Commercial Banks

Commercial banks are at the centre of most money markets, as both suppliers and users of funds, and in many markets, a few large commercial banks serve also as intermediaries. These banks have a unique place because it is their role to furnish an important part of the money supply. In some countries, they do this by issuing their own notes, which circulate as part of the hand-to-hand currency. More often, however, it is checking accounts at commercial banks that constitute the major part of the country's money supply. In either case, the outstanding supply of bank money is in a continual circulation, and any given bank may at any time have more funds coming in than going out, while at another time the outflow may be the larger. It is through the facilities of the money market that these net excesses and shortages are redistributed, so that the banking system as a whole can at all times provide the means of payment required for carrying on each country's business.

In the course of issuing money, the commercial banks also actually create it by expanding their deposits, but they are not at liberty to create all that they may wish whenever they wish, for the total is limited by the volume of bank reserves and by the prevailing ratio between these reserves and bank deposits—a ratio that is set by law, regulation, or custom. The volume of reserves is controlled and varied by the central bank (such as the Bank of England, the Bank of France, or the Federal Reserve System in the U.S.), which is usually a governmental institution, always charged with governmental duties, and almost invariably carries out a major part of its operations in the money market.

Central Banks

The reserves of the commercial banks, which are continually being redistributed through the facilities of the money market, are in fact mainly deposit balances that these commercial banks have on the books of the central bank or notes issued by the central bank, which the commercial banks keep in their own vaults. As the central bank acquires additional assets, it pays for them by crediting depositors' accounts or by issuing its own notes; thus the potential volume of commercial bank reserves is enlarged. With more reserves, the commercial banks can make additional loans or investments, paying for them by entering credits to depositors' accounts on their books. And in that way the money supply is increased. It may be reduced by reversing the sequence. The central bank can sell some of its marketable assets in the money market or in markets closely interrelated with the money market; payment will be made by drawing down some of the commercial bank reserve balances on its books; and with smaller reserves remaining, the commercial banks will have to sell or reduce some of their investments or their loans. That, in turn, results in shrinkage of the outstanding money supply. Central bank operations of this kind are called open-market operations.

The central bank may also increase bank reserves by making loans to the banks or to such intermediaries as bill dealers or dealers in government securities. Reduction of these loans correspondingly reduces bank reserves. Although the mechanics of these lending procedures vary widely among countries, all have one feature in common: the central bank establishes an interest rate for such borrowing—the bank rate or discount rate—pivotally significant in the structure of money market rates.

Money market assets may range from those with the highest form of liquidity—deposits at the central bank—through bank deposits to various forms of short-term paper such as treasury bills, dealers' loans, bankers' acceptances, and commercial paper, and including government securities of longer maturity and other kinds of credit instruments eligible for advances or rediscount at the central bank. Although details vary among countries, the touchstone of any money market asset other than money itself is its closeness—i.e., the degree of its substitutability for money. So long as the institutions making use of a money market regard a particular type of credit instrument as a reasonably close substitute—that is, treat it as “liquid”—and so long as the central bank acquiesces in or approves of this approach, the instrument is in practice a money market asset. Thus, no single definition or list can apply to the money markets of all countries nor will the list remain the same through the years in the money market of any given country.

Responsibilities of Central Banks

The principles of central banking grew up in response to the recurrent British financial crises of the 19th century and were later adopted in other countries. Modern market economies are subject to frequent fluctuations in output and employment. Although the causes of these fluctuations are various, there is general agreement that the ability of banks to create new money may exacerbate them. Although an individual bank may be cautious enough in maintaining its own liquidity position, the expansion or contraction of the money supply to which it contributes may be excessive. This raises the need for a disinterested outside authority able to view economic and financial developments objectively and to exert some measure of control over the activities of the banks. A central bank should also be capable of acting to offset forces originating outside the economy, although this is much more difficult.

The first concern of a central bank is the maintenance of a soundly based commercial banking structure. While this concern has grown to comprehend the operations of all financial institutions, including the several groups of non bank financial intermediaries, the commercial banks remain the core of the banking system. A central bank must also cooperate closely with the national government. Indeed, most governments and central banks have become intimately associated in the formulation of policy.

Relations with Commercial Banks

One source of economic instability is the supply of money. Even in relatively well-controlled banking systems, banks have sometimes expanded credit to such an extent that inflationary pressures developed. Such an overexpansion in bank lending would be followed almost inevitably by a period of undue caution in the making of loans. Frequently the turning point was associated with a financial crisis, and bank failures were not uncommon. Even today, failures occur from time to time. Such crises in the past often threatened the existence of financial institutions that were essentially sound, and the authorities sometimes intervened to prevent complete collapse.

