Beyond their regulatory and monetary policy functions, central banks can foster financial innovation and development

Abstract

Beyond their regulatory and monetary policy functions, central banks can foster financial innovation and development

Anand Chandavarkar

The rationale of central banking has been argued too exclusively in terms of monetary policy and control of the financial system even though historically and logically its role in the development of the financial system precedes control. A central bank is commonly seen in terms of its traditional functions as issuer of currency, government’s banker, banker’s bank, controller of credit, and a lender of last resort. But it can also be viewed as a developer of the financial system and promoter of economic development. This article analyzes the developmental role of central banks and the problems of harmonizing it with their monetary, regulatory, and prudential functions.

Central bank objectives may be broadly classified into (1) the tactical or conjunctural objectives of short- or medium-term monetary stabilization, and (2) the strategic or developmental objectives. Conjunctural objectives are spelt out in central bank statutes in both developed and developing countries, whereas the developmental objectives normally are stated explicitly only in the statutes of developing country central banks. The US Federal Reserve Act is one of the few developed country exceptions. This Act enjoins the Board of Governors and the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” (Section 2 A. 1). It also requires that the Board of Governors should act “in furtherance of the purposes of the Full Employment and Balanced Growth Act of 1948.” In contrast, the statutes of the two oldest central banks, the Swedish Riksbank (1668) and the Bank of England (1694) do not specify any developmental goals.

The absence of statutory provision for promotional activity has not inhibited central banks even in developed countries from using monetary policies to implement basic national economic goals. For instance, the Swedish Riksbank has been active in promoting programs for priority sectors, such as housing, principally through asset reserve requirements. Similarly, the Bank of England which, historically, has taken a very broad view of its functions as the “Curator of Financial Organization,” pioneered in establishing specialized institutions like the Industrial and Commercial Finance Corporation, the Finance Corporation for Industry, the Securities Management Trust, and the Bankers’ Industrial Development Company. The central banks of Italy, the Federal Republic of Germany, Japan, and the Netherlands have used various techniques such as asset reserve requirements and lending (with or without interest subsidies) to priority sectors, for example, housing, agriculture, exports, small business, and underdeveloped regions. Such promotional techniques have been justified on the grounds that these are typically the sectors which suffer disproportionately from credit restrictions in deflationary policies.

This article is based on a longer paper presented to the Asian Seminar on Financial Structure and Policies, February 8-20, 1987, Bombay. The complete version is due for publication in The International Journal of Development Banking (published by the Industrial Credit and Investment Corporation of India, Bombay).

The statutes of central banks and monetary authorities established in the 1970s and 1980s, with the technical assistance of the International Monetary Fund, have specific provisions for developmental roles (e.g., Bhutan, Botswana, Fiji, Maldives, Solomon Islands, Swaziland, and Vanuatu). Central banks may, however, take a rather long time to implement developmental objectives even when they have the necessary legal mandate. For instance, the Statutory Report of the Reserve Bank of India, issued in 1938, observed: “During a period of financial development such as exists in India today, it may be desirable for Central Bank credit to be made available in a larger number of ways and with less restrictions than when the financial structure is more complete.…” (p. 35). But it was not until the 1950s that the Reserve Bank of India embarked on its developmental activities.

In addition to their role in promoting the development of the domestic financial sector, central bank operations also have a bearing on foreign borrowing by both the private and the public sector in developing countries, thus contributing to development by helping monitor and raise needed resources. While public foreign debt is guaranteed and approved by the ministry of finance in most developing countries, there are instances where these functions are shared with the central bank. Most private foreign borrowing is handled mainly through the central bank, but again there are some cases where the bank shares the approval authority with the finance ministry.

More than statutes and formal powers, it is the central bank’s status, expertise, and influence which determine the efficacy of its promotional activities as a regulator, innovator, participant, guarantor, and catalyst. The various techniques of central banking like variation of reserve ratios, open market operations, bank rate policy, rediscount and refinance facilities, and selective credit controls can function concurrently as instruments of monetary as well as development policy. Further, there is no one-to-one relationship between monetary instruments and targets since the same instrument can have multiple targets.

