What Exactly Does a Central/Reserve Bank Do?
A central or reserve bank, which in some cases is also called a monetary authority, is a public body responsible for managing a country’s money supply, currency and interest rates. Its primary function is to manage its nation’s money supply, which it does through active duties such as setting the reserve requirement, managing interest rates, and acting as a lender of last resort to financial institutions if they become insolvent or during times of financial crisis.
In addition to issuing a common currency and controlling money supply, a central bank is also responsible for regulating banks, clearing payments and acting as a bank for bankers. The bank holds deposits for commercial banks and other financial institutions as well as the government. All central banks act as bankers for their own governments. They act as the supervisory authority for commercial banks and other financial institutions that take deposits, issue loans and arrange the settlement of accounts according to the legislation of the countries in which they operate.
Each central bank has its own monetary policy. A common monetary policy is to maintain inflation at a certain level (usually around 2 percent). Central banks have different tools for enforcing their monetary policies, a major one being the control of interest rates, which can influence both a country’s inflation rate and its currency exchange rates.
The first central bank was the Bank of Sweden (Sveriges Riksbank), founded in 1668, but it is the second oldest, the Bank of England, which was established in 1694, that most central banks around the world use as a model. After several failed attempts in the eighteenth and nineteenth centuries, the Federal Reserve Bank of theUnited Stateswas established in 1913. TheUnited Stateswas the last major country to establish a central bank.
Central banks have been known to join forces in times of financial crisis. For example, in September 2011, amid fears that Europe’s banks would succumb to the euro-zone’s government debt catastrophe, the world’s primary central banks came together to offer the region’s struggling banks access to dollars. Bank of England, the US Federal Reserve, Swiss National Bank, European Central Bank, Bank of Canada and Bank of Japan coordinated to ensure banks unlimited dollar funding through the end of 2011.
This move by these six central banks was designed to help European banks carry on with their borrowing and lending activities, and it sought to prevent a collapse of international financial markets, givingEuropemore time to grapple with its debts. In a joint statement, the banks said they were offering these bailouts to help relieve the stressed European financial market and in so doing enable households and businesses to gain credit and so aid in fostering economic activity.
There are other examples of central banks forming strategic alliances, such as the May 2012 decision by the Reserve Bank ofIndiato sign a Memorandum of Understanding with the Central Bank ofBahrainto encourage collaboration and sharing of supervisory information between the two regulators.
Although central banks are primarily set up to regulate the banking sector, they can have an effect on stock markets, as evidenced by the surge in the US’s Standard & Poor’s 500-stock index (1.7 percent), the German stock market (3.2 percent) and Japan’s Nikkei 225 index (1.7 percent) as news broke about the coordinated response of the six central banks to the European financial crisis.
Although central banks around the world have common roles, each still works in distinct ways, and those differences are mainly the result of the banks’ historical foundations. The eight main central banks are: US Federal Reserve System, Bank of England, European Central Bank, Swiss National Bank, Bank of Canada, Bank of Japan, Reserve Bank of New Zealand and Reserve Bank of Australia.
flickr image by Sam Howzit