Chapter 1: Evolution of Central Banking Globally and in India PDF

# Chapter 1: Evolution of Central Banking Globally and in India “There have been three great inventions since the beginning of time: fire, the wheel and central banking” – Will Rogers ## Evolution of Central Banking - The evolution of central banks can be traced back to the seventeenth century wh...

# Chapter 1: Evolution of Central Banking Globally and in India “There have been three great inventions since the beginning of time: fire, the wheel and central banking” – Will Rogers ## Evolution of Central Banking - The evolution of central banks can be traced back to the seventeenth century when Riksbank, the Swedish Central Bank was set up in 1668. - The Bank of England was founded in 1694. - The Central Bank of the United States, the Federal Reserve established in 1914, was relatively a late entrant to the Central Banking arena. - The Reserve Bank of India, India's central bank, started operations in 1935. - At the turn of the twentieth century there were only eighteen central banks. Today, most of the countries have a central bank. ## Central Banks - Central banks are not regular banks. They are unique both in their functions and their objectives. - In the beginning, central banks were established with the primary purpose of providing finance to the government to meet their expenses and manage their debt. - They were initially known as banks of issue with the term central banking coming into existence only in the nineteenth century. - They were founded as “special” commercial banks and would evolve into public-sector institutions much later. - The “special” nature of these banks was based on government charters, which made them not only the main bankers to the government but also provided them monopoly privileges to issue notes or currency. - Central banks also held accounts of other banks even as they engaged in normal commercial banking activities. - Given their “special” status and their size, they soon came to serve as banker to banks facilitating transactions between banks as well as providing them banking services. ## Financial Panics - The eighteenth and nineteenth century witnessed several financial panics. Panics are a serious problem as failure of one bank may lead to failure of others. - Banks are susceptible to panics or "runs” as more popularly known, due to the nature of their balance sheets. - Their liabilities are short-term and liquid (banks' major liabilities are **demand deposits**, which means depositors can ask their money back anytime they want and therefore immediately payable) and the assets are long-term and illiquid (in the sense that it is not easy to sell them and convert into cash quickly). - Banks engage in this so-called **maturity or liquidity transformation** to allocate society's available pool of resources effectively between savers and borrowers. - The failure of banks and its potential adverse impact on the real economy was and is a serious concern for all policymakers. - In 1873, Walter Bagehot, an editor of the Economist magazine, published a book titled “Lombard Street”, where he clearly articulated that to avoid panics, central banks should assume the role of “lender of last resort”. - The doctrine, which came to be known as Bagehot's dictum states that a central bank, in periods of panics or crisis, should lend freely, against quality collateral and at a penal rate of interest. - The idea being, a bank that is facing a “run” by its depositors or other lenders can tide over temporary liquidity problem in the stress period, by borrowing from the central bank against collateral. - It can pay off the depositors and buy some time before things calm down. Given bank runs are self- fulfilling prophecies, if the banks can navigate this period without becoming insolvent, a crisis could be averted. - The very fact that the bank was able to meet the withdrawal demands would comfort the other depositors waiting to withdraw and wean them away. - Without the 'lender of last resort' facility, banks must resort to fire-sale of their assets and that too at a deep discount. Thus, in addition to be a banker to the government and banks, central banks also became lenders of last resort. ## The Main Mission of a Central Bank - The main mission of a central bank is to maintain macroeconomic stability and financial stability. - Macroeconomic stability refers to achieving stable and sustainable growth and keeping prices stable, i.e., low and stable inflation. - Financial stability on the other hand refers to keeping the financial system resilient and avoiding financial crisis. - The relative importance of these objectives has varied over time. While the pursuit of sustainable economic growth and low and stable inflation have been fundamental to central banking activities since the early nineteenth century with the advent of the gold standard, the importance of financial stability became more prominent since the Great Depression of the 1930s when the world economy faced large bank failures and deep recession. ## Tools of Central Banks - To achieve the objectives of macroeconomic stability and financial stability, central banks have certain tools at their disposal. - To achieve ***economic stability***, central banks use **monetary policy.** - By varying short-term interest rates, i.e., either raising or lowering the interest rates, they control the supply of and demand for money in the economy and thereby economic activity and inflation. - For example, if the economy is growing fast and inflation is high, the central bank may raise the interest rates it charges the banks to lend money. - Higher interest rates will permeate into other rates, such as housing loan, consumer loan, etc. As the cost of borrowing increases, it discourages consumption and investment and thus reduces growth and inflation. - On the other hand, if the economy is growing too slow or if the inflation is too low, the central bank will lower the interest rate. - This will feed into other rates and encourage spending and investment thereby pushing economic growth and inflation. - The trick of the trade is to achieve sustainable growth and low and stable inflation. Thus, sometimes, central banking is said to be “neither a science nor an art, but a craft”. - To deal with ***financial stability***, central banks main tool is provision of **liquidity**. - This tool, as explained earlier, is referred to as “lender of last resort”. - Some