The willingness of a central bank to offer support to the commercial banks and other financial institutions in time of crisis was greatly encouraged by the gradual disappearance of weaker institutions and a general improvement in bank management. The dangers of excessive lending came to be more fully appreciated, and the banks also became more experienced in the evaluation of risks. In some cases, the central bank itself has gone out of its way to educate commercial banks in the canons of sound finance. In the United States, the Federal Reserve System examines the books of the commercial banks and carries on a range of frankly educational activities. In other countries, such as India and Pakistan, central banks have also set up departments to maintain a regular scrutiny of commercial bank operations.

The most obvious danger to the banks is a sudden and overwhelming run on their cash resources in consequence of their liability to depositors to pay on demand. In the ordinary course of business, the demand for cash is constant or subject to seasonal fluctuations that can be foreseen. It has become the responsibility of the central bank to protect banks that have been honestly and competently managed from the consequences of a sudden and unexpected demand for cash. In other words, the central bank came to act as the “lender of last resort.” To do this effectively, it was necessary that the central bank be permitted either to buy the assets of commercial banks or to make advances against them. It was also necessary that the central bank has the power to issue money acceptable to bank depositors. However, if a central bank was to play this role with respect to commercial banks, it was only reasonable that it or some related authority be allowed to exercise a degree of control over the way in which the banks conducted their business.

Most central banks now take a continuing day-to-day part in the operations of the banking system. The Bank of England, for example, has been increasingly in the market to ensure that the banks have a steady supply of cash, even during periods of credit restriction. It also lends regularly to the discount houses, supplementing their resources whenever the commercial banks feel the need to call back money they have on loan to them. In the United States, the Federal Reserve System has operated in a similar way by buying and selling securities on the open market and by lending to dealers in government securities based on repurchase agreements. The Federal Reserve may also discount paper submitted by the commercial banks through the Federal Reserve banks. The various techniques of credit control in use are discussed in greater detail below.

The evolution of those working relations among banks implies a community of outlook that in some countries is relatively recent. The whole concept of a central bank as responsible for the stability of the banking system presupposes mutual confidence and cooperation. For this reason, contact between the central bank and the commercial banks must be close and continuous. The latter must be encouraged to feel that the central bank will give careful consideration to their views on matters of common concern. Once the central bank has formulated its policy after a full consideration of the facts and of the views expressed, however, the commercial banks must be prepared to accept its leadership. Otherwise, the whole basis of central banking would be undermined.

The Central Bank and the National Economy

Relations with Other Countries

Since no modern economy is self-contained, central banks must give considerable attention to trading and financial relationships with other countries. If goods are bought abroad, there is a demand for foreign currency to pay for them. Alternatively, if goods are sold abroad, foreign currency is acquired that the seller ordinarily wishes to convert into the home currency. These two sets of transactions usually pass through the banking system, but there is no necessary reason why, over the short period, they should balance. Sometimes there is a surplus of purchases and sometimes a surplus of sales. Short-period disequilibrium is not likely to matter very much, but it is rather important that there be a tendency to balance over a longer period, since it is difficult for a country to continue indefinitely as a permanent borrower or to continue building up a command over goods and services that it does not exercise.

Short-period disequilibrium can be met very simply by diminishing or building up balances of foreign exchange. If a country has no balances to diminish, it may borrow, but normally it, at least, carries working balances. If the commercial banks find it unprofitable to hold such balances, the central bank is available to carry them; indeed, it may insist on concentrating the bulk of the country's foreign-exchange resources in its hands or in those of an associated agency.

Long-period equilibrium is more difficult to achieve. It may be approached in three different ways: price movements, exchange revaluation (appreciation or depreciation of the currency), or exchange controls.

Price levels may be influenced by expansion or contraction in the supply of bank credit. If the monetary authorities wish to stimulate imports, for example, they can induce a relative rise in home prices by encouraging an expansion of credit. If additional exports are necessary in order to achieve a more balanced position, the authorities can attempt to force down costs at home by operating to restrict credit.

The objective may be achieved more directly by revaluing a country's exchange rate. Depending on the circumstances, the rate may be appreciated or depreciated, or it may be allowed to “float.” Appreciation means that the home currency becomes more valuable in terms of the currencies of other countries and that exports consequently become more expensive for foreigners to buy. Depreciation involves a cheapening of the home currency, thus lowering the prices of export goods in the world's markets. In both cases, however, the effects are likely to be only temporary, and for this reason the authorities often prefer relative stability in exchange rates even at the cost of some fluctuation in internal prices.

