The Evolving Role of Central Banks
Front Matter

Front Matter

Editor(s):
Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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The Evolving Role of Central Banks

Editors

Patrick Downes

Reza Vaez-Zadeh

Papers presented at the fifth seminar on central banking, Washington, D.C., November 5-15, 1990

Central Banking Department

International Monetary Fund

Washington • 1991

© 1991 International Monetary Fund

Cover design by IMF Graphics Section

Joint Bank-Fund Library Cataloging-in-Publication Data

The Evolving role of central banks: papers presented at the fifth seminar on central banking, Washington, D.C., November 5–15, 1990 / Patrick Downes, Reza Vaez-Zadeh, editors.

  • p. cm.

Includes bibliographical references.

ISBN 1-557-75185-4

1. Banks and banking, Central—Congresses. I. Downes, Patrick, II. Vaez-Zadeh, Reza.

HG1811.E95 1991 CIP

Price: US$28.50

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Foreword

The art of central banking has evolved over time and continues to change, but the principles of sound central banking practice have remained largely unchanged. This is the message that has emerged from a series of central banking seminars for senior officials of the Fund’s member countries that have been held at the International Monetary Fund (IMF) since 1983. These seminars have provided a forum for an open and lively exchange of views between the participants, speakers, and the staff of the Fund about the evolving role of central banks. While there was lively controversy on almost all the issues discussed in the seminars, a remarkable measure of support emerged for the idea that the central bank should have a degree of autonomy in pursuing single-mindedly the objective of price stability, which is generally agreed to be an important factor contributing to long-run growth and prosperity.

The success of the seminars owes a great deal to the participants, who come from an ever-widening range of countries. Their questions and active participation enriched the discussion and helped us to obtain a better grasp of the major concerns among member central banks, which will enable us to focus our own efforts. We are grateful to the many distinguished guest speakers who invested their time in preparing for the seminar and participating in stimulating discussions. Finally, I would like to thank the members of the Fund’s Executive Board, who assisted in the recruitment of speakers.

The papers in the present volume were presented at the fifth seminar in this series, held November 5–15, 1990. The theme was the interdependence of central banking functions and the role of central bank autonomy viewed against the background of economic transition, financial sector reform, and banking system crisis. As a former central banker, I believe that the issues raised in this volume are important, thought-provoking, and exciting. They are both relevant to the day-to-day art of central banking and important for the evolving role of the central bank in an ever-changing world.

Michel Camdessus

Managing Director

International Monetary Fund

Preface

The organization of the seminars on central banking—which is done jointly by the Central Banking Department and the IMF Institute—is an important aspect of the work of the Central Banking Department. The main responsibility of the department is to assist member countries improve their capacities to implement sound economic policies through financial systems reform. This is a broad term that includes a revamping of the institutional and regulatory framework. It means, for example, establishing or restructuring a central bank with an appropriate degree of autonomy that can operate a market-oriented monetary policy; introducing modern instruments and operating procedures for implementation of monetary and foreign exchange market operations and banking supervision; promoting a sound and robust financial system designed to deliver an appropriate range of financial services; and establishing a legal and accounting framework and effective payment and clearing systems that allow the proper functioning and adequate monitoring of the operations of the financial institutions in a market-based economy.

We see the seminar as a forum for the exchange of ideas—to learn from the participants and our invited speakers, and to share with them the experience we have gathered from our operations in member countries. On each occasion, we have adapted the content of the seminars to reflect the concerns and experiences of member country central banks and those of the staff of the Central Banking Department in responding to the requests for technical assistance. We have tried to incorporate the views and suggestions of the past seminar participants. In the latest seminar, which focused on the role, functions, and independence of central banks, the objective was to present the evolving views about the proper role of the central bank and about the design of monetary and regulatory policies, and to review and analyze the developments in financial markets around the world. The major objective of the Central Banking Department in the 1990s is to help strengthen the role of monetary policy in member countries, and this seminar was the first installment toward that goal.

Within the Fund, many people have contributed to the successful organization of the seminar and the production of this volume. I would mention in particular the teamwork of Patrick Downes, Reza Vaez-Zadeh, and Hannah Faux of the Central Banking Department, which has guided this project from start to finish, and the editorial assistance provided by Juanita Roushdy of the External Relations Department of the IMF.

