Role of the Central Bank

The central banks manage the fiscal policy of a state or group of states. They control the money supply and supervise the activities of member banks. Since the central banks determine how much money should be in circulation, they also have control over exchange rates and inflation. There is a risk of creating excess money thus diluting the exchange rate against other currencies and causing price inflation. This has happened in many developing countries, for example, Zimbabwe, where the central bank is under the direct control of the government. They issued money to fund politically motivated projects causing havoc in the financial system and hyperinflation.

More developed countries in the Western World have used private central banks to manage the money supply. These are relatively free of government control. However, that has not been as effective either since the privately owned central banks would work for the benefit of their shareholders. The economic cycles of recessions and growth in the western world have been blamed on these privately controlled central banks.

The central bank can increase the money supply either by depositing money in the commercial banks or by lending money to the government. If the currency managed by the central bank is one of the reserve currencies of the world like dollar, euro, pound sterling, or Japanese yen, excess currency could be disastrous to the global financial markets. The power of central bank should be kept in check by the government through legislation and other independent government entities.

Another important role of the central banks is to serve as the banker of banks or the government’s banker. Besides issuing currency, they act as the lender of last resort for other banks and ascertain a stable banking system through regulation and supervision. There are international standards in place, such as Basel Committee, which provide guidelines and standards for banking supervision. Basel II Accord provides international standard for risk management and compliance.

The central banks play a critical role in safeguarding the financial system against overambitious bankers whose only motive is to maximize profit without regard to any principles or standards. It was proven in 2008 financial crisis that the bankers issued unworthy loans and then packaged these as securities even under the watchful eyes of the central banks. The government authorities need to be more vigilant to assure that the central bank is providing the supervision expected of it and not working with the banks to maximize their profits.