Even if a central bank adopts a passive approach to its developmental role, as is the case in many developed economies, the neutrality of monetary policy is not assured. Consequently, even in the absence of formal credit directives credit priorities will be created. The large corporate business sector effectively functions as the preferred sector for credit in all industrialized countries even when it is the primary target of credit restrictions. Central banks in developing countries, which have less developed financial sectors and are also more prone to financial market failures, need to take a more active role in making up for these shortcomings. This can be achieved by the central bank through a coherent strategy of widening and deepening financial intermediation and savings mobilization, involving greater maturity transformation, enlargement of portfolio choices of savers and investors, reduction of transaction and information costs, and the redress of sectoral and regional financial imbalances. These objectives cannot be achieved by the unaided efforts of the private sector. In an underdeveloped economy the development of an adequate banking system must take place before it can serve as an efficient transmission mechanism for monetary policy.

Modalities of developmental role

Financial liberalization. A liberal financial system is essential for the developmental role of a central bank. This implies the elimination of “financial repression” defined as the cumulative effects of factors, such as interest rate ceilings, reserve requirements, and credit subsidies, which together with inflation interact to reduce and misallocate scarce capital (see “Financial Liberalization in Developing Countries” by Michael Dooley and Donald Mathieson, in Finance & Development, September 1987). However, not all the instruments of financial control are equally repressive in substance. While interest rate ceilings repress savings by generating negative rates of return to savers and act as indiscriminate subsidies to borrowers, reserve ratio requirements are a means of prudential control of banks as well as being one of the most efficacious traditional instruments of monetary policy in developing countries. Developmental objectives can also be achieved through the earmarking of reserves for assets of a developmental character (e.g., housing or public utility bonds) or the prescription of regional reserve requirements so as to promote the spread of banking. Non-interest bearing bank reserves may also function as an implicit tax on commercial banks and therefore contribute partially to financial repression. This drawback can, however, be remedied by payment of interest on reserves by the central bank.

The label of financial repression applies, strictly, to the organized, relatively small, financial sector in the developing countries. The informal financial sector is beyond the purview of the controls applicable to organized banking but the central bank can play a substantial role in integrating the formal and informal financial sectors, making monetary and developmental policy more effective.

The banking industry in most developing countries does not enjoy great freedom of entry, which is a necessary condition for a liberal system. Even if licensing of domestic banking units is comparatively liberal there are usually severe restrictions on the entry of foreign units into the financial services sector. The organized financial sector in most developing countries has comparatively a high degree of concentration of ownership, leading to monopolistic and oligopolistic conditions. This poses problems in maintaining an effectively competitive financial system. The maintenance of a liberal financial system is, therefore, a continuing task for the central bank.

Regulatory and prudential role

A central bank’s traditional role as the regulator as well as the lender of last resort to the banking system should be supplemented by promotional elements including the insurance of bank deposits and the inspection and supervision of banks to promote the banking habit and financial intermediation by inspiring greater public confidence in financial institutions. Deposit insurance has been adopted in virtually all the industrial countries and in some developing countries. The rest of them rely on a less efficient implicit policy of the central bank not to let financial institutions fail. Central banks should, however, examine the merits and feasibility of establishing deposit insurance for all financial intermediaries. Deposit insurance itself has also to be flexible enough to cover new types of institutions and instruments and to ensure that coverage limits are adjusted for inflation. From the prudential point of view, it is far more important for a central bank to ensure the viability of banks through timely and effective inspection and supervision so that liquidity problems do not lead to insolvency.