J.B. Zulu

Director

Central Banking Department

International Monetary Fund

Contents

Introduction

PATRICK DOWNES and REZA VAEZ-ZADEH

This volume brings together papers submitted by speakers at the fifth seminar on central banking. The seminar came at a time of unprecedented change in the world economic and political order, with many countries moving toward market-based economic systems and democratic government. These countries are placing emphasis on a well-functioning central bank as one of the most essential management tools in a market economy and on the need for a sound legal and regulatory framework to underpin the effective development of market-oriented financial systems. Many central banks in Asia, Africa, Eastern and Central Europe, and Latin America are being established or reorganized in the context of the restructuring and modernization of the financial sector, to reflect this new orientation. These developments reflect a general awareness in these countries of the need to strengthen competitive forces and promote sound financial systems, in order to be better placed to achieve the goals of economic policy. There is little doubt that, in this new environment, monetary policy will take on a greater significance, and central banks will be called upon to play a more crucial role in economic management.

Indeed, the trend has already started. Recent years have seen central banks growing in influence and stature. This reflects, in large measure, the fact that, in major industrial countries especially, central banks have shown more assertiveness in dealing with economic problems. The fruit of these actions has been less inflation and a long period of sustained growth in many countries. Out of this experience has emerged a growing recognition that achieving price stability should be a cornerstone of any program to redress economic problems; that credible monetary policy—supported, of course, by other policies, particularly fiscal—has an important contribution to make to this process; and that the central bank should be given sufficient autonomy to conduct monetary policy in a manner conducive to achieving this goal. Nowhere is this recognition more apparent than within the European Community, where the debate on the formation of a monetary union seems to be leading to support for the idea that the crucial component of such a union would have to be an operationally independent central bank with a strong mandate for price stability.

Against the background of these momentous changes occurring in world economic and political relationships, the seminar program was prepared to reflect the current concerns of central bankers about the appropriate role, functions, and degree of independence of central banks in market-based economies and their input to the formulation and implementation of economic policy. The presentation of the papers dealing with these issues in the present volume generally follows the order in the seminar program and is organized in four parts: a) the functions normally performed by a central bank and their interaction; b) the importance of central bank independence for the conduct of central banking functions; c) the role of the central bank in dealing with financial system crises; and d) the role of the central bank in financial reform, particularly in countries in transition from a centrally planned to a market-based economy.

What should be the role of a central bank in a market economy? There is little disagreement among practitioners that the conduct of monetary policy and the parallel development of the money market should be the primary responsibility of the central banks. Foreign exchange management is also usually accepted as a closely interrelated central banking function. Views diverge, however, on the extent to which the central bank should take on other responsibilities in such areas as prudential supervision, domestic debt management, and clearing and payments system. These functions are seen by some as complementary to, and by others as potentially in conflict with that of preserving the value of the currency. The first part of the volume is devoted to a discussion of these alternative points of view.

Perhaps the most controversial issue considered in this part of the volume is the role of the central bank in prudential supervision. Supporters of the idea that central banks should have responsibility for prudential supervision view this function—defined broadly to include also the oversight of clearing and payment systems and money and securities markets—as analytically interconnected and mutually reinforcing with the monetary policy function of the central bank. They argue that these linkages enhance, in the long run, the capacity of the central bank to implement monetary policy in an effective manner. Others, however, argue that the portfolio restrictions imposed for prudential purposes, and the occasionally conflicting interactions between prudential supervision considerations and monetary policy objectives—especially in relation to the central bank’s role as a lender of last resort—could detract from the effectiveness of monetary control. Thus, they suggest that having monetary policy and prudential supervision functions both performed by the central bank could compromise monetary policy and undermine a central bank’s independence from the political process. Nevertheless, there is little disagreement between the two groups that, when the responsibility for the two functions is separated, economies of scale in information gathering and the efficient implementation of supervisory and monetary actions call for close coordination by the supervisory and monetary authorities.

There can also be important interactions between various other functions performed by the central bank. For example, the issuance of government debt instruments for fiscal purposes or as an instrument of sterilization, and the limits on central bank lending to government, directly influence monetary aggregates and the development of financial markets. Clearing and payment arrangements managed in varying degrees by central banks around the world have implications for both monetary policy and prudential supervision. The use of indirect instruments of monetary policy by the central bank, and the development of the financial system can be greatly facilitated by establishment of efficient payment clearing and settlement arrangements. However, such arrangements could necessitate new prudential rules, such as those aimed at control of systemic risk in the payments system, daylight exposure, etc. Moreover, such rules would have to be taken into account in designing the mechanism for the implementation of monetary policy by the central bank.

