Central Bank
A central bank is a national financial institution that manages a country's currency, money supply, and interest rates, and that serves as the overarching authority in the banking system. Central banks conduct monetary policy, act as lender of last resort, supervise the financial system, and perform various other functions essential to the stability of the economy.
Definition
A central bank is a public institution with responsibility for a country's monetary and financial stability. Unlike commercial banks, which serve the public and seek profit, a central bank serves the public interest and is typically given a mandate to maintain price stability and, sometimes, to support full employment and financial stability.
Central banks have a monopoly on the issuance of the national currency and on the creation of the monetary base. They are the ultimate source of liquidity in the financial system and the supervisor of the banking system.
Core functions
Central banks perform several core functions.
Monetary policy is the management of the money supply and interest rates to achieve macroeconomic objectives, most commonly price stability. Central banks set the base rate—the rate at which they lend to or borrow from banks—and use it to influence the cost of credit in the economy.
Currency issuance involves issuing banknotes and coins and managing their circulation. The central bank is typically the sole issuer of legal tender.
Lender of last resort refers to the central bank's role in providing liquidity to solvent but temporarily illiquid banks during a crisis. This function, articulated by Walter Bagehot, aims to prevent bank runs and financial panics from spreading.
Bank supervision and regulation involve monitoring the safety and soundness of banks and enforcing prudential rules. In some countries, this function is performed by a separate agency rather than by the central bank.
Payment systems are operated or overseen by central banks, which ensure that payments settle reliably among banks.
Government banking involves holding the accounts of the government and managing its receipts and payments.
Foreign exchange reserves are managed by central banks, which use them to intervene in currency markets and to meet external obligations.
Financial stability is a broad mandate that includes monitoring risks in the financial system, conducting stress tests, and taking action to prevent systemic crises.
Independence
Central bank independence refers to the degree to which a central bank is able to conduct monetary policy free from political interference. Independence is thought to enhance credibility and effectiveness, because it allows the bank to take unpopular actions—such as raising interest rates to control inflation—without consideration of short-term political consequences.
Central bank independence takes several forms. Instrument independence means that the central bank has discretion over how it achieves its objectives. Goal independence means that the central bank can set its own objectives. Most central banks have instrument independence within objectives set by government.
Independence is supported by institutional arrangements: long, non-renewable terms for governors; restrictions on government borrowing from the central bank; and transparent reporting requirements.
The central bank balance sheet
Central banks hold assets—including government securities, foreign exchange reserves, and loans to banks—and liabilities, principally banknotes in circulation and the reserves of commercial banks. During periods of crisis, central banks may expand their balance sheets substantially through asset purchases, a policy known as quantitative easing.
The composition of the central bank's balance sheet affects its exposure to risk and its ability to conduct policy. Large holdings of assets may expose the central bank to credit and interest rate risk, potentially requiring recapitalisation—a politically sensitive issue.
Historical development
Central banking has evolved over several centuries. The Bank of England, founded in 1694, is often regarded as the world's first central bank, though its modern functions were consolidated over time. The Riksbank of Sweden, founded in 1668, is generally considered the oldest central bank. The Federal Reserve System of the United States was established in 1913 in response to repeated banking panics. Central banking spread worldwide during the twentieth century, and central banks took on a more prominent policy role after the abandonment of the gold standard and the development of monetary policy as a tool of macroeconomic management.
Central banks today
Modern central banks operate in a complex environment, characterised by globalised financial markets, rapid technological change, and evolving mandates. Many central banks have adopted inflation targeting, a framework in which they publicly commit to a numerical inflation target and are held accountable for achieving it. This framework is thought to anchor expectations and enhance credibility.
Central banks have also expanded their focus to include financial stability, following the global financial crisis of 2007–2008, which revealed gaps in the supervision of the financial system. They conduct stress tests, monitor the build-up of systemic risk, and use macroprudential tools to contain risk.