lecture 04-central bank (e)

8/14/2019 Lecture 04-Central Bank (E)

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The Central Bank Vu Thanh Tu Anh

Lecture 4

THE CENTRAL BANK


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The Prevalence of Central Banks

The number of central banks in the world has beenincreasing rapidly in the 20th century

The number of central banks in the world

0

20

40

60

80

100

120

140

160

180

1800 1900 1930 1950 1990


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The Necessity of the Central Bank

Conducting monetary policy Monetary policy is closely related to

macroeconomic policies and objectives

Macro policies: Fiscal, trade, exchange rate

Macro objectives: Inflation, growth, employment

The necessity of the Central Bank is clearly and

fully reflected by exploring its functions


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Functions of the Central Bank (1)

Creating Money Issuing new currency

Withdrawing damaged currency from circulation

Conducting monetary policy (interest rates,inflation)

Directly managing the money supply: Controlling the

credit supply of commercial banks

Indirectly managing the money supply: Utilizing thediscount rate, open-market operations, reserve

requirement ratio.


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Acting as the governments banker Managing the governments accounts Lending to the government

Issuing the government securities

Maintaining foreign-exchange reserves andmanaging the balance of payment

Managing foreign exchange reserves (incl. gold)

Intervening into the foreign-exchange market to

regulate the exchange rates Managing the current account (import-export

payment) and capital account (FDI flows, portfolioinvestment, commercial loans, and aids) in thebalance of payment


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Overseeing the banking system (acting as banksbanker)

Licensing the establishment, merging, and dissolution of

banks

Promulgating protective regulations in banking activities

Monitoring banking activities

Establishing and managing the inter-bank settlement system

Discount-lending

Acting as the lender of the last resort to commercial banks

Developing the information system and undertaking

research related to the conduct of monetary policy


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The Central Banks Independence

and Organization



The Central Banks Degree of

Independence Financial independence

Who owns the Central Bank The ability of government to fund its expenditure directly with loans

from the central bank

The relationship between monetary policy and fiscal policy

Personnel independence

Representation of the government in the board of the central bank? The governments influence in appointing/dismissing key personnels?

Policy independence

Goal independence

Instrument independence

Discussion: Arguments in favor of the high degree independence of the central

bank?

Arguments against the high degree of independence of the centralbank?



The Ownership of the Central Bank

United Kingdom

Sweden

Spain

Norway

New Zealand

Netherlands

Ireland

Italy (Public company)India

Turkey (25%)Germany

Mexico (51%)France

Japan (55%)Finland

Greece (10%)Denmark

Chile (50%)United StatesCanada

Belgium (50%)SwitzerlandAustralia

Austria (50% government share)South AfricaArgentina

State and private ownership combinationPrivate ownershipState ownership



Why is the independence

of the central bank necessary?

It is necessary to have a separation betweenthe creating money agency (the central bank)

and the spending money agency (the govt)

If the central bank is under the government:

Monetary policy may be used by the government to

support its economic policy, which is not always

optimal in terms of allocation of resources

Example: Growth rate of money supply, directed

credit, inflation, fiscal deficit



Why is the independence of CB necessary?

Evidence from empirical research

The correlation between the Central Banks

degree of independence with:

Inflation (negative)

Budget deficit (negative)

Economic growth (ambiguous)



The Central Banks degree of independence and

inflation rate in some countries (1955-1988)

Source: Alesina and Summers (1993), excerpts in Pollard (1993)




variation in inflation in some countries (1955-1988)



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e en ra an s egree o n epen enceand growth rate in some countries (1955-

1987)



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variation in growth in some countries (1955-1987)



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The Central Banks degree of independence

and fiscal deficit in some countries (1973-89)

Source: Pollard (1993)


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The CBs degree of independence and variation in

fiscal deficit in some countries (1973-89)

Source: Pollard (1993)


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The State Bank of Vietnam

&The Federal Reserve System (FED)


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Arguments against the independence

of the Central Bank

Countries used to face difficulties and are adverse toinflation tend to accept central banks independence

Whats the implicit assumption in the above argument?

