History and Need of the Central Bank

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HISTORY AND NEED OF THE CENTRAL BANK 13

Historyand Need of the Central Bank

Historyand Need of Central Bank

Acentral bank is an institution that has the role of managing thecurrency of a country, interest rates and money supply. The centralbanks as well oversee their respective countries system of commercialbanking. The Central Bank in distinction to a commercial bank owns amonopoly on increasing the nation’s monetary base and normallyprints the currency used in the state, which serves as the legaltender for the state (Wood, 2005).Centralbanks have responsibility to create stability of the financialsystem. This function makes them to be the custodians of integrity ina country’s payment system. Integrity refers to the ability of apayment system to function safely and in an efficient manner evenduring times of financial stress. Financial stress emanates fromgeneralized market factors such as swings in asset prices that makeit difficult for borrowers to meet their debt obligations. Financialstress also occurs when large participants in a country’s paymentsystem experiences financial problems. An example of a financialproblem that may face a huge participant in the payment system iswhen a big bank fails to meet the demands of its customers because itis running insolvent. This paper critically analyzes the history ofcentral banks and the evolution of the concept upon which the firstcentral bank in the world, The Bank of England was established. Itis evident that central banks continue to play new roles as the worldfaces many uncertainties in the financial markets. An example if the2008 financial crisis that continues to shape the role played bybanks in ensuring that financial systems functions efficiently.

Historyand need for central bank

Beforethe 17th century most currency was normally commodity money,generally silver and gold. Promises to make payments largely werehowever distributed and accepted about five hundred years earlierboth in Asia and Europe (Goodhart, 1995). Circulating paper money wasfirst issued by the Song dynasty while Yuan Dynasty used notes firstas the principal medium of circulation. The Bank of Amsterdam wasestablished as the first public bank that offered accounts that couldnot be converted to coins directly. It is perceived as thepredecessor to the modern central banks (Goodson, 2015).

Theprincipal role of a central bank is to monitor and control the supplyof money by applying monetary policy tools such as providing thereserve requirement, supervising interest rates, and functioning asthe last resort lender to the sector of banking in times of financialcrisis or bank bankruptcy. The central banks are normally vestedwith supervisory powers, aimed at avertingbank runs and to lower the risk that the financial institutions andcommercial banks involve themselves in fraudulentbehavior. In most of the developed nations, the central banks arepolitically independent though there is limited control of thelegislative and executive arms of the government (Khanna, 2005).

Centralbanks were basically dominant issuers of bank notes and served as themain bankers of the government. The dominance in note issuanceresulted from the privileges that governments gave central banks suchas being the sufficient scale to be the government’s natural choicefor banking issues. Central advanced the proceeds from the issuanceof bank notes to the government. Examples of early central banks thatplayed their roles in the context of being the main government’slender’s, leader of last resort, and the government’s bankinclude: The National Bank of Denmark, the Bank of France, TheAustrian National Bank, the Bank of Spain, The Bank of Portugal, andthe Bank of Italy. All the central banks in Europe were replicas ofthe Bank of England. They were established to deal with monetarystability problems that had emerged as a result of the loss ofcredibility of bank notes after the collapse of convertibility andover-issuance. Thus, central banks in Europe were formed primarily tocreate monetary stability and create a stable currency system thatwas not prone to the challenges that has become common. Adjustment ofinterest rates only aimed to preserve stability. Banks maintainedcurrency and monetary stability mainly through ensuring that thefraction bank notes in circulation were backed by specie sufficientlyenough to sustain the required level of liquidity.

TheBank of England

Inthe late 17thCentury, Great Britain was going through a lot of economic flux.International events had given her the authority and the opportunityto acquire colonies in the New World. Internally, the country wasgoing through massive economic changes such as an increase in thenumber of people living in urban centers that made the generalpopulation to need a hard currency. New Joint stock companiesestablished new control of the commodity and services markets,increased imports, and expanding markets for Great Britain’s goodin the colonies and in other world powers. The economic changes werebeing catapulted by political changes. Earlier the crown did not havesufficient powers to levy taxes or confiscate public funds to use onnational priorities. The limitation to collect and manage publicfunds was, unfortunately, not supported by a limited demand for thecrown to launch military expeditions to increase Great Britain’sterritory and protect citizens against foreign aggression. The rapidgrowth required a stable financial and monetary basis to sustain it.The Bank of England was, therefore, formed in 1694 to meet increasingmonetary and fiscal demands that characterized Great Britain’srapid growth. Consequently, Great Britain’s liquidity needs in thenational marketplace would be met, she experienced an increase inforeign trade, and more funds were available for the crown’smilitary expeditions. The formation of the Bank of England replaced abullion-oriented economy with a credit-based economy where privateindividuals could be involved in the growth of an empire. Settlersfrom Great Britain, therefore, went to the colonies as privateindividuals financed by a credit-based economy. In 1688, joint stockventures had invested 630,000 pounds in overseas ventures. Theyincreased their investments to 1,312,049 pounds by 1695. GreatBritain’s foreign trade was worth 5.6 to 7 million pounds.Investors in the joint stock companies, therefore, supported theformation of the bank of England to act as a safer centralinstitution to determine policy in credit market to replace privatebankers.