The need for prudence by the central bank in taking on additional responsibilities is especially apparent in the case of quasi-fiscal activities performed by the central bank in support of government policies. Such activities—which include, for example, preferential refinancing of banks’ loans to priority sectors, foreign borrowing for on-lending to government, and coverage of foreign exchange risk of loans to public entities—have resulted in substantial losses for many central banks around the world. It may be argued that central bank losses do not matter because a central bank cannot become insolvent in the conventional sense of the word. The experiences of many countries indicate, however, that central bank losses can entail adverse implications for the economy as they can undermine the effectiveness of monetary control, depending on the way that they are financed. These adverse effects are to some extent related to the fact that often the losses of a central bank are both a symptom of its lack of independence and a source of further erosion of its independence.

The second part of the volume is devoted to a discussion of the appropriate degree of central bank independence; a question that boils down to how much freedom should a central bank have in managing the constituent items of its own balance sheet. The advantages and disadvantages of providing a central bank with autonomy from the political process in carrying out its different function relate to the question of monetary policy credibility and the impact of autonomy on the overall effectiveness of economic policy in achieving its objectives. The desirable degree of a central bank’s autonomy has to be assessed with due regard to the level of development of the country and its institutional and political structures. Indeed, it is probably more salutary to talk about conditions for successful central banking rather than the ideal attributes of an independent central bank: an independent central bank is unlikely to be any more effective than a dependent one if the legal and institutional structures are inadequate, political institutions unstable, the financial system repressed, fiscal policy out of line, and the household savings rate insufficient. Moreover, in practice, the effective degree of independence and public acceptance of a central bank will depend crucially on how well it defines and performs its role over time.

Several Eastern European countries are currently debating these issues, and the question of independence also lies at the center of discussions concerning the establishment of a central bank for Western Europe. This volume presents views on these issues from the perspective of several eminent central bankers around the world, dealing with the experience of their own countries. In this regard, the much-debated evolution of the autonomy of the Reserve Bank of New Zealand, which culminated in innovative legal arrangements—the socalled policy target agreement—governing the operations of the Bank, provides an especially interesting case study.

The role of central banks in banking crises is examined in the third part of the volume. Recent years have seen a sharp increase in the number of financial institutions in distress, owing to such factors as economic mismanagement, adverse external shocks, and—some will argue—inadequate prudential supervision of the financial institutions. Many central banks now confront the challenge of developing new initiatives—such as “bad banks” and the Resolution Trust Corporation established in the United States—to deal with financial institutions in distress. An important issue in this regard relates to the desirable degree of cooperation among supervision agencies around the world in dealing with banking crises. Of particular interest is how to apply prudential supervision and regulation to prevent financial crisis.

The last part of the volume considers a range of issues relating to the role of the central bank in financial reform and economic transition. Governments in many countries have been pursuing reforms of the financial sector to increase savings, enhance intermediation, and raise the productivity and the level of investment—with the ultimate objective of improving the growth performance of the economy. Financial sector reform has constituted an important element of adjustment programs supported by the International Monetary Fund. The reform programs have focused on the monetary control framework, especially the design of instruments that would facilitate a switch away from direct controls; institutional and regulatory reforms to improve the soundness and efficiency of the financial system; and measures to promote market-based interest rates. The central bank has a paramount role to play in the reform process, especially to determine its content and the sequencing of specific financial sector reforms. The reform process also presents a challenge to the central bank in setting up new organizational structures, facilities, and operating procedures in all areas of central banking (monetary management, money market development, research and analysis, prudential supervision, foreign exchange operations, accounting and audit, and clearing and payment systems) and, generally, in ensuring adequate monetary control during the reform period.

Nowhere has the process of financial sector reform been more sweeping than in the formerly centrally planned economies. The spotlight shines most brightly on the Eastern and Central European countries. But, many developing countries in other parts of the world have been following a similar path, albeit, in some cases, at a slower pace. In Asia, the Lao People’s Democratic Republic, and Viet Nam come to mind, countries with planned economies that have embarked on far-reaching reforms. In Africa, there are several countries where elements of central planning are being dismantled and replaced by market-based strategies, such as Algeria, Guinea, and Madagascar. And in Latin America also, there is growing acceptance of the need for market-based systems of economic management, and for strong central banks with a greatly reduced role in financing budgetary deficits. The volume presents the case of several of these countries.

A great deal of discussion took place on all of the above topics in the course of the seminar presentations and during panel discussion sessions. The papers presented in this volume—and, indeed, the discourse in this introduction—do not, therefore, necessarily reflect the consensus of the seminar. Rather they could be viewed as starting points for an analysis of issues which central bankers and many government officials have to deal with in the day-to-day task of managing an economic system.

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