Monetary policy is an organic part of the economic

policy system (incl. fiscal, trade, and employment) Politically, it is unacceptable that a powerful body (the

central bank) is not elected in a democratic manner

Distinction between independence with accountability and

dialogue (such as, reporting to the legislative body)


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Controlling & balancing power in FED

Why was FED established so late? The viewpoint against the over-centralization of power: 12 Fed

Reserve Banks, representative for 12 districts

Each Federal Reserve Bank has 9 governors:

Group A: 3 governors, who are experts in banking sector,

elected by private banks in the district

Group B: 3 governors, who are excellent leaders, on behalf of

the industrial, agricultural sectors, labors, consumers, also

elected by private banks in the district

Group C: 3 governors act on behalf of the communitys

interests, appointed by the Fed Board of Governors (they must

not be officials, employees, or shareholders of the bank)

9 governors elect president under the Fed Board of Governors

approval


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The Board of Governors

Including 7 members appointed by the President ofthe US and approved by the Senate

Each member has a 14-year term, not extended de

facto

Two members coming from the same district are notallowed

The Fed president has a 4-year term and can be

extended

As a new president takes over, the former presidentwithdraws from the Board (even if his 14-year term is

not over)

F d l O M k t C i i


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Federal Open Market Commission

(FOMC)

Including 12 members: 7 members of Board ofGovernors, the president of New York Federal

Reserve Bank, and 4 presidents (rotating) of the

remaining 11 Federal Reserve Banks

The president of Fed is also the president of FOMC FOMC meet 8 times every year to decide the activities

of the open market

Although only 4 rotating presidents are allowed to

vote, all presidents have to be present In fact, all three important decisions (open market

operations, required reserves, discount rate) of Fed

are made in the FOMC meetings

M h i t th F d'


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Mechanism to ensure the Feed's

independence

Financial independence Feds income from securities holdings and loans to

commercial banks is very huge

Feds net income amounts to dozen billions of dollars

This income then must be transferred to the Treasury


The Board of Governors

Federal Open Market Commission

Policy independence

Goals

Instruments


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Allocation of Federal Reserves Banks


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Federal Reserve System Chart


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Organization Chart of the SBV

The Governor

Deputy Governors

SB Offices,

DepartmentsRepresentative Office

of SB in HCMCProfessional

Organizations

64 Provincial

Branches

Monetary Policy Dept.

International Collaboration

Bank & Non-bank FI Dept.

Controlling Dept.

Credit Department

Banking Inspection

Banking Development

Foreign Exchange Management

Legislation Dept.

Personnel Dept.

Securities Exchange

Commission

State Bank Office

Management Office

IT Office

Financial Accounting Dept.

Banking University of HCMC

Banking Institute

Credit information Center

Banking Journal

Banking Times

Th St t B k f Vi t d f


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The State Bank of Vietnams degree of

independence

The SBV vs. commercial banks May 6, 1951, the President Ho Chi Minh

promulgated the Ordinance no 15/SL establishing

the National Bank of Vietnam

Circular no 20/VPTH (21/1/1960) changes itsname to the State Bank of Vietnam

Discussion:

Financial independence


Policy independence (goals and instruments)


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The CB in Developing Countries

Low degree of independence Dominant in the financial system

Central banks assets/ total assets of the financial

system

Reserve/M2

Bank reserves/bank deposits

M2/Total value of financial assets

Often pursuing multiple goals besidescontrolling the money supply and inflation

Undertaking the responsibility to promote the

financial systems development


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Controlling and Monitoring the

Banking Activities


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Controls of banking activities

Insurance for the safety of the commercialbank system

Regulations on lending, investment

Capital requirement Controlling, monitoring, and assessing the

risk-management system

Other regulations: Information disclosure

Consumer protection

etc


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Lender of Last Resort

The central bank lends to banks when they fall shortof cash in a bank run

Knowing that, depositors are more confident, and

bank run can be avoided

Necessary condition: The distressed bank is only in a

temporary cash shortage and its assets are still

greater than its liabilities

The problem is its not easy to distinguish a bankrupt

bank from a temporarily distressed bank. In this

situation, the lending policy of the central bank may

give way to moral hazard problems.


