Topic 1: Central Banking Law

Topic 1: Central Banking Law

Core purposes of the CB • Core purposes 1 -Monetary Stability. • Core purposes 2-Financial Stability • http://www.bankofengland.co.uk/about/Pages/corepurposes/default.aspx • http://www.federalreserve.gov/ • http://www.ecb.int/home/html/index.en.html

Monetary Policy • Monetary policy consists basically of three elements: objectives of monetary policy, instruments of monetary policy and organization for formulating and implementing monetary policy.

A. Objectives of Monetary Policy • Under the Bank of England Act, the monetary policy objectives of the Bank of England are to maintain price stability, and subject to that, to support the economic policy of the Government, including its objectives for growth and employment. • Under the Federal Reserve Act, the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

To be continued • the 2003 PBOC Law states that the objectives of monetary policy are to maintain monetary stability, and in this way promote economic growth. • Why is monetary stability a primary objective while economic growth is a secondary one? --to avoid the time inconsistency problem

B. Instruments of Monetary Policy • Monetary policy Instrument is defined to mean the tool to achieve the monetary policy objectives. • Traditionally, the instruments of monetary policy include reserve requirements, discount facilities and open market operations.

To be continued • Under the 2003 PBOC Law, the following monetary policy instruments are at the PBOC’s disposal in implementing monetary policy: reserve requirements, base interest rates, rediscount facilities, provision of loans, open market operations, and other monetary policy instruments determined by the State Council.

To be continued • Reserve requirements are the fraction of deposits that banks and other depository institutions are required by law or regulation to hold in reserve and not lent out. • Through varying the reserve requirement ratios, central bank can adjust the money supply amount in the market. The higher the reserve requirement ratio and the more the type of reservable deposits, the less the money and the derivative deposits used by banks.

To be continued • However, reserve requirements are not costless. Holding a percentage of their deposits in reserve as non-interest-bearing balances at central bank is burdensome to banks.

To be continued • The base interest rate is set by the central bank, upon which all other lending or savings interest rates are based. The increase (or decrease) in the base interest rates would increase (or decrease) the financing cost of a financial institution, whether from the central bank or from the market.

To be continued • Rediscount facilities are one of the means by which banks borrow funds from central bank. Banks use immature commercial papers that have been discounted by themselves to obtain loans from central bank, and the central bank discounts the commercial papers for a second time. The central bank can adjust the rediscount rate to affect the bank’s cost of borrowing money from the central bank, by means of which the central bank controls the money supply.

To be continued • Central bank relending is a loan extended by central bank to financial institutions. The central bank is able to adjust the money supply through varying relending rates.

To be continued • Open market operations are central bank’s principal tool for implementing monetary policy. Through purchasing and selling government securities in the open market, a central bank largely determines the interest rates, by which banks lend the balances at the central bank to other banks and adjust the money supply in the banking system.

To be continued • A question: How monetary policy affects the economy

To be continued • -- A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. -- Lower interest rates can boost the prices of assets such as shares and houses -- Changes in interest rates can also affect the exchange rate --Changes in spending feed through into output and, in turn, into employment

Financial Stability • a financial system can be considered stable if it (1) facilitates the efficient allocation of economic resources; (2) assesses, prices, allocates, and manages financial risks; and (3) maintains its ability to perform these key functions even when faces with external shocks or a build-up of imbalances.

B. Lender of Last Resort (LOLR) • A LOLR is an institutional arrangement with responsibility for providing credit under condition of stress. • What’s the purpose of emergency lending?

1. The Criteria for Lending of Last Resort • “liquidity criterion”: LOLRs can only lend freely to temporarily illiquid but nonetheless solvent banks • “double risk criterion”: LOLRs is a remedy solely for emergencies affecting the entire banking system, not for isolated emergency situations affecting an individual bank.

To be continued The liquidity criterion and the double risk criterion may not be operative because it is often difficult to distinguish between illiquidity and insolvency due to the non-marketability of loans.

To be continued • “systemic risk criterion” the criterion for providing last resort lending is whether the bank failure could trigger systemic risk, regardless of whether the bank is illiquid or insolvent • justifications: Firstly, The systemic risk criterion coincides with central bank’s function on maintaining financial stability

To be continued • justifications: Secondly, the philosophy of the LOLR function is that LOLRs must not be concerned about the fate of individual banks, but only about the banking system as a whole.(financial stability vs. market discipline) Thirdly, the LOLR function should be distinguished from the provision of discount or other routine credit facilities.

To be continued • The crux of the systemic risk criterion is how to determine systemic risk.

2. Conditions, Instruments and Scope • The traditional rule for the provision of lending of last resort is that LOLRs can only lend freely to temporarily illiquid but nonetheless solvent banksat a penalty rate and on good collateral. • penalty rate? • good collateral • traditional instruments vs. innovations • Banks? Financial institutions? Non-financial institutions?

