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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
VU
Lecture # 3
CENTRAL BANK
A central bank, reserve bank or monetary authority, is an entity responsible for the
monetary policy of its country or of a group of member states, such as the European Central
Bank (ECB) in the European Union or the Federal Reserve System in the United States of
America. Its primary responsibility is to maintain the stability of the national currency and
money supply, but more active duties include controlling subsidized-loan interest rates, and
acting as a "bailout" lender of last resort to the banking sector during times of financial
crisis (private banks often being integral to the national financial system).
It may also have supervisory powers, to ensure that banks and other financial institutions do
not behave recklessly or fraudulently. A central bank is usually headed by a governor, but
the titles are president, chief executive, and managing director respectively for the European
Central Bank the Hong Kong Monetary Authority and the Monetary Authority of
Singapore.
In most countries the central bank is state owned and has a minimal degree of autonomy,
which allows for the possibility of government intervening in monetary policy. An
"Independent central bank" is one which operates under rules designed to prevent
political interference; examples include the US Federal Reserve, the Bank of England (since
1997), and the Bank of Canada, the Reserve Bank of Australia, the Banco de la República
de Colombia, and the European Central Bank.
Activities and responsibilities
Functions of a central bank (not all functions are carried out by all banks):
Implementing the basis of monetary policy
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Monopoly on the issue of banknotes
·
Controls the nation's entire money supply
·
The Government's banker and the bankers' bank ("Lender of Last Resort")
·
Manages the country's foreign exchange and gold reserves and the Government's
·
stock register
Regulation and supervision of the banking industry
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Setting the official interest rate - used to manage both inflation and the country's
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exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms.
Monetary Policy
Central banks implement a country's chosen monetary policy. At the most basic level, this
involves establishing what form of currency the country may have, whether a fiat currency,
gold-backed currency, currency board or a currency union. When a country has its own
national currency, this involves the issue of some form of standardized currency, which is
essentially a form of promissory note: a promise to exchange the note for "money" under
certain circumstances. Historically, this was often a promise to exchange the money for
precious metals in some fixed amount. Now, when many currencies are fiat money, the
"promise to pay" consists of nothing more than a promise to pay the same sum in the same
currency.
Many central banks are "banks" in the sense that they hold 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.
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Management of Financial Institutions - MGT 604
VU
Unusually, however, central banks in jurisdictions with fiat currencies may "create" new
money to back its own liabilities, to theoretically unlimited amounts.
In many countries, the central bank may use another country's currency either directly (in a
currency union), or indirectly, by using a currency board. In the latter case, local currency is
directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this
mechanism is used, notably, in Hong Kong and Estonia.
In countries with fiat money, monetary policy may be used as a shorthand form for the
interest rate targets and other active measures undertaken by the monetary authority.
Central or National
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). Some
are styled national banks, such as the National Bank of Ukraine. In other cases they may
incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland). In
many countries, there may be private banks that incorporate the term national. Many
countries have state-owned banks or other quasi-government entities that have entirely
separate functions, such as financing imports and exports.
In some countries, particularly in some Communist countries, the term national bank may
be used to indicate both the monetary authority and the leading banking entity, such as the
USSR's Gosbank (state bank). In other countries, the term national bank may be used to
indicate that the central bank's goals are broader than monetary stability, such as full
employment, industrial development, or other goals.
Interest Rate Interventions
Typically a central bank controls certain types of short-term interest rates. These influence
the stock- and bond markets as well as mortgage and other interest rates. The European
Central Bank for example announces its interest rate at the meeting of its Governing
Council (in the case of the Federal Reserve, the Board of Governors).
Both the Federal Reserve and the ECB are composed of one or more central bodies that are
responsible for the main decisions about interest rates and the size and type of open market
operations, and several branches to execute its policies. In the case of the Fed, they are the
local Federal Reserve Banks, for the ECB they are the national central banks.
Interest rate interventions are the most common and are dealt with in more detail below.
Limits of Enforcement Power
Contrary to popular perception, central banks are not all-powerful and have limited powers
to put their policies into effect. Most importantly, although the perception by the public may
be that the "Central bank" controls some or all interest rates and currency rates, economic
theory, (and substantial empirical evidence) shows that it is impossible to do both at once in
an open economy. Robert Mundell's "Impossible Trinity" is the most famous formulation of
these limited powers, and postulates that it is impossible to target monetary policy (broadly,
interest rates), the exchange rate (through a fixed rate) and maintain free capital movement.
Since most Western economies are now considered "Open" with free capital movement, this
essentially means that central banks may target interest rates or exchange rates with
credibility, but not both at once.
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Management of Financial Institutions - MGT 604
VU
Even when targeting interest rates, most central banks have limited ability to influence the
rates actually paid by private individuals and companies.
Even the US must engage in buying and selling to meet its targets. In the most famous case
of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and
(after making $2B himself and forcing the UK to spend over $8B defending the pound)
forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies
and argued that no one should be able to do what he in fact did.
The most complex relationships are those between the yuan and the US dollar, and between
the Euro and its neighbors. The situation in Cuba is so exceptional as to require the Cuban
peso to be dealt with simply as an exception, since the US forbids direct trade with Cuba.
US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were
officially removed from circulation in 2004 and replaced by the Convertible peso.
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Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  7. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS:Banking Inspection Department
  8. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Debt Management
  9. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Training Programs by SBP
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  11. MAJOR DRIVERS OF FINANCIAL INDUSTRY:GLOBAL FINANCIAL SYSTEM, The World Bank
  12. INTERNATIONAL FINANCIAL INSTITUTIONS:ADB Projects in Pakistan, Paris Club
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  18. ROLE OF COMMERCIAL BANKS:Problem bank management, BANKING SECTOR REFORMS
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  21. ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday
  45. RECAP:FINANCIAL INSTITUTIONS, CENTRAL BANK,