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Deposit Insurance

Objective: To secure the banking systems stability and protectdepositors, especially small ones

Mechanism:

A deposit insurance institution is established,usually with the governments capital contribution

Banks pay insurance premiums in proportion to

their deposits

Insurance is provided for all or some particularkinds of deposits

Insurance claims are of full coverage or set with an

upper cap


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Too big to fail?

Moral hazard (too big to fail) is a down side of the role

as the lender of last resort,

Big financial organizations know that if they fail, govt

would rescue Unsolved challenge: How to deal with the moral hazard

associated with big banks.


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Deposit Insurance: Costs and Benefits

Benefits: An increase in social benefits, since: It helps prevent bank runs induced by psychological factors,

and hence enhance the stability of the banking system;

It protects depositors, thus increases deposits and promotesfinancial development

Costs: An increase in social costs, since: It causes moral hazard

It causes adverse selection

Increasing risks in banking activities, and hence hinderingfinancial development

Cost-benefit balance depends on the institutionalenvironment : A favorable institutional environment: Benefits > Costs

A weak institutional environment: Benefits < Costs


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Deposit Insurance and Moral Hazard

Depositors know that their money is insured,so they do not pay attention to the banks

operations

The insured bank is not afraid of being drawn

down by depositors if it gets involved in riskylending, since the insurance institution is

responsible for all claims

The insured bank thus has incentives to lendto risky projects for big profit if these projects

are successful


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Deposit Insurance and Adverse Selection

Without deposit insurance, depositors are more carefulin selecting good banks to deposit their money

With the presence of deposit insurance, depositors

tend to deposit at banks that pay higher interest rates

though they may get involved in risky lending Banks that pay higher deposit rates and get involved in

risky lending can raise more funds

Banks that pay lower deposit rates and make safe

loans find lower level of deposits. They are forced toengage in risky lending so as to be able to increase

deposit or shut down otherwise.

Deposit Insurance


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Deposit Insurance

As a Bank Goes Bankrupt Liquidation

The deposit insurance institution pays to insured depositors up

to the maximum prescribed amount

The deposit insurance institution serves as an unsecured

creditor

Restructuring The deposit insurance institution guarantees to repay all

deposits and takes over the distressed bank

The distressed bank is merged with or sold to another bank

The deposit insurance institution often purchases some bad

assets of the distressed bank, or loans to the merging/

acquiring bank at preferential lending rates


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Lessons from Deposit Insurance

Coverage: No full coverage Set a reasonable maximum coverage (example, equal to 1

or 2 times the average GDP per capita)

Management:

The private sectors participation in managing and

controlling deposit insurance funds

Limited liability:

The deposit insurance institution has a limited liability: The

insurance premiums and capital are used to meetinsurance claims

The government is not required to refinance the insurance

institution in case of its inability to pay all insurance claims


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2. Regulations on lending/investment

Restriction on investment in corporate

securities (especially risky securities such as

stocks)

Restriction on participation in investmentbanks activities (for example, underwriting)

Requirement to diversify lending portfolios:

Monitoring the maximum credit line to a single

borrower

3 C it l R i t


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3. Capital Requirement To Ensure Bank Capital Adequacy

A banks capital must reach a minimum ratio of the

total assets

Simple regulation: A bank has adequate capital when

its capital-to-assets ratio is above 5%. (A bank is put

under special surveillance if its capital-to-assets ratio

falls below 3%)

The importance of the CAR requirement:

Reducing risks for depositors

Banks shareholders have incentives for a closer monitoring


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Simple Regulation on CAR

The regulation does not differentiate different types ofassets (assets of different exposures)

It does not take into account the off-balance-sheet

items of the banks, such as endorsement of deferred

L/C A better CAR regulation should set a lower capital-to-

assets ratio for banks holding safe assets, and a

higher one for banks holding riskier assets

Basel Regulation on the minimum ratio of capital/risk-adjusted-assets (CAR 8%)


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Banks Tier-1 Capital

Tier-1 capital (core capital): Equity contributed by shareholders: common stock

Disclosed reserves (appropriated from retained

earnings and other surplus)

Non-cumulative preferred stock (i.e., if a company

did not have enough income to pay dividends to

preferred shareholders last year, it does not have to

pay that amount this year)


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Tier-2 capital

Tier-2 capital (supplementary capital): Undisclosed reserves: those not officially

disclosed, but approved by regulatory bodies

(such as retained after-tax profits).

