Modern central bank functions and their role in financial sector development and stability

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1 Modern central bank functions and their role in financial sector development and stability Georg Rich Presentation at the SECO/State Bank of Vietnam Restructuring Workshop Hanoi, February 25 and 26 Ho Chi Minh City, February 28 and 29

2 Two main roles of modern central banks Responsible for safeguarding macroeconomic stability, in particular, low inflation and as far as possible steady real growth of the economy Responsible for stability of financial markets However, many central banks are responsible only for macro aspects of financial-market stability, but not for supervision of individual banks and other financial institutions

3 Function I: Safeguarding macroeconomic stability It is now widely agreed that the central banks principal task is to safeguard price stability, that is, to keep inflation at a low level Central banks may also have some scope for stabilizing fluctuations in real activity such as cyclical movements in output However, central banks ability to stabilize the business cycle should not be overstated; paying too much attention to output may jeopardize the objective of maintaining price stability

4 Numerous central banks, including several in East Asia, now fix a target for inflation consistent with their desire to maintain price stability They regularly produce inflation forecasts for the coming two or three years Deviations in forecasted inflation from the central banks inflation targets signal a need for an adjustment in monetary policy If central banks see a need for a policy change, they normally adjust a short-term term interest rate, which tends to be their main policy instrument

5 Central banks in developed countries now largely rely on market-related related techniques of managing short-term term interest rates and bank liquidity The most popular technique involves open- market operations in securities concluded with the domestic banks (normally repurchase agreements repos) In developing and transition countries lacking well-developed money markets, use of administrative techniques such as credit controls, controls of loan and deposit rates, and minimum- reserve requirements for banks still widely used also the case in Vietnam

6 Effective inflation targeting requires floating exchange rate Only floating exchange rates allow central banks to control fully domestic interest rates and bank liquidity Under managed floating and quasi-fixed exchange rates, central banks may find it difficult to control inflation This is a problem in Vietnam as strong capital inflows lead to excessive expansion in domestic liquidity and thus fuel inflation To contain inflation, the Vietnamese authorities in the longer run will have to allow for greater flexibility in the exchange rate of the dong

7 Why is price stability important? Prices are important signals helping to allocate efficiently the scarce resources of an economy High inflation distorts the signaling function of prices It may punish wage earners and undermine the population s s willingness to work It may prompt excessive taxation of profits These problems can be avoided only through costly indexing

8 Empirical studies suggests that high inflation (>10 percent) impedes real growth in the economy Vietnam below that threshold, at least as far as core inflation is concerned Inflation also leads to an undesirable redistribution of wealth and normally hurts poor people, while the rich may gain Especially retired people living on benefits from government pension schemes tend to suffer from inflation

9 High inflation may also undermine the stability of the financial sector It renders investment in fixed-income income assets such as bank deposits and bonds less attractive and leads to excessive investment in real assets such as housing May therefore generate undesirable housing bubbles While bond yields may adjust to expected inflation, real losses on low-yield bank deposits may again be avoided only through costly indexing schemes

10 Limited mandates of central banks In many countries, the mandate of central banks is now limited macroeconomic and financial stability In the old days, central banks often had numerous other tasks such a helping the government in promoting economic development through channeling bank credit to priority sectors Central banks may also be abused for financing excessive government deficits Overburdened mandates may lead to conflicts among policy goals and stimulate inflation

11 Function II: Safeguarding financial stability This function normally involves four different central-bank tasks: Acting as lender of last resort Operating or overseeing the payments systems Acting as an adviser to the government in matters involving legislation and regulation with respect to the financial sector Some but not all the central banks also act as supervisors of banks and other financial intermediaries

12 Central banks as lenders of last resort An important task of central banks is to provide adequate liquidity to the domestic financial institutions Provision of liquidity must be consistent with overall objectives of monetary policy However, in the event of financial crises associated with liquidity problems, central banks my be compelled to provide emergency liquidity to financial institutions

13 Most central banks prefer to provide liquidity to the money market as a whole through open- market operations Individual institutions short of liquidity may in turn borrow from the market, that is, from institutions with excess liquidity Under certain conditions central banks may be forced to lend directly to institutions facing a liquidity squeeze Normally, central banks are authorized only to lend to solvent institutions and against collateral Therefore, central banks must have information on solvency of potential borrowers

14 Payments system Central banks play an important role in the payments system They are in charge of providing currency to the economy They also operate or oversee the operation of the interbank payments system or other payments systems

15 Adviser to the government Often central banks possess more expertise in financial matters than the government Therefore, it is useful for central banks to act as advisers to governments in matters of financial legislation and regulation In developing and transition countries, in particular, central banks may play an important role in helping to set up efficient money and capital markets, and in helping to privatize state- owned banks

16 Supervisor of banks and other financial institutions Main functions of supervisors: Licensing of institutions Monitoring conduct and performance of managers of institutions Auditing institutions in order to check whether they comply with regulations, notably with capital and liquidity requirements, and whether they manage properly their risks Closing insolvent institutions

17 Should central banks act as supervisors of financial institutions? In many countries including Vietnam the central bank also acts as a supervisor of banks and other financial institutions There is currently a tendency to separate the monetary policy and supervisory functions of central banks In some countries (e.g. United Kingdom and Switzerland) supervision is vested in a completely separate government agency, with the central bank playing no role in supervision Other countries (e.g. US) feature mixed systems

18 Advantages of separating monetary policy and supervisory functions Separating the two functions avoids conflicts of interests among policy objectives The central bank as lender of last resort may be tempted to provide liquidity to an insolvent bank in order to avoid having to opt for the unpopular measure of closing down that institution

19 Assessing the solvency of banks is sometimes difficult. Supervisors may, by mistake, keep insolvent banks alive As market participants realize that the banking system suffers from insolvency problems, a financial crisis may erupt Central banks may overreact to the financial crisis by providing too much liquidity to the banks This implies an overly loose monetary policy jeopardizing price stability These conflicts can be avoided if the central bank is only responsible for the provision of liquidity, while the supervisor is concerned about solvency

20 Disadvantages of separation The main disadvantage is that the central bank may not possess all the information required to act as effective lender of last resort The supervisor should inform the central bank regularly about solvency problems in the banking system Because of inadequate information, the central should not be mislead to lend to an insolvent bank or as overseer of the payments system to allow payments to be made to an insolvent bank (settlement or Herstatt risk)

21 The disadvantages of separation may be overcome as follows: There are regular and frank exchanges of views between the central bank and the supervisor The central bank though not responsible for supervision assists the supervisor in certain tasks such as the collection of banking statistics and auditing of banks Example of how not to do it from Swiss experience

22 Other institutional issues According to numerous empirical studies, central banks that enjoy a high degree of independence from the government do a better job at preserving price stability than those that do not The same conclusion holds for supervisors of financial institutions, who should also possess some independence from the government Independence allows central banks and supervisors to withstand political pressure for easy money and keeping alive insolvent banks Greater independence an issue in Vietnam

23 The supervisor may also find it easier to close down insolvent banks if bank deposits are insured However, banks deposit insurance must be carefully designed to avoid moral hazard Another problem arises from closing down big insolvent banks as such closures may undermine the health of other banks and thus create systemic risks ( too( big to fail ) No ready-made solution to too big to fail problem This problem may be exacerbated if the government remains a partial owner of banks as is envisaged in Vietnam