central banks, which are also the banking regulators in their economies employ another tool, viz., ***regulation and supervision***, also to foster financial stability. - By setting prudent rules and principles and examining and monitoring banks adherence to these rules and principles, the central banks aim to create a healthy and robust banking and financial system. - A resilient and safer banking system will reduce the chances of financial crisis in the first place. - In many countries the regulatory and supervisory roles are performed by multiple agencies and therefore may not be a main function of the central bank. ## Internationalization Of Commercial Banking Activity - The internationalization of commercial banking activity brought several risks to the fore. - The failure of two banks in 1974, the Franklin National Bank in the United States and Bank Herstatt in Germany, which had international implications necessitated international cooperation and coordination among central banks. - The **Basel Committee for Banking Supervision (BCBS)** was thus established. - The committee sets international regulatory standards, known as **Basel Standards**, that forms the bedrock for all national and international banking regulations. ## The Toolbox Of Central Banks - Since the outbreak of the financial crisis in 2007-08, the toolbox of central banks has been strengthened. - These tools or measures are popularly known as “unconventional policies", reflecting their use in extraordinary circumstances. - **Quantitative or credit easing, negative interest rates, forward guidance, etc.,** are some of the tools employed by central banks to deal with the crisis and its aftermath. - The central banks also became "market makers of last resort" during the crisis as the markets became dysfunctional. - These concepts will be explained in subsequent chapters. ## Another Incident That Further Shaped Evolution of Central Banks - Another incident that further shaped evolution of Central Banks is the once-in-a-millennium outbreak of CoVID-19 pandemic. - Unlike many other crises that tested or rather shaped the functioning of Central Banks globally, this one emanated from outside the financial sector but nevertheless pushed the Central Banks to put their best foot forward to work together with respective sovereigns to try and minimize the impact of the pandemic on the real economies. - Many Central Banks responded invariably but the approach remained quite varied. - Expectedly, the central banks deployed their full arsenal of tools, but the responses were tailored to the nature of stress experienced in each country and the evolutionary stage or structure of their financial systems. - Central Banks have promptly eased their policy stance, acting decisively to prevent market dysfunction and complemented the same with regulatory forbearance, supervisory flexibility, to support banks' ability and intent to lend. - The fiscal policy response from the sovereigns too was swift and forceful. However, the faster recovery has come with some surprises in the form of unleashed inflation. ## Post Pandemic Developments For Central Banks - Post pandemic, many central banks have also trained their sights on **digital payments including a digital currency**. - Similarly, as fintech is transforming the financial landscape, the nature of regulation has to adjust. - The sheer diversity in the functions performed by fintech firms, necessitates a widening of the regulatory perimeter. - The approach to regulation also needs to adapt to the type of entity being regulated. - While similar activities should attract uniform regulation in most cases, such activity-based regulation might be less effective than entity-based regulation when one is dealing with financial activities by bigtech firms. - Cybersecurity risks are likely to overshadow financial risks for all. - Systemic risks, operational risks and risks affecting competition are of prime importance when dealing with large financial market infrastructure entities or bigtech. - Countries need to overcome the legislative and regulatory deficits in dealing with concerns surrounding **privacy, safety and monetisation of data.** Regulations pertaining to data issues needs to adapt to a world where boundaries between financial and non-financial firms is getting increasingly blurred or geographical boundaries are no longer a constraint. ## Managing Climate Change Risks - Another area where central banks are increasingly becoming involved is managing the risks emanating from climate change. - Climate change poses a threat to our long-term growth and prosperity. - It has potential to create shocks to **monetary stability, growth, financial stability, the safety and soundness of regulated entities.** - In many countries, including India, the Central Banks are statutorily mandated to pursue a given set of objectives. - This means that they should address risks and threats that impact their core mission. - Climate change does pose such a risk. They must, therefore, manage outcomes which could affect the stability of the financial system and safety and soundness of the financial entities. - More Importantly, the risks arising from climate change transverse geographical boundaries and sectoral segmentations. - Therefore, tackling climate change requires global co-ordination and co-operation. - Being mindful of these challenges, international organisations such as the IMF and standard-setting bodies such as the **BCBS and FSB** are stepping up their work on issues relating to climate change. ## Initiatives Under The Aegis Of G-20 - At the global level, several initiatives are already underway under the aegis of the G-20. - Different standard setting bodies are undertaking focused work to address the vulnerabilities arising from climate change. - The **Financial Stability Board (FSB)** had published a "**Roadmap for Addressing Financial Risks from Climate Change**, which was endorsed by the G20 in July 2021 and has since been updated. - The Roadmap sets out a comprehensive and coordinated plan for addressing climate-related financial risks and covers four areas, i.e., **firm-level disclosures, data, vulnerabilities, and regulatory and supervisory practices & tools**. ## Evolution of the Reserve Bank of India - The origins of the **Reserve Bank of India (RBI)** can be traced to 1926, when the Royal Commission on Indian Currency and Finance - also known as the **Hilton-Young Commission** - recommended the creation of a central bank for India to separate the control of currency and credit from the Government and to augment banking facilities throughout the country. - The **Reserve Bank of India Act of 1934** established the Reserve Bank and set in motion a series of actions culminating the start of operations in 1935. - Since then, the Reserve Bank's role and functions have evolved, as the nature of the Indian economy and financial sector changed. - Though started as a private shareholders' bank, the Reserve Bank was nationalised in 1949. ## The Preamble To The Reserve Bank of India Act, 1934 - The Preamble to the Reserve Bank of India Act, 1934, under which it was constituted, specifies its objective as “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”. - The primary role of the RBI, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country's money or preserve the purchasing power of the currency. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures. - In addition, the RBI has two other important mandates, **inclusive growth and development, as well as financial stability**. ## Inclusive Growth and Development - In a country where a large section of the society is still poor, inclusive growth assumes great significance. - Access to finance is essential for poverty alleviation and reducing income inequality. - One of the core functions of the RBI, therefore, is to promote financial inclusion that leads to inclusive growth. - As the central bank of a developing country, the responsibilities of the RBI also include the development of financial markets and institutions. - Broadening and deepening financial markets and increasing their liquidity and resilience so that they can help allocate and absorb the risks entailed in financing India's growth is a key objective of the RBI. ## Regulation and Supervision Of Banks - India's financial system is dominated by banks. - Their regulation and supervision are therefore important both from the viewpoint of protecting the depositors' interest and preserving financial stability. - The RBI, deriving powers from the **Banking Regulation Act, 1949**, designs and implements the regulatory policy framework for banks operating in India. - Over the years, the purview of regulation and supervision has been expanded to include non- banking entities also. ## Global Economic Uncertainties After World War 2 - The global economic uncertainties during and after the Second World War warranted conservation of scarce foreign exchange by sovereign intervention and allocation. - Initially, the RBI carried out the regulation of foreign exchange transactions under the **Defence of India Rules, 1939** and later, under the **Foreign Exchange Regulation Act of 1947**. - Over the years, as the economy matured, the role shifted from foreign exchange regulation to foreign exchange management. ## The 1991 Balance Of Payment And Foreign Exchange Crisis - The 1991 balance of payment and foreign exchange crisis was a watershed event in India's economic history. - Being at the centre of country's monetary and financial system, the RBI played a key supporting role in helping the Government manage the crisis and undertake necessary market and regulatory reforms. - The approach under the reform era included a thrust towards liberalisation, privatisation, globalisation and concerted efforts at strengthening the existing and emerging institutions and market participants. - The Reserve Bank adopted international best practices in areas, such as, prudential regulation, banking technology, variety of monetary policy instruments, external sector management and currency management to make the new policy framework effective. ## Functions Of A Central Bank - Central banks are at the heart of a country's payment and settlement system. - “One of the principal functions of central banks is to be the guardian of public confidence in money, and this confidence depends crucially on the ability of economic agents to transmit money and financial instruments smoothly and securely through payment and settlement systems"1. - The RBI has, over the years, taken several initiatives in building a robust and state-of-the-art payment and settlement system that not only improves the “plumbing” of the financial system but also its stability. ## Growing Integration Of The National Economy - The last two and a half decades have also seen growing integration of the national economy and financial system with the world. - While rising global integration has its advantages in terms of expanding the scope and scale of growth of the Indian economy, it also exposes India to global shocks. - The crisis of 2007-08 gave a glimpse of financial instability in other economies posing threat to our financial stability. - Hence, preserving financial stability has become an even more important mandate for the RBI. - In order to alleviate COVID-19 related stress in the financial markets and specific segments of the economy, the Reserve Bank had used a number of targeted and system-level liquidity measures as part of unconventional monetary policies, which led to stable expansion in its balance sheet size. - As a per cent of GDP, the Reserve Bank's balance sheet size expanded to 28.6 per cent in 2020-21 from 24.6 per cent in 2019-20, before moderating to 26.7 per cent in 2021-22 and further to 22.5 per cent in 2022-23 (Chart II.4.2 a & b). - The expansion in the Reserve Bank's balance sheet was, however, relatively subdued as compared with that in the US, the UK and the Euro Area. - During the same period, the reserve money (the stock of monetary liabilities in the central bank's balance sheet/base money) as per cent of GDP in India also remained stable vis-à-vis other major economies as the liquidity measures were carefully designed and targeted with in-built terminal dates, reducing the challenge of exiting from post-COVID unconventional policies¹. ## Money Supply, Commonly Proxied By Broad Money (M3) - Further, Money supply, commonly proxied by **broad money (M3 – Sum of currency with public, demand and time deposits with banks and other deposits with Reserve Bank)**, viewed in the context of economic activity - M3 to nominal GDP ratio - indicates that India witnessed a faster normalisation of COVID-19 induced stimulus, with the ratio reverting to the pre-pandemic steady levels unlike other major economies (Chart II.4.8). 1. Bank oversight of payment and settlement systems, BIS, May 2005