Reserves from asset revaluation: reflecting theadjustment of assets to their current market

value.

General provisions/loan-loss reserves: created

against the possibility of future loss of loansextended, provided that these reserves must not

be associated with any particular assets.


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Tier-2 capital

Tier-2 capital: Hybrid capital: instruments that combine characteristics of

both equity and debt, e.g. cumulative preferred stock.

Subordinated debt: Debt with fixed maturity, but having

lower seniority than the other debts and only more senior

than equity. Banks capital = Tier-1 capital + Tier-2 capital.

Banks capital does not include:

Deposits

Short-term debt Other liabilities

Goodwill

Weights of Assets by Their Risk Levels


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(wi)

0% Cash

Government securities and deposits at thecentral bank (denominated in domestic

currency). Government securities and deposits at the

central banks of OECD countries.

Securities, loans guaranteed by the

governments of OECD countries orcollateralized with OECD governmentsecurities.



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20% Claims issued by multilateral development banks (IBRD,IADB, ADB, AfDB, EIB); claims guaranteed by orcollateralized with securities issued by those institutions.

Claims on banks in OECD countries or claims guaranteed

by banks in those countries. Claims on banks in non-OECD countries or claims

guaranteed by banks in those countries, provided that theremaining time to maturity of those claims is less than orequal to 01 year.

Claims on government agencies in foreign OECD countries,(excluding central governments), claims guaranteed bythose agencies.

Cash being collected.


(wi)



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50%

Loans fully guaranteed by housing mortgage.

0, 10, 20 hay 50% (at each countrys discretion)

Claims on domestic public-sector entities(excluding the central government), and loans

guaranteed by those entities.


(wi)



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100% Claims on the private sector.

Claims on banks in non-OECD countries with remainingtime to maturity being greater than 01 year.

Claims on non-OECD central governments. Premises, machinery, and equipment and other fixed

assets.

Real estates and other investments.

Financial instruments issued by other banks. Off-balance-sheet activities, e.g. deferred L/Cs.

All other assets.


(wi)


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Risk-Adjusted Total Value of Assets

Risk-Adjusted Total Value of Assets = 0%V1+

20%V2+ 50%V3+ 100%V4 = wiVi

Capital/Assets Ratio = Capital/wiVi

Basel Regulation on banks capital/assets ratio:

Adequate Good

Tier-I Capital 4% 6%Total Capital 8% 10%

W k f B l R l ti


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Weaknesses of Basel Regulation

Risk weights do not fully reflect the risks inherent in abanks investment activities:

A loan to an A-rated firm is clearly safer than that to a B-rated firm,

but both of these loans are 100% weighted because they are loans

to the private sector.

Basel Regulation ignores capital required to compensate:

Operational risk

Interest rate risk

Market risk

Basel Regulation does not catch up with financial

renovations, such as securitization and derivatives.

B l II P l Th Pill


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Basel II Proposal Three Pillars

Pillar I: Standard mechanism: minimum capital/assets ratio, similar tothat of Basel I. However, the number of risk weightsincreases to reflect more closely the risk levels of variousassets. (For example, weights for the private sector are 20,50, 100, and 150% rather than only 100% previously; bankclaims on the government, enterprises, and other banks have

weights according to their credit ratings). Alternative mechanism: Large banks are allowed to have

their internal regimes based on their own risk managementmodels.

Pillar II: Enhancing the surveillance mechanism,

especially the evaluation of banks risk management. Pillar III: Improving market discipline by requiringbanks to disclose in more detail their risks, reserves,capital

lecture 04-central bank (e)

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