Lesson 26

Central Banking
Origins of the central
banking

Lecture No. 112

Central Bank

A Central bank is a government authority in charge of

monetary policy

Central bank’s actions affect interest rate, amount of

credit and money supply

Central bank’s actions affect financial market, economic

activity, exchange rate and inflation
The oldest central banks

Sveriges Riksbank or the Bank of Sweden was the first

central bank

Established in 1668

Bank of England was established in 1694

Functions of old central banks
Function of Sveriges Riksbank: lending money to the
government of Sweden.

Buying government debt

Securing cashless international payments to increase

efficiency

To maintain monetary stability

Federal Reserve System
Opposition of establishing a central bank because of concentration of
powers
But financial crises during 1870 to 1907 led to weaken this opposition

Federal reserve system was established in 1913

To avoid power concentration, power was distributed among 12
regional Federal Reserve Banks
Privately owned by its member banks
Establishment of Central banks in emerging
economies
Many emerging market economies established their
central banks after world war II.

They established central banks a few years after their

independence from colonialism.

The structure of these banks was very similar to those of

European central banks.
Ownership of central banks

Different ownership structures; e.g.

Bank of Italy is privately owned by commercial bank members

Fed is partially privately owned and partially publicly owned

European central bank is owned by central banks of member states

Small fraction of shares of some central banks is privately owned; e.g.
Belgium, Greece, Switzerland, Japan, Turkey, South Africa
Changing Functions of Central Banks
Historically different functions were set like;
Issuing bank notes
Regulating banks
Monitoring international payment system
Regulating exchange rate
Financing government
Supporting banks with short liquidity.
Functions of a Central Bank
-I
Lecture No. 113
Currency regulator/issuer
Central banks possess exclusive rights to issue currency,
especially notes

A central bank is also called ‘Bank of Issue’

If all banks are allowed this function then economy will be

disorganized
Money supply can be regulated only if there is one issuing
authority
Bank to the Government

Accepts deposits from and makes payments to or on

behalf of government

May also lend to or on behalf of the government

Act as an advisor to the government in the areas of

economic policy, capital market and money market
Custodian of Cash Reserves

Central bank is bankers’ bank

Holds commercial banks’ deposits known as reserves

All transactions between central bank and commercial banks and

between commercial banks are done through these reserve accounts
Commercial banks may maintain reserves as insurance against
unexpected large withdrawals
Custodian of International Currency

Central banks maintain foreign exchange reserves

To manage emergency needs of foreign reserves

To manage deficit on external account / avoiding excess

fluctuations in exchange rate
Lender of last resort

Discount loans to commercial banks

In case of a bank is liquidity constrained

Short term loan

Using government securities as collateral

Protecting financial system from collapsing

Functions of a Central Bank
- II

Lecture No. 114

Clearing House for banks’ transactions

Interbank check clearance

Through reserve accounts of commercial banks with the

central bank

To facilitate banks’ checks for use of medium of exchange

For efficiency of payments and economic transactions

Controlling cost of credit

Credit creation by commercial banks may not align with

the objectives of economic policy

Central banks can change interest rates charged on loans

to commercial banks and paid to them on excess reserves

To mainly change demand for credit

Controlling credit creation
Commercial banks create credit
Excess credit creation may cause inflation, while less creation causes
recession
Central bank controls/regulate credit creation by:

Changing excess reserves through open market operations

Changing required reserve ratio on deposits

To mainly change supply of credit

Protecting depositors/savers’ interest

Commercial banks may exploit depositors

Financial system collapse results in depositors losing

money

Keeping real interest rate for depositors at reasonable

level.
Functions of the State bank
of Pakistan

Lecture No. 115

Functions of SBP as mentioned in SBP Act,
1956 Amended in 2022

To determine and implement monetary policy;

To formulate and implement the exchange rate policy;

To carry out and disseminate research relevant to Bank's

objectives and functions;
Functions of SBP as mentioned in SBP Act,
1956 Amended in 2022

To hold and manage all international reserves of Pakistan;

To issue and manage the currency of Pakistan, including

regulating their denominations;

To collect and produce statistics relevant to the Bank's

objectives and functions;
Functions of SBP as mentioned in SBP Act,
1956 Amended in 2022
To operate and exercise oversight over payment systems;

To act as lender of last resort;

To license, regulate and supervise scheduled banks and financial
institutions that fall under the domain of the Bank as further specified
in this Act or any other Act;

To resolve scheduled banks and other financial institutions that fall

under the domain of the Bank as further specified in this Act or any
other Act;
Functions of SBP as mentioned in SBP Act,
1956 Amended in 2022
To adopt and implement macro-prudential policy measures for
scheduled banks and financial institutions that fall under the domain
of the Bank;
To act as the banker, financial adviser and fiscal agent to the
Government, and its agencies, on the mutually agreed terms and
conditions;

To promote financial inclusion in Pakistan;

Functions of SBP as mentioned in SBP Act,
1956 Amended in 2022
To develop financial market infrastructures;

To participate in international councils and organizations,

including multilateral, international financial institutions,
To cooperate with domestic and foreign public entities,
concerning matters related to its objectives and functions;
To carry out any ancillary activities incidental to the exercise
of its objectives under this Act.".