Dr.

Mohammed Alwosabi ECON248 University of Bahrain

CENTRAL BANKING AND THE MONETARY POLICY

GENERAL INTRODUCTION
— Every country with an established banking system has a central bank.
— The central bank of any country can be defined as a government authority in
charge of regulating the country’s financial system, controlling the quantity
of money and conducting monetary policy.
— There is only one central bank for each country with few branches.
— The central bank is a "bank" in the sense that it holds assets (foreign
exchange, gold, and other financial assets) and liabilities. A central bank's
primary liabilities are the currency outstanding, and these liabilities are
backed by the assets the bank owns.
— The central bank is the bank of government. It does not provide general
banking services to individual citizens and business firms
— The central bank is the bank of the banks and acts as a lender of last resort to
the banking sector during times of financial crisis
— The central bank has supervisory powers, to ensure that banks and other
financial institutions do not behave recklessly or fraudulently.
— There is no standard terminology for the name of a central bank, but many
countries use the "Bank of Country" form (e.g., Bank of England, Bank of
Canada, Bank of Russia). In other cases, they may incorporate the word
"Central" (e.g. European Central Bank, Central Bank of Bahrain). The word
"Reserve" is also used, primarily in the U.S., Australia, New Zealand, South
Africa and India. Some are styled national banks, such as the National Bank
of Ukraine.

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

THE MAIN ROLES OF CENTRAL BANK

— The central bank (CB) regulates and supervises depository institutions. The
main roles of central banks are:
1. To ensure monetary stability through monetary policy tools that keep
inflation low and stable, and, hence, preserving local currency purchasing
power and promoting economic activity
2. To ensure financial stability and to have resilient and efficient financial
system
3. To have effective policy for risk management and control supervision
4. To issue and enforce anti-money laundering and fraud laws
5. To enhance the economic developmental through institutional building
and market infrastructure and through ensuring healthy competition and
efficient financial markets
6. To create a sound payments system through efficient means of
transferring funds between parties and for commercial transactions
7. To have a real time gross settlement system and check clearing system
8. To play the role of economic and financial adviser to the government.
9. To help in managing government borrowing
10. To represent the government in international agencies and meetings
11. To strengthen cooperation with international financial community
12. To manage the country's foreign exchange and gold reserves
13. To issues new currency and withdraw damaged one
14. To collect data and make economic forecasting and policy
15. To review and approve annual accounts of all banks and conduct regular
onsite inspection
16. To evaluate and approve proposed mergers and expansions

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

Role of Central Bank – Islamic banking and finance

— In addition to the above-mentioned general roles, CB has a crucial role to
supervise and monitor Islamic banking and finance.
1. To ensure Shari’a compliance and to monitor Shari’a implementations by
Islamic financial institutions, whether full-fledged or just Islamic banking
windows
2. To set up a Shari’a Supervisory Board (SSB) at the central bank level to
approve the Islamic financial products and instruments developed by
Islamic financial institutions
3. To approve the appointment of CEOs and directors of Islamic financial
institutions
4. To monitors the compliance of Islamic banks to regulatory requirements

MONETARY POLICY AND ITS INSTRUMENTS

— Despite their names, central banks are not banks in the sense that commercial
banks are. They are governmental institutions that are not concerned with
maximizing their profits, but with achieving certain goals for the entire
economy.
— The purpose of the central bank is to help achieve stable prices, full
employment, and economic growth through the regulation of the supply of
money and credit in the economy.
— Changing the money supply and credit to achieve these goals is called
monetary policy. Monetary policy is the management of the money supply
for the purpose of maintaining stable prices, full employment, and economic
growth.
— The main monetary policy instruments available to central banks are open
market operation, bank reserve requirement, interest rate policy (discount
rate).

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

— While capital adequacy is important, it is defined and regulated by the Bank

for International Settlements (BIS), and central banks in practice generally do
not apply stricter rules.

Open Market Operations (OMO)

— Through open market operations, a central bank influences the money supply
in an economy directly.
— An open market operation is the purchase or sale of government securities by
the central bank in the open market.
— To reduce inflation, the central bank conducts a contractionary monetary
policy using the open market operation. Central bank sells government
securities Ö people pay money to buy government securities from the central
bank Ö banks deposit decreases Ö banks reserves decrease Ö Loans
decrease Ö money supply (Ms) decreases Ö AD decreases Ö AD curve
shifts leftward.
— To reduce unemployment, the central bank conducts an expansionary
monetary policy using the open market operation. Central bank buys
government securities Ö people receive money from the central bank Ö
banks deposit increases Ö banks reserves increase Ö Loans increase Ö
money supply (Ms) increases Ö AD increases Ö AD curve shifts rightward.