Theinstitution of the Bank of England, the representation up on whichthe central banks today are based, was developed by Charles Montagu,in 1694, as William Paterson, the banker had projected three yearsearlier although it was not implemented by then (Fforde, 1992).Although the establishment of the Bank of England would be pointedout by some as the foundation of central banking, its functions thendiffered from the modern roles of the central bank, specifically, tobe only authorized banknotes distributer, finance the government,serve as the lender of last resort to financial institutionsexperiencing a liquidity crisis, and to monitor the nationalcurrency’s value. There was a gradual evolution of the moderncentral bank through 18th and 19th centuries to get to the presentform (Andreades, 2013).

Themodern bank of England with a governor and a deputy governor wasfirst constituted in 1694. 663 proprietors that owned over 500hundred shares each elected the governor and the deputy. Theprosperity of the bank was spurred by the individual notoriety of thedirectors that were also shareholders. They gave the bank a lot ofcredibility in the British public because wealthy merchants andBritons of high social standing became shareholders of the Bank ofEngland (Goodman, 2009). The bank lent all of its capital to thegovernment and that meant that all their shares were in the hands ofthe king. The government paid back the loan by 1705. The bank alsogot the powers to print and issue notes up to an amount it has lentto the government. It was also responsible for discounting bills at arate of 6 per cent while foreign bills were discounted at a rate of 4per cent as a way to encourage the British public to deposit money.

SpreadAround the World

Therewas the establishment of the central banks in many countries inEurope in the 19th century. The Banque de France was created in 1800as a result of the War of the Second Coalition, with an aim toimprove the war’s public financing. Even though the present-daycentral banks are related to fiat money, the development of mostcentral banks in Japan and Europe in the 19th and early 20th centurywas based on the international gold standard, whereas in othercountries, the usual standards were normally currency boards or freebanking (Oecd, 2005). Challenges with banks collapsing in times ofdownturns led to greater support for the central banks in theparticular nations that did not own them, especially in Australia.

Australiastarted its initial central bank in 1920, in 1923 Colombia, Chile andMexico in 1925 and the 1934 Great Depression aftermaths’ NewZealand and Canada established their central banks. The only notableindependent country that had not possesseda central bank by 1935 was Brazil which later developed in 1945, apioneerto it and twenty years later it established the modern Central Bankof Brazil. The countries in Asia and Africa as well started theirmonetary unions or central banks after they gained independence(Polillo &amp Guillén, 2005).

Thepartition of Africa and the islands in the pacific and the control ofother territories in Asia in the late nineteenth and early twentiethcentury also brought new demands for colonial banking activity (Bonin&amp Valério, 2015). Initially, the colonial demands were met bythe activities of chartered companies that managed protectorates suchas the British South Africa Company in the Zambezi or theInternational African Association in the Zaire basin. One of the mostsignificant expansions in banking that laid the ground forestablishment of central banks in former colonies was in the Frenchcolonial Empire. Banquedu Senegal wastransformed in 1901 into Banquede l’Afrique occidentale (BAO).It comprised of French colonies in West Africa such as Senegal, Mali,Niger, Mauritania, Guinea, Upper Volta, Cote D’ IVoire , andDahomey. BAO extended to Equatorial Africa and in the French mandateterritories of Togo and the Cameroon. Other European powers alsoestablished central banking systems in the rest of Africa. The firstbank of the to act as a central bank in colonial Africa was the StateBank of Morocco, which was created in 1906 to support theconsolidation of the submissions of Morocco to the protectorate ofEuropean powers. It acted as the issuing bank for part of the Moroccounder French protectorate and eventually became the central bank ofmorocco after independence on 1956 under the name Bank of Morocco.

