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A central bank operates as an autonomous and non-partisan financial institution responsible for overseeing monetary policy. Its main objectives are to manage cash reserves, both domestic and foreign, to foster economic growth, and regulate inflation. Every country has its central bank to handle financial and banking matters.
On December 21, 1911, Sir Sorabji Pochkhanawala founded the Central bank of India, which was the first commercial Indian bank to be wholly owned and run by Indians. The bank widened its reach in the early 20th century by opening branches in Hyderabad (1918) and Secunderabad (1925). It bought the Tata Industrial Bank in 1923, which resulted in the foundation of the Central bank of India, Madras.
The Central Exchange Bank of India, the first Indian exchange bank, was founded in London in 1936 thanks in large part to the bank. But in 1938, it was combined with Barclays Bank. The bank established a branch in Rangoon prior to World War II with an emphasis on facilitating trade between Burma and India, including money transfers and currency exchange operations.
In 1963, following World War II, the bank’s operations in Burma were nationalized, and it changed its name to People’s Bank No. 1. Along with 13 other banks, the Central bank of India was nationalized by the Indian government in 1969. One of the first banks in India to issue credit cards, the bank made history in 1980 by partnering with MasterCard to do so.
The bank unveiled “MEDHA,” a robot that marked its first push into robotic banking, on its 108th Foundation day. The Central bank of India was recapitalized in 2009 and is now a public sector bank. The bank has a vast network as of 31 March 2021, with locations in all 28 states, seven of the eight union territories, ATMs, satellite offices, and extension counters.
The central bank of any nation performs crucial tasks that include determining the base rate, regulating the money supply through open market operations, managing the country’s foreign currency reserves, and maintaining the appropriate reserves. Let’s explore these functions in detail
One of the primary functions of the central bank is to set the base rate, which determines the rate at which it lends to commercial banks. Commercial banks, in turn, use this base rate as a reference to set the interest rates on loans and credit for the public.
If the central bank raises the base rate, it leads to higher interest rates for consumers and companies, making borrowing more expensive. Consequently, the money circulation in the market reduces. Conversely, a decrease in the base rate results in cheaper loans, increasing the market’s money circulation and boosting demand for goods and services
Open market actions are taken by the central government to control the amount of money in the economy. By buying or selling financial securities or investments, the central bank can inject or withdraw liquidity into/from the system. When it buys financial assets, funds are transferred to the seller’s banking institution, injecting new money into the economy. Conversely, selling financial assets reduces the money supply.
Central banks regulate the statutory cash reserve requirements of commercial banks to control the money supply. The Central bank’s Reserve Requirements: A Tool for Controlling the Money Supply
The central bank ensures that the country has sufficient foreign currency reserves to preserve the value of its national currency. If the local currency loses value, the central bank may intervene in the foreign exchange market by purchasing the local currency, signaling to the market that the currency is in demand. This action can help stabilize or strengthen the value of the national currency.
The central bank’s functions play a vital role in controlling the money supply, influencing interest rates, and maintaining the stability and value of a nation’s currency, all of which are crucial in fostering economic growth and stability.
Example #1: Recent news highlighted a trend among global central banks to raise interest rates in an effort to control inflation. Notably, banks such as the US Federal Reserve, the Reserve Bank of Australia, and the Bank of England have implemented rate increases, raising concerns about the potential risk of recession in their respective countries.
In 2021, central banks initially viewed inflation as temporary, attributing it to supply chain disruptions resulting from COVID-19 lockdowns. However, global inflation continued to surge, particularly due to Russia’s invasion of Ukraine, causing a sharp rise in oil and food prices. Consequently, economists have revised down their global growth forecasts for 2022.
Financial analysts argue that central banks might not have direct control over factors driving inflation, such as high energy and food costs, and supply chain bottlenecks. Despite their efforts to address inflationary pressures through interest rate adjustments, these external factors continue to pose challenges to economic stability.
Example #2: Due to the popularity of the U.S. dollar as the world’s reserve currency, the Federal Reserve (Fed), the country’s central bank, has significant influence both domestically and internationally. The Fed plays a crucial role in maintaining overall financial health by regulating monetary policy, ensuring the stability of financial institutions, securing monetary transactions, and functioning as a settlement system.
