that the financial situation has stabilized and that the U.S. economy does not need more monetary stimulus. The rate is stable until September.
we should notice that the money lent by the Fed do not inflate the monetary base: they sell bonds to finance its loans.
Phase 2: September 2008 / February 2009
In September 2008, the market turmoil began with the announcement of the tutelage of Freddie Mac and Fannie Mae on September 7. Between Monday 8 and Friday 12, a lot of rumors alarmed the financial markets about financial stocks and a fall in prices. Sunday 14 September 2008, the announcement of the Lehman bankruptcy, but also the acquisition of Merrill Lynch by Bank of America and the profound difficulties of AIG and Washington Mutual, will be the trigger of one of the most tempestuous financial crisis.
The Fed will react very quickly to ensure market stability and mitigate systemic risks. Then, to counteract deflationary pressures, it prepares the transition to an unconventional monetary policy.
Without going into the details of all measures taken between September and December 2008, the Fed will support Fannie Mae and Freddie Mac, to participate in the rescue of financial institutions significantly expand the scope of collateral accepted for loans, buy directly from financial assets (MBS, GSE debt, short-term debt) and lower at lower interest rates.
The risks to the global economy is now cataclysmic Fed with the ECB, SNB, Bank of Canada and the Riksbank (Sweden) undertake the first rate cut concerted history (-50 bp), the October 8, 2008. The U.S. rate is brought to the lowest in December (band 0% / 0.25%).
Remember that this phase is that the Fed reduces interest rates to a minimum and that the liquidity injected quickly becomes unsterilized. Is to do quantitative easing without saying. From September 2008, the liquidity injected exceeds the amount of Treasuries (debt U.S. State) remaining on the balance sheet of the Fed. At first, the U.S. Treasury this imbalance, but the beginning of October, the dam broke. The Fed then engages in a policy of balance sheet expansion unsterilized, with an increase in the monetary base (reserve money). It passes 900 billion to $ 1 $ 800 billion between September 2008 and March 2009.
Phase 3: March 2009 / July 2010 | 1 quantitative easing – QE 1
From early 2009, the Fed began to wonder how to stimulate the economy with rates at 0%? In a speech on 13 January 2009, the “Bernanke Doctrine” is exposed. It is anchored rate expectations at low levels, changes in the composition of assets held by the central bank to increase the size of the balance sheet of the central bank (quantitativism).
At the FOMC March 18, 2009, the central bank crossed the Rubicon and one announces quantitative easing targets for unsterilized purchases of debt: debt GSE ($ 200 billion), MBS ($ 750 billion) and debt (300 billion $). The program runs until the end of 2009.
In addition, the Fed introduced the famous sentence “The Committee will Maintain the ranks for the target federal funds rate at 0 to 1/4 percent and anticipates economic terms That are Likely to warrant exceptionally low levels of the federal funds rate for year extended period “. It is committed over a long period (years) to keep rates low.
Until late 2009, the U.S. economy out of the recession, there will be more movement towards monetary policy. Speech on growth becomes increasingly positive. The amount of purchased debt agency will even reduced to $ 175 billion. From the spring, the FOMC no longer evokes purchases in its communiqués.
It should be noted that liquidity injections become less important, quantitative easing 1 (EQ 1) resulting in an excess supply of liquidity growing. Loan facilities are largely removed.
Phase 4: August 2010 / August 2011 | First fear of double dip – QE 1.2 and QE 2
The Fed noted that the growth was not as strong as expected, that the labor market remains very poor and that underlying inflation plunges more. She decided in August not to allow its balance sheet to deflate some debt maturing (ie destruction of money injected). She reinvested the money recovered in U.S. government bonds so that the long-term balance sheet size remains unchanged. There is no additional injection, just a re-investment (EQ 1.2).
Continuing economic deterioration (rising unemployment, inflation at its lowest for 50 years), the Fed launches quantitative easing 2 (QE2). She decided in November 2010 to buy $ 600 billion of debt] b (from November 2010 to mid-2011) and continue to reinvest. The balance begins to swell until June 2011.
FOMC releases are progressively more positive, even if economic activity is considered at best “a phase of moderate recovery.” Then, from the late spring, it deteriorates again. Following the August 2011 FOMC, the Fed announced that it will keep the Fed Funds rate unchanged until mid-2013 (at least 2 years). The idea is to anchor expectations on Fed Funds, thus lowering the rate to maturity longer.
Phase 5: September 2011 / … | The twist, QE 2.2
Fear of double dip continues to strengthen. At the end of September 2011 FOMC, the Fed announces a twist.
It extends the maturity of its holdings of U.S. government bonds. This “operation twist” is to sell the bonds in the short term (less than 3 years) to buy long-term loans (between 6 and 30 years). The Fed will “twister” for $ 400 billion. This was already implemented in the 60s (1961-1963).
The Fed will now reinvest the money recovered on refunds of MBS and agency debt and MBS in more in bonds to support the mortgage market in the USA.
The idea is to lower interest rates in the long term, short-term ones are already almost at its lowest. These two transactions will not generate inflation balance as purchases will be offset by sales or repayments (no printing money, no QE3 but QE 2.2).
Comparison : ECB vs FED
The European System of Central Banks and the US Federal Reserve are the two biggest and most active central banks. Although they present many apparent differences, they still have several similarities:
â€¢ They are independent from any direct political authority and hence are protected from political interferences.
â€¢ They have decentralized structures: a system of national/regional banks coordinating with a central entity, i.e. the Board of Governors.
â€¢ They modify the interest rate structure by targeting short-term money-market rates, specially the Marginal Lending Rate in the EU or the discount window in the US and the inter-bank rates (Federal Funds rate in the US).
â€¢ They use the basic monetary policy tools to achieve their objectives: reserve requirements, discount window lending and open-market operations.
â€¢ They share the s
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