Discount Rate
— The discount rate is the interest rate the central bank charges the commercial
banks and other depository institutions when they borrow reserves from it.
— To reduce inflation, the central bank conducts a contractionary monetary
policy using the discount rate. It increases the discount rate Ö higher cost of
borrowing reserves Ö banks borrow less reserves from central bank Ö but
with a given required reserves banks decrease their lending to decrease their

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

borrowed reserves Ö Loans decrease Ö money supply (Ms) decreases Ö

AD decreases Ö AD curve shifts leftward.
— To reduce unemployment, the central bank conducts an expansionary
monetary policy, using the discount rate. It decreases the discount rate Ö
lower cost of borrowing reserves Ö banks borrow more reserves from central
bank Ö banks increase their lending Ö Loans increase Ö money supply (Ms)
increases Ö AD increases Ö AD curve shifts rightward.

Reserve Requirements
— Another significant power that central banks hold is the ability to establish
reserve requirements for other banks. All depository institutions in the
country are required to hold a minimum percentage of deposits as reserves
(cash or deposited with the central bank). This minimum percentage is known
as a required reserve ratio.
— To reduce inflation, the central bank conducts a contractionary monetary
policy using the required reserve ratio. It requires depository institutions to
hold more reserves, which results in increasing the reserves and thus reducing
the amount they are able to lend Ö Loans decrease Ö money supply (Ms)
decreases Ö AD decreases Ö AD curve shifts leftward.
— To reduce unemployment, the central bank conducts an expansionary
monetary policy using the required reserve ratio. Required reserves decrease
Ö loans increase Ö Ms increase Ö AD increase Ö AD curve shifts
rightward.

Capital requirements
— All banks are required by the central bank to hold a certain percentage of
their assets as capital.

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

— For international banks, including the 55 member central banks of the Bank
for International Settlements (BIS), the minimum capital requirement is 8%
of risk-adjusted assets, whereby certain assets (such as government bonds)
are considered to have lower risk and are either partially or fully excluded
from total assets for the purposes of calculating capital adequacy.
— Partly due to concerns about asset inflation and repurchase agreements,
capital requirements may be considered more effective than deposit/reserve
requirements in preventing indefinite lending: when a bank cannot extend
another loan without acquiring further capital on its balance sheet.

— In conclusion,
o To increase commercial bank lending the central bank can lower
reserve requirements, lower capital requirements, lower the discount
rate, or buy government securities.
o To decrease commercial bank lending the central bank can raise the
reserve requirements, raise the capital requirements, raise the discount
rate, or sell government securities.

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

CENTRAL BANKS INDEPENDENCE

— Although central banks are part of the government, they usually have much
more independence than other government agencies.
— The literature on central bank independence has defined a number of types of
independence. The most important ones are:
1. Goal independence: The central bank has the ability to set its
monetary policy goals, whether inflation targeting, control of the
money supply, or maintaining a fixed exchange rate. While this type
of independence is more common, many central banks prefer to
announce their policy goals in partnership with the appropriate
government authority. The setting of common goals by the central
bank and the government helps to avoid situations where monetary
and fiscal policy are in conflict; a policy combination that is clearly
sub-optimal.
2. Operational (Instrument) independence: The central bank has the
ability to determine the best way of achieving its policy goals,
including the types of instruments used and the timing of their use.
This is the most common form of central bank independence.
3. Management Independence: The central bank has the authority to
run its own operations (appointing staff, setting budgets, etc) without
excessive involvement of the government. The other forms of
independence are not possible unless the central bank has a significant
degree of management independence.
— Governments generally have some degree of influence over even
"independent" central banks; the aim of independence is primarily to prevent
short-term interference.
— International organizations such as the World Bank, the BIS and the IMF are
strong supporters of central bank independence. This results, in part, from a

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

belief in the intrinsic merits of increased independence, and from the

connection between increased independence for the central bank and
increased transparency in the policy-making process.