There are other areas, too, where the prudential and developmental roles overlap, like the use of credit guarantees by the central bank for specific types of lending by commercial banks. Many central banks have helped to establish institutions to guarantee commercial bank loans to small enterprises in specified sectors. Such guarantee institutions have played an influential role in improving the access of small borrowers to organized finance by eliminating or de-emphasizing collateral-based transactions. However, like other central banking promotional activities, guarantee mechanisms also need to be kept under review not only for appropriate modification of their scope but, equally important, to hive off categories which no longer merit special treatment.

Advice, research, and training

Insofar as a central bank functions as an autonomous bureau, rather than as the agent of a principal (i.e., the government), it constitutes a unique source of disinterested technocratic advice to both the treasury and development agencies, a role most memorably phrased by Governor Montagu Norman of the Bank of England: “I look upon the Bank as having the unique right to offer advice and to press such advice even to the point of nagging; but always of course subject to the supreme authority of the government.”

The advisory responsibility of a central bank acquires an even sharper focus in a developing economy in regard not only to the maintenance of monetary stability by exerting its influence against governmental deficit financing but also in promoting an efficient and dynamic financial structure. But an effective advisory role for central banks requires that the head of the research department have independent access to the governor and the board of directors. The director of research may be allowed, for instance, to participate in the deliberations of the Board but without the right to vote as is the case in the central banks of many countries. Such provisions help safeguard the quality of advice by not involving advisers in bureaucratic games of “second-guessing” the views of the powers-that-be. Unless the economic unit of a central bank has the requisite independence in addition to expertise, the credibility and influence of the central bank in its relations with the treasury and the development agency can be seriously eroded. As a minimum, a central bank should have also effective channels of communication and representation on joint organs of decisionmaking involving the treasury and the development agency (e.g., for external borrowing). In federations it is equally important for a central bank to remain in close and constant contact with the state governments, to forestall and tackle problems such as the recurring overdrafts of State Governments to the Reserve Bank of India.

The focus of central bank research should be on macroeconomic issues bearing on developmental problems, as for instance, the fostering of an intermediate financial technology, the regional impact of monetary policy, constant review of the instruments legislation to accommodate new financial instruments, the scope for rediscounting of traditional credit instruments (e.g., the hundis in India and the cek putih in Indonesia), and the loan experience of commercial banks and cooperatives. This research could also identify new techniques such as lease financing, project-related in place of collateral-oriented credit, and development of efficient and economical clearing and remittance facilities. The central bank can play a positive role in optimizing the choice of invoicing currencies in foreign trade and payments. This choice of invoicing currencies is made by individuals and may not necessarily be optimal from the country’s point of view. For instance, a country’s exports may be invoiced in depreciating currencies whereas its imports and external liabilities may tend to be invoiced in appreciating currencies.

The training of financial manpower is also a special responsibility of central banks considering that this is a more critical bottleneck in extending financial intermediation than premises or equipment. Given the costs and administrative difficulties of providing such training, individual banks do not find it worth their while to offer basic training to financial personnel. Central bank training facilities for financial personnel are an apt example of the macroeconomic benefits of investment in human capital. An important related area of central bank research and policy is the impact of information technology on the manpower requirements of the financial sector.

Catalyst and innovator

The promotional role of the central bank should be guided by supply rather than demand considerations, considering that the financial system, which is akin to a public utility, is predicated on the dictum that “facilities create traffic.” A central bank has to be an innovator as well as a catalyst in its promotional role for which there is a wide variety of techniques available (see table). It is noteworthy that in some countries, notably in Africa, central banks, which were initially assigned specific commercial and development banking tasks, are currently trying to separate these functions, in the light of experience of conflict of interest with the effective performance of basic central banking functions of monetary policy. But a separation of functions need not preclude the central bank’s role in the creation of development finance institutions through provision of part or whole of their equity or working capital and fostering the market for their securities. Although a widespread technique, it carries the risk that excessive dependence upon a central bank’s capital credit and profits, as well as devices such as repurchase agreements for securities, are inflationary.