The21st Century

Followingthe 2007- 2008 financial crisis, central banks were able to make achange. However, by 2015 their capability to enhance economic growthhas slowed down. There has been debate by the central bank on whetherto try new measures such as direct government financing or use ofnegative interest rates. The Bank of Japan and the European CentralBank with their economies in or approaching deflation, go on carryingout quantitative easing of purchasing securities with the aim ofpromoting more lending (Jackson, 2013). It is worth noting that theNorth Atlantic Financial Crisis in the year 2008 caused central banksin advanced economies in North American and Europe to take onaccommodative approaches in executing monetary policy. Some arecurrently using unconventional policy actions to deal with economicpressure that are considered harmful to the monetary and fiscalstability of the economy. One of the recent examples of the changingroles of central banks in the 21stCentury is the current fall of interest rates in developed countriesto zero for periods as long as five years. The low interest ratesapply to both long-term and short-term interest rate settings thatgreatly influence the level of borrowing in an economy. The cost ofcapital in developed economies has fallen to all-time lows as aresult of zero or near-zero interest rates. Capital owners indeveloped economies responded to the very low interest rates bydeciding to look for yield in other growing economies. The generalconsequence of the changed role of central bank is that developedcountries are experiencing the highest rate of capital outflows.Reserve-currency economies such as the United States are having moredollars getting into emerging market economies (EMEs) furthercomplicating the role of 21st-Centurycentral will continue playing in managing the macro-economy (Kapur &ampMohan, 2014). History proves that massive capital inflows to emergingeconomies often cause volatility in their economies. This explainsthe decision by the United States Reserve Bank to taper it’svigorous unconventional monetary policy so as to mitigate possiblevolatility in EMEs that experienced massive capital inflows as aresult of the low interest rates. As a result, there were massivereverse capital outflows from EMEs that had received a lot ofcapital, causing historic currency depreciations. However, EMEs hadinstituted strong macroeconomic and financial policy prior to thetapering decision by the U.S. Reserve Bank that cushioned from afinancial crisis. However, the tapering decision causes a slow-downin the medium-term macroeconomic goals while also proving thatcentral banks still have a more robust role to play in theinternational monetary system than they did before. The internationalmonetary system is still very vulnerable to shocks. The changing roleof central banks pits them against laying down policies that willprotect their economies against shocks from outside economiesespecially developed economies as well as work with other centralbanks to create a stable global monetary system.

The2008 financial crisis also shaped a new discourse about the rolecentral banks as independent economic agents on the internationalstage that are subject to regulation by monetary policies adopted inreserve-currency countries (Goodhart, 2011). If the current discourseis anything to go by, central banks are likely to have a more activerole at the local economic in their respective economies. There havebeen arguments about the lack of tangible evidence to support theidea that there are benefits that countries or rather theinternational economy derive from the current internationalco-ordination of monetary policies. More countries and monetarypolicy experts are in favor of central banks paying attention todomestic issues such as inflation and output objectives. The viewthat that domestic financial regulation is vital for economicstability was dominant before NAFC. However, the argument hasgradually been weakened in the post-NAFC era where central banks areincreasingly being required to apply both macro-and micro-prudentialmeasures to create a stable financial sector. Furthermore, centralbanks are likely to be directly involved in adopting financialstabilization measures on the international stage.

Inthe pre-NAFC era, central banks used traditional approaches of havingone objective and using one monetary instrument to deal financialinstability. It was considered unorthodox to use several instrumentsto deal with macro and micro issues that were responsible fordifferent situations of financial instability at local level. Forexample, many central banks focused on price stability and short-terminterest rate adjustments as the major instruments to foster monetarystability. Financial regulation was left to market forces. Theso-called orthodox instruments have been challenged after the 2008financial problem. A 21stCentury central bank is likely to be involved in financial regulationand monetary policy rather than strictly focusing on the latter.Examples of indicators of the change of roles for central banks arethe Bank of England, The European Bank, and U.S. Federal Reserve,which have re-designed their set-ups to get them more involved infinancial regulation. Through international cooperation of centralbanks, there is more coordination on kinds of financial policies tobe used regulate the financial sector. For instance, G-20 countriesagreed in 2008 that they can apply “unprecedented and concerted”efforts that would cause fiscal expansion in case there aresufficient signs of economic shrinking that would affect the world’sfinancial sector (Amato, Morris, &amp Shin, 2002). The concertedfiscal regulations that would be worked out by central banks wouldfocus on restoring growth, dealing with negative spill-overs betweeneconomies, and bolster growth in emerging economies. In summary, the21stCentury central bank is likely to have balanced approach towardsfiscal policies and monetary policies. While focusing on stabilizingthe financial sectors in their respective economies, they will alsoinvolved in creating an international monetary and fiscal regime thatwill be based on sound regulation, transparency, cooperation,integrity, and continuous reforms of international institutions.

Conclusion

Centralbanks around the world were established based upon the same conceptas the first central bank, the Bank of England. Since the time oftheir initial establishment, Central banks have been of help to thecommercial banks, the government, and other financial institutionsand the public at large. The primary functions of the central banksas discussed above include supervising and monitoring the bankingindustry, executing monetary policies, managing the gold reserves andforeign exchange of a country and the stock register of thegovernment, controlling the money supply of the whole nation andsetting the appropriate interest rates. Today, central banks not onlyensure use monetary policies to ensure that the financial systemfunctions, but also financial regulation. The 2008 financial crisisintroduced a new line of thinking about the roles that central banksshould play in ensuring that there is financial stability. Secondly,foreign reserve countries have been at the center-stage of managingglobal financial stability. There is a continuing discourse in theworld that is gradually shifting towards fostering more cooperationbetween central banks rather than relies on the stewardship ofinternational institutions such as the World Bank and theInternational Monetary Fund. The 21stCentury presents a new paradigm in the role of central banks. Theyare not just moving away from sticking to their traditional roles,but also embracing more innovative ways of dealing with financialstability. The methods being proposed aim to prevent the occurrenceof financial crisis by making it possible for central banks to detectit and implement monetary and fiscal measures to prevent it fromhappening.

References

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