The Design of the Central Bank

The banking system is an integral part of the financial system of many countries. In fact, as we have discussed in the previous articles, many countries base their entire financial system on the banking system.

The central bank plays a very important role in the financial system of any country. This is the reason why the design of the central bank is extremely important. The central bank of all countries may appear to be similar. However, the reality is that the central banks of different nations are not identical. There are differences in the authorities and responsibilities of the central banks of different nations. Therefore, understanding the design of the central bank becomes a stepping stone for understanding the design of the nation’s financial system.

Functions Performed by the Central Bank

In order to gauge the usefulness of the design of the central bank, we first need to understand the different functions which the central bank is supposed to perform. The core functions of the central bank are as follows:

• The central bank is the only institution in the nation that is legally allowed to issue banknotes. As such, the central bank is the gatekeeper of the money supply in an economy

• Since the central bank plays a very important role in controlling the monetary policy of an economy, it is expected to maintain minimum inflation in the economy.

• The central bank is a banker to other banks. This means that it is supposed to hold deposits provided by other banks. This is done to safeguard the interest of the common public in a fragile monetary system, which is already based on fractional reserve banking.

• The central bank is supposed to be the lender of last resort. This means that the bank is supposed to bail out other private banks. This is done to ensure that the faith of the people in the safety of the banking system remains in place.

• The central bank is supposed to be the regulator of all banks in the economy. As such, it decides the basic policies which all the banks in the sector need to follow.

As we can see, the central bank performs a wide variety of heterogeneous functions. The difference in the design of central banks arises from two basic parameters:

• Which of the above-mentioned responsibilities does the central bank consider its primary responsibility? In some countries, the efforts of the central bank are focused on reducing inflation. In other countries, the focus is to provide funds to the government for development work. In yet other countries, the focus is on regulating the behavior of the sector as a whole. Based on the primary function chosen by the bank, the structural design will differ For instance, if a bank is focused on regulating the affairs of the banking industry, it will have more committees and meetings focused on that topic

• Secondly, the ownership pattern of the central bank also plays an important role in the design of the bank. In some countries, the central bank is privately owned, whereas, in some others, it is owned by the state. In many countries, the central bank is an independent body with some degree of government control. At the present moment, most central banks in the world are quasi-government authorities. This is because problems have been faced in both private as well as publicly owned central bank. These problems have been listed in this article.

The Problem with Private Central Banks

In some countries of the world, central banks were private banks. For instance, when the Bank of England began its operations, it was a private bank and, therefore, a for-profit institution. As a result, certain problems were faced. These problems have been listed below:

• Profiteering: It needs to be understood that central banks have the authority to print money literally. It also needs to be understood that central banks come into action when other banks fail. Hence, it was alleged that central banks were being used by their owners to make undue profits. For instance, it was alleged that circumstances were created wherein certain banks would fail, then the more prominent banks would buy them for a bargain.

• Public Acceptance: In most parts of the world, public acceptance for private central banks was limited. This is because people believed that only the state should have the authority to issue fiat money.

Despite these objections, there are still many central banks in the world that are owned by private bodies.

The Problem with Government Controlled Central Banks

If central banks are owned by the government, then too, they face certain problems. For example:

• Political Control of Financial Resources: It is well known that the political objectives may not always be in line with the financial objectives of the country. Therefore, if the government ends up in complete control of the central bank, it could manipulate the economy for political gains.

• Excess Emphasis on Regulation: Central banks do play a regulatory role in the banks. However, this is just a minor role. If there is an excessive focus on regulation, then the central bank is not able to fulfill other more important functions like control of the money supply.

Despite these flaws, most central banks in the world are controlled by the government. Governments often claim that their central banks are independent bodies. However, it is a known fact that it is impossible for any central bank to be completely independent of the government.