3. Constructive Ambiguity • Constructive ambiguity means keeping ambiguous not only whether or not a rescue would be forthcoming, but also the terms and conditions at which it would come if the authorities deemed it necessary to intervene.

To be continued • two justifications for constructive ambiguity: ----One is the issue of equality. ----Another justification relates to moral hazard.

To be continued • However, favoring constructive ambiguity does not mean that LOLR assistance completely falls outside the scope of laws or regulations. • There are three approaches to the ex ante specification of operational rules of LOLR facilities.

Independence and Accountability of the CB

Is central bank independence an important issue? Why? • Government’s strong incentives for monetary expansions • Intrinsic conflict between government’s goals and monetary stability

Concept of central bank independence • absence of political interference; • independence from political interference and freedom from “industry capture”

To be continued • Based on different legal criteria, de jure central bank independence is classified into different types: --- four types: goal autonomy, target autonomy, instrument autonomy, and limited autonomy; ---three types: personal independence, financial or economic independence, and political independence; --- two types: political and economic independence.

Ⅰ. Independence • In some countries, central bank law contains a formal declaration of central bank independence • article 12 of the German Central Bank law provides that the Deutshce Bundesbank shall be independent and not subject to instructions from the Federal government; as far as is possible without prejudice to its tasks, it supports the general economic policy of the Federal government.

A. Functional Independence • How to assess functional independence of central bank

----Monetary Policy • The autonomy to determine and implement the monetary policy objectives most notably reflects a central bank’s functional dependence.

To be continued • Goal autonomy gives the central bank authority to determine its primary objective from among several objectives stipulated in the central bank law; • With target autonomy, the central bank has one clearly defined primary objective included in the central bank law;

To be continued • Instrument autonomy gives the government or the legislature rather than the central bank authority to decide on the target of monetary policy, but the central bank can use any instrument if it is necessary to implement the monetary policy target subject to the central bank law. • Limited autonomy indicates that the government determines the monetary policies (objectives and targets), and also influences the implementation of the monetary policy

B. Personal Independence • Personal independence is assessed by tenure, nomination, dismissal, remuneration, qualification of the governor and other senior members of a central bank

1. Qualification Requirements • Professional requirements mean professional skills in the financial or economic sectors. • Fit and proper requirements refer to a candidate’s integrity. • Personal requirements pay attention to age limits and citizenship. • Why are these qualification requirements contributed to the independence of central bank?

2. Appointment • Double-veto approach • Why to choose this approach? • Chinese legislature also applies the double-veto approach to the appointment process. • It’s good in literal understanding.

3. Dismissal • In general, senior members of a central bank can not be dismissed during their term of office without any legal grounds. • Grounds for dismissal are clearly stipulated by law, including crimes, serious misconduct, gross negligence, permanent mental or physical incapability, adjudicated bankruptcy, and even absence of meetings

4. Term of office • In most central bank laws, the term of office of governors are fixed and is usually longer than the term of the body which nominates or appoints them. Why ?

5. Conflict of Interest • Why to avoid conflict of interest? ---- to maintain personal independence • How to avoid ----Some central laws require central bankers to perform their functions on a full time basis ----Others prohibit a central banker from being an officer or director, or holding stock in financial institutions, and even in any private and public entity ----Some countries forbid a central banker from being a member of the parliament, and of a political party

C. Financial Independence • Financial independence can be assessed mainly from the perspective of capital subscription and determination of budget. • Why does that matter? • A central bank should have an initial capital to cover its risks.

To be continued • The capital of a central bank can be subscribed to by the government solely, the government and non-government investors jointly, or non-government investors solely. • A central bank should have an initial capital to cover its risks. • Which of the subscription approaches is better ? • The government can intervene in a central bank’s operations by means of its appropriation channels.

Ⅱ. Accountability • Central bank accountability implies that the central bank explains, justifies and assumes responsibility for its performance to the body delegating authority to it. • What’s the relationship between central bank independence and accountability? Contradictory? Complementary? • The basic contents of accountability include accountable for what, to whom and how to be accountable

A. Performance Accountability • Performance accountability refers to the extent to which the objectives of a central bank, in terms of monetary policy and other delegated functions, are achieved. • Legitimacy of the objectives and functions is both a precondition of central bank accountability and a yardstick to evaluate central bank accountability.

B. Institutional Accountability • Central bank accountability relates first and foremost to parliament • Traditionally, central banks have been accountable to the government • How to distinguish it from government interventions • Judiciary accountability

C. Instrument Accountability • Instrument accountability refers to transparency of central bank performance. • To enhance transparency, generally speaking, the central bank must prescribe the requirements for the publication of the report on central bank performance and of the minutes of central bank meetings. • Whether and to what extent the central bank explains its performance in the report to be disclosed publicly varies among the central bank laws.

To be continued • The minutes of the central bank meetings should be made public to improve the transparency. • Whether voting records should be revealed is still open to discussion.

Topic 1: Central Banking Law