Development finance institutions are frequently financed from external sources, but consideration should be given to providing them with more domestic capital from genuine savings. Even if initially the whole or part of the capital of development finance institutions is provided by the central bank, consideration should be given to the eventual divestiture of the central bank’s share in the capital of such institutions. A good example of this approach is the gradual reduction of the Government of Bangladesh’s share in the paid-up capital of the Grameen Bank for the landless poor from 60 percent (September 1983) to 25 percent (July 1986) with a corresponding increase in the shares subscribed by the borrowers of the Bank.

The most favored promotional technique of central banks is that of preferential (i.e., below market levels) rediscount rates and facilities for officially approved categories of commercial bank credit so as to induce greater lending to the preferred sectors or to reduce the cost of credit to sectors from which the credit originates. However, the use of multiple preferential rates by the central bank can seriously frustrate a restrictive credit policy when such a policy is warranted on macroeconomic grounds. Even with a unitary rediscount rate for eligible assets, banks may overextend credit to such sectors.

The subsidization of development credit, through preferential interest and rediscount rates and refinancing facilities to preferred sectors such as housing, export finance, agriculture, cottage industries, cooperatives, and small businesses, can distort the efficient allocation of credit and capital if these schemes are open-ended and costly. Most central banks do not seem to provide for effective control and review of credit subsidies. Selective credit controls too raise the problem of reconciling monetary policy with developmental objectives since preferred categories of borrowers are exempted from credit controls. The same trade-offs can arise in respect of open market operations when the requirements of credit policy may conflict with the objective of fostering a continuous, wide, and active market for government securities through repurchase agreements, and so on. Nevertheless, as the experience and so on. Nevertheless, as the experience of many developed and developing countries suggests, it is feasible to implement an effective credit policy while promoting the securities market.

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Promotional techniques of selected Asian central banks

Citation: Finance & Development 0024, 004; 10.5089/9781616353711.022.A010

Sources: National sources.Note: The country information in this is incomplete. It covers instruments have been in use at one time or another.

Differentiated reserve requirements linked to the composition of commercial bank portfolios or to the regional distribution of credit (rural or semi-urban branches) may also be used as a developmental device. But this technique, which historically has been employed in some Latin American countries, has not been used in Asia, Africa, or the Middle East. An allied technique to redress the urban bias in the financial system is the specification of minimum credit-deposit ratios for rural or semi-urban offices of banks, as for instance in Thailand where bank branches in the undeveloped North-East region are required to extend not less that 60 percent of local deposits for local credit and not less than 20 percent for agriculture. In India a target credit-deposit ratio of 60 percent has been set for branches in rural or semi-urban areas. The credit-deposit ratio, however, is not an unambiguous guideline unless further refined to take account of population density (to establish the ratio per capita), the man-land ratio (per unit of land cultivation), and the differential credit absorption capacities of regions. Moreover, such targets may not always be attainable for reasons beyond the control of the lending institutions.

Conclusions

Although the developmental rationale of central banks is well grounded, it must take into account the possibility of failure in achieving the desired policy goals, or of conflict between the allocation of credit and the control of credit. In the event of such conflict the control of credit should be its first priority. Central banks are also known to have hampered financial innovation in the private sector through doctrinaire adherence to legal forms. The promotional role, however, needs to be critically evaluated, particularly the open-ended approach to credit subsidies. Central bank profits or credit are not substitutes for genuine savings for financing development. Even when the leadership of the central bank remains clear on its primary functions, it has often proven too attractive to many governments to finance “development” objectives through the money creation powers of the central bank rather than explicitly through the budget. While a stable and liberal monetary system and climate are essential prerequisites for the promotional role of a central bank, their maintenance is, however, a continuing task given the oligopolistic tendencies of most financial systems. A central bank’s promotional role is not merely one of passively adapting its techniques to suit the changing economic structure but of actively modifying the financial structure itself to promote development. The central bank is perhaps best viewed as a catalyst and innovator, a Platonic guardian and curator of the financial system rather than as a perennial participant in development finance.

Finance & Development, December 1987
Author: International Monetary Fund. External Relations Dept.