THE BANK FOR INTERNATIONAL SETTLEMENTS (BIS)

— The Bank for International Settlements (BIS) is an international
organization, which fosters international monetary and financial cooperation
and serves as a bank for central banks.
— The BIS fulfils this mandate by acting as:
o a forum to promote discussion and policy analysis among central
banks and within the international financial community
o a center for economic and monetary research
o a prime counterparty for central banks in their financial transactions
o agent or trustee in connection with international financial operations
— The BIS banking services are provided exclusively to central banks and other
international organizations. As its customers are central banks and
international organizations, the BIS does not accept deposits from, or provide
financial services to, private individuals or corporate entities.
— The head office of BIS is in Basel, Switzerland and there are two
representative offices: in the Hong Kong Special Administrative Region of
the People's Republic of China and in Mexico City.
— Established on 17 May 1930, the BIS is the world's oldest international
financial organization.
— The BIS unit of account is the IMF special drawing rights, which are a basket
of convertible currencies. The reserves that are held account for
approximately 7% of the world's total currency.

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

The BIS carries out its work through subcommittees, the secretariats it hosts,
and through its annual General Meeting of all members.
— The BIS' main role is in setting capital adequacy requirements. BIS requires bank
capital/asset ratio to be above a prescribed minimum international standard, for the
protection of all central banks involved.
— Another role for BIS is make reserve requirements transparent
— The BIS also comments on global economic and financial developments and
identifies issues that are of common interest to central banks.
— The BIS carries out research and analysis to contribute to the understanding
of issues of core interest to the central bank community, to assist the
organization of meetings of Governors and other central bank officials and to
provide analytical support to the activities of the various Basel-based
committees.

BASEL ACCORDS
— The Basel Committee on Banking Supervision is an institution created in
1974 by the central bank Governors of the Group of Ten nations (Belgium,
Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States).
— Its membership is now composed of senior representatives of bank
supervisory authorities and central banks from the G-10 countries, and
representatives from Luxembourg and Spain. It usually meets at the Bank for
International Settlements in Basel, where its 12 member permanent
Secretariat is located.
— The Basel Committee formulates broad supervisory standards and guidelines
and recommends statements of best practice in banking supervision in the
expectation that member authorities and other nations' authorities will take

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

steps to implement them through their own national systems, whether in

statutory form or otherwise.

Basel I
— Basel I is the term which refers to a round of deliberations by central bankers
from around the world, and in 1988, the Basel Committee (BCBS) in Basel,
Switzerland, published a set of minimal capital requirements for banks.
— This is also known as the 1988 Basel Accord. It was enforced by law in the
Group of Ten (G-10) countries in 1992, with Japanese banks permitted an
extended transition period.
— Basel I is now widely viewed as outmoded, and a more comprehensive set of
guidelines, known as Basel II are in the process of implementation by several
countries.
— Basel I primarily focused on credit risk. Banks with international presence are
required to hold as capital at least 8 % of the risk-weighted assets.

Basel II
— Basel II is the second of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking
Supervision. The purpose of Basel II, which was initially published in June
2004, is to create an international standard that banking regulators can use
when creating regulations about how much capital banks need to put aside to
guard against the types of financial and operational risks banks face.
— Several countries started to implement Basel II in 2008.
— Advocates of Basel II believe that such an international standard can help
protect the international financial system from the types of problems that
might arise should a major bank or a series of banks collapse.

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

— In practice, Basel II attempts to accomplish this by setting up rigorous risk

and capital management requirements designed to ensure that a bank holds
capital reserves appropriate to the risk the bank exposes itself to through its
lending and investment practices.
— Generally speaking, these rules mean that the greater risk to which the bank is
exposed, the greater the amount of capital the bank needs to hold to safeguard
its solvency and overall economic stability.
— Basel II uses a three pillars concept:
1. The first pillar intends to link capital requirements for large,
internationally active banks more closely to actual risk. It deals with
maintenance of regulatory capital calculated for three major
components of risk that a bank faces: credit risk, operational risk and
market risk. Other risks are not considered fully quantifiable at this
stage.
2. The second pillar focuses on strengthening the supervisory process,
particularly in assessing the quality of risk management in banking
institutions and in evaluating whether these institutions have adequate
procedures to determine how much capital they need. It also provides
a framework for dealing with all the other risks a bank may face, such
as systemic risk, pension risk, concentration risk, strategic risk,
reputation risk, liquidity risk and legal risk, which the accord
combines under the title of residual risk
3. The third pillar focuses on improving market discipline through.
increasing the disclosure of details about the bank’s credit exposure,
its amount of reserves and capital, the officials who control the bank,
and the effectiveness of its internal rating system. This is designed to
allow the market to have a better picture of the overall risk position of

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Dr. Mohammed Alwosabi ECON248 University of Bahrain

the bank and to allow the counterparties of the bank to price and deal
appropriately.
— Although Basel II makes great strides toward limiting excess risk taking by
internationally active banking institutions it increased complexity compared
to Basel I, which raised the concerns that it might be unworkable.

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