Quite often governments have resorted to exchange controls (sometimes combined with import licensing) to allocate foreign exchange more or less directly in payment for specific imports. At times, a considerable apparatus has been assembled for this purpose, and, despite “leakages” of various kinds, the system has proved reasonably efficient in achieving balance on external payments account. Its chief disadvantage is that it interferes with normal market processes, thereby encouraging rigidities in the economy, reinforcing vested interests, and restricting the growth of world trade.

Whatever method is chosen, the process of adjustment is generally supervised by some central authority—the central bank or some institution closely associated with it—that can assemble the information necessary to ensure that the proper responses are made to changing conditions.

Economic Fluctuations

As noted above, monetary influences may be an important contributory factor in economic fluctuations. An expansion in bank credit makes possible, if it does not cause, the relative overexpansion of investment activity characteristic of a boom. Insofar as monetary policy can assist in mitigating the worst excesses of the boom, it is the responsibility of the central bank to regulate the amount of lending by banks and perhaps by other financial institutions as well. The central bank may even wish to influence in some degree the direction of lending as well as the amount.

An even greater responsibility of the central bank is that of taking measures to prevent or overcome a slump. Recessions, when they occur, are often in the nature of adjustments to eliminate the effects of previous overexpansion. Such adjustments are necessary to restore economic health, but at times they have tended to go too far; depressive factors have been reinforced by a general lack of confidence, and, once this has happened, it has proved extremely difficult to stimulate recovery. In these circumstances, prevention is likely to be far easier than cure. It has therefore become a recognized function of the central bank to take steps to preclude, if possible, any such general deterioration in economic activity.

For the central bank to be effective in regulating the volume and distribution of credit so that economic fluctuations may be damped, if not eliminated, it must at least be able to regulate commercial bank liquidity (the supply of cash and “near cash”), because this is the basis of bank lending. Monetary authorities in a number of countries have begun to resort increasingly to the management of monetary aggregates as a basic policy. This does not mean an uncritical acceptance of monetarist philosophy but rather what the U.S. economist and banker Paul A. Volcker has called “practical monetarism.” In addition to the Federal Reserve in the United States, a growing number of western European countries have adopted the practice of setting growth targets for the money supply and sometimes other monetary targets as well (like domestic credit expansion), usually setting some range of allowable variation. Japan has had reservations and has preferred to indicate monetary projections or forecasts, partly because of the difficulty of changing a set target should it become necessary. Nor is there any great degree of consensus as to which target or aggregate to employ. In general terms, the choice of a particular aggregate as a basis for reference would be linked to the theories—more or less explicit—on which the actions of a particular central bank are based and also on the state of the country's economy and its financial environment. Where there are publicly declared targets, these can have an important effect by the very fact of being announced.

There is now little dispute about the broad objectives, though the techniques of control are various and depend to some extent on environmental factors. It would be incorrect to suppose, however, that the actions of the central bank can, unaided, achieve a high degree of stability. It can, by wise guidance, contribute to that end but monetary action is in no sense a panacea; at all times, the degree to which it is likely to be effective depends on the provision of an appropriate fiscal environment.

Supervision and Promotion of Banking Services

Another responsibility of the central bank is to ensure that banking services are adequately supplied to all members of the community that need them. Some areas of a country may be “under-banked” (e.g., the rural areas of India and the northern and more remote parts of Norway), and central banks have attempted, directly or indirectly, to meet such needs. In France, this need underlay the early extension of branches of the Bank of France to the departments. In India, the authorities encouraged the opening of “pioneer” branches by the former Imperial Bank of India and its successor, the State Bank of India, later by all the nationalized banks, and particularly their extension to rural and semi rural areas. In Pakistan, officials of the State Bank of Pakistan played an active part in the foundation of the semipublic National Bank of Pakistan with a similar objective in view.

A different sort of problem arises when the business methods of existing banks are unsatisfactory. In such circumstances, a system of bank inspection and audit organized by the central banking authorities (as in India and Pakistan) or a system of bank “examinations” (as in the United States) may be the appropriate answer. Alternatively, the supervision of bank operations may be handed over to a separate authority, such as France's Banking Control Commission or South Africa's Registrar of Banks.

In developing countries, central banks may encourage the establishment and growth of specialist institutions such as savings institutions and agricultural credit or industrial finance corporations. These serve to improve the mechanism for tapping existing liquid resources and to supplement the flow of funds for investment in specific fields.