Major central banks, including the Federal Reserve and the European Central bank, face mounting pressure to reduce their balance sheets, which expanded significantly during their recessionary buying activities.
The process of selling off or reducing these large positions is causing market concerns, as the resulting influx of supply could reduce demand. Particularly in less liquid markets like the Mortgage-Backed Securities (MBS) market, central banks have become the primary buyers. In the United States, for instance, with the Fed no longer purchasing and facing pressure to sell, uncertainties arise over whether there will be enough buyers at fair prices to acquire these assets from the central bank.
The potential repercussions extend to interest rates associated with these assets, especially mortgage bonds, which may rise, thus putting upward pressure on mortgage rates and potentially hampering the housing recovery, which has been slow and gradual.
To mitigate market anxieties, one strategy being considered is for central banks to allow certain bonds to mature and refrain from purchasing new ones, rather than immediately selling off their existing holdings. The market’s ability to withstand this change in their buying habits is still unknown because central banks have been active and consistent buyers for almost ten years.
From the 1960s until the 1980s, Japan endured an economic downturn and deflation. The 1990s’ “Lost Decade” came after the crash of the stock market and housing market. The global financial crisis and deflationary pressures were additional effects of the Great Recessions of 2008–2009.
To combat the 2008 crisis, the Federal Reserve used unconventional tools
The European Central bank adopted quantitative easing and experimented with negative interest rates in 2015. Other central banks like Switzerland, Sweden, and Denmark reduced interest rates to zero.
Modern central banks face challenges with their expanded balance sheets. As major market players, they must manage deflation risks while reducing their balance sheets without causing disruptions. Panic from potential price declines adds to the complexity of maintaining financial stability. Central banks strive to deploy effective policies for economic resilience in the dynamic global landscape.
Government-issued digital currencies known as CBDCs are unrelated to tangible goods. They are produced by central banks like the US Federal Reserve, Bank of Japan, and People’s Bank of China, and act as digital representations of traditional currencies.
Account-Based Model: Customers have direct deposit accounts with the central bank (for instance, DCash in the Eastern Caribbean).
Distribution by private banks (like China’s e-CNY): Private Banks provide and oversee users’ digital currency accounts.
The European Central bank is considering a block chain-based model where authorized financial firms run permissioned nodes to distribute digital euros.
Fiat Currency released as Anonymous Fungible Tokens (Experimental): To ensure user privacy, fiat currency was released as tokens.
Central banks are showing an increasing interest in Central Bank Digital Currencies (CBDCs) as a result of several emerging patterns. They are forced to reconsider their place in the monetary system because of the decline in cash transactions.
The conventional function of fiat currency is being challenged by the growth of privately created digital assets. Central Bank Digital Currencies (CBDCs) give central banks the chance to take the lead in talks on the real-world uses of currency. In the context of the developing global payment landscape, CBDCs can also stabilize regional digital payment systems.
CBDCs may result in cheaper and quicker transactions, increased financial inclusion for the unbanked population, and improved payment security.
Stakeholders must be ready for these challenges. Concerns about tax compliance are raised by the traceability of transactions. The successful implementation of CBDCs depends on maintaining technological security and stability. To make sure CBDCs are effective, the business case must be assessed.
Stakeholders, such as central banks, financial service providers, retail banks, and investors, must get ready for the future of CBDCs by enhancing infrastructure for their implementation, closely observing liquidity and capital requirements, and putting in place effective KYC and anti-money laundering procedures to guard against potential risks.
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1. Do Government Institutions Function as Central Banks? In general, central banks are independent, non-governmental organizations. However, some central bank jobs are open to government appointment, and those in those positions must uphold the law while benefiting from it.
2. What Are the Core Responsibilities of Central Banks?
Influencing monetary policy, serving as the lender of last resort, and supervising the banking sector are all crucial functions of a central bank. They regulate the money supply, determine interest rates, and make loans to other banks.
3. The Federal Reserve is Funded in What Way?The interest collected on the securities held by the Federal Reserve serves as its main source of funding. It also derives income through fees levied for services including check clearing, fund transfers, and automated clearing house (ACH) activities that are given to depository institutions. The Federal Reserve does not receive funding from Congress.
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