CHAPTER 7

CENTRAL BANKS

Role of Central BankCentral bank is the most important financial institution in the financial systemIt is a government agency responsible for the conduct of monetary policy – involves the management of interest rate and money supply

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Banking Regulation

Banks are the most highly regulated industryMain objective of bank regulations – designed to protect the public interest

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Why Banks are Heavily Regulated

To protect the safety of the public’s savings Banks are among the leading repositories of the

public’s savingsTo control the supply of money and credit in order to achieve a nation’s broad economic goals (such as high employment and low inflation)Banks have the power to create money in the

form of readily spendable deposits by making loans and investments (extending credit)

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To ensure equal opportunity and fairness in the public’s access to credit and other vital financial servicesTo promote public confidence in the financial system, so that savings flow smoothly into productive investment, and payments for goods and services are made speedily and efficientlyTo avoid concentrations of financial power in the hands of a few individuals and institutionsTo provide the government with credit, tax revenues and other servicesTo help sectors of the economy that have special credit needs (such as housing, small business and agriculture)

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However, regulation must be balanced and limited so that:

a) Banks can develop new services that the public demands

b) Competition in financial services remains strong enough to ensure reasonable prices and an adequate quantity and quality of service to the public

c) Private-sector decisions are not distorted in ways that misallocate and waste scarce resources (such as by governments propping up banks that should be allowed to fail)

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The Impact of Regulation on Banks

Regulations often block entry into the regulated industryRegulation shelters a firm from changes in demand and cost, lowering its riskRegulations can increase customer confidence in banks, which in turn may create greater customer loyalty toward banks

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MalaysiaCommercial banks in Malaysia are under The

Banking and Financial Institutions Act 1989 (BAFIA)

Replace the Banking Act 1973 and Finance Companies Act 1969

Intended to provide an integrated supervision of the Malaysian financial institutions and to modernise and streamline the laws relating to banking and all other financial institutions under one supervisory and regulatory legislative regime

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CENTRAL BANK OF MALAYSIA

Bank Negara Malaysia (BNM)Established on January 1959, under the Central Bank of Malaya Ordinance (CBO), 1958The CBO was revised in 1994, and now the Central Bank of Malaysia Act (CBA) 1958The CBA defined BNM as the bank which constitutes the apex of the monetary and banking structure of the country

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Legislation To enable BNM to meet its objective, it is vested with comprehensive legal powers under various Acts and Ordinance to regulate and supervise the financial systemThese Acts include: The Central Bank of Malaysia Act 1958 (CBA) The Islamic Banking Act 1983 (IBA) Banking and Financial Institutions Act 1989 (BAFIA) Essential (Protection of Depositors) Regulations 1986

under Section 2 of the Emergency (Essential Powers) Act 1979

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Cont… Insurance Act 1996 (replaced the Insurance Act

1963) Takaful Act 1984 6 legislations pertaining to the promotion of Labuan

as an International Offshore Financial Center (IOFC)

The introduction of BAFIA on 1 October 1989 for licensed institutions, extended BNM’s powers for supervision and regulation from institutions involved only in deposit-taking to institutions also engaged in the provision of finance and credit

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Cont…BNM also act as: An agent to the government on exchange

control matters Administers the Exchange Control Act 1953,

with the governor having assumed authority as the Controller of Foreign Exchange on 1 August 1960

1989 – through an amendment to the CBA, BNM was made directly responsible for all exchange control matters instead of just being an agent to the government

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1988 – governor act as the Director-General of Insurance and Takaful

BNM was made responsible for the supervision, regulation and development of the insurance industry as part of the financial system

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The Functions of BNM

Maintaining monetary stabilityPromoting a sound financial systemIssue of currency and management of the nation’s international reservesBanker / adviser to the government

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Maintaining Monetary StabilityUltimate objective of monetary policy – attaining monetary or price stabilityPrice stability is a key prerequisite for sustained economic growthAttaining monetary stability: Prior 1990s – the monetary strategy of BNM was to

target monetary aggregates as the movements of these aggregates were highly correlated with inflation

Early 1990s – developments in the economy and financial system weakened the relationship

BNM gradually shifted its focus from monetary targeting to interest rate targeting

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Cont…BNM conduct the monetary policy through short-

term interest rates to achieve its ultimate objective of price stability

BNM used a wide range of monetary instruments to manage liquidity to achieve its objective of price stabilityThese include:Open market operations

the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments.

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Direct intervention by BNM to borrow or lend in the interbank money market

the issuance of BNM papers and variations of the statutory reserve requirement (SRR)

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Promoting a sound financial system

The existence of a sound and stable financial system is necessary for the conduct of monetary policyThe maintenance of financial stability - dependent on the existence of stable monetary conditions so that the balance sheets of corporations and financial institutions are not adversely affected by conditions of macroeconomic stressEssential element for the promotion of financial stability is the existence of a strong and effective prudential framework

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To ensure that banking institutions operate in a sound and prudent manner - minimising the risk of bank failure which may affect the whole economy

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Cont…BNM is the sole authority regulating the banking industry in Malaysia under BAFIA 1989 and also IBAThe BAFIA provides BNM to grant and revoke banking licenses, and also to take prompt corrective actions to deal with ailing financial institutions

These powers, among others include: Removal of directors Appointment of directors and advisors Suspension of lending activities Reduction of capital

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Cont…BNM also act as a banker to the financial institutionsConducting supervisions and inspections

To ensure sound and prudent conduct of operations to safeguard the interest of the depositors and the public

To ensure that the financial institutions comply with the banking act

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Cont…Mechanics of supervision:BNM applies the CAMEL framework to

evaluate the overall financial and general condition of a banking institution

The CAMEL rating is reviewed once a yearThis would provide a means for supervisors to

evaluate the types and severity of problems that banking institutions are experiencing and to adopt the necessary supervisory response

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Cont… Inspection mainly concentrated in the following

areas:Investment and lending policiesState of its assetsQuality of managementCompliance and statutory requirements and

guidelines and directives issued by the central bank

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Cont…CAMEL:C = Capital Adequacy

The heart of an institution’s safety and solvencyMeasure of financial strength and also act as a

cushion in the case of bank lossesA = Asset Quality

Has direct impact on the financial performance of a banking institutions

The quality of assets depends on bank loans and investments

In recent years, loan losses are often the primary source of large losses for institutions

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Cont…M = Management Quality

The most important element of the CAMEL components

The performance of the other four CAMEL components will depend on the vision, capability, agility, professionalism, integrity and competence of the management

Have greater weightage in the assessment of overall CAMEL composite rating

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Cont…E = Earnings Performance

The quality and trend of earnings of an institution depend largely on how well the management manages the assets and liabilities of the institution

Good earnings performance would inspire the confidence of depositors, investors, creditors and the public at large

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Cont…L = Liquidity Position

A banking institution must always be liquid to meet depositor’s and creditor’s demand in order to maintain public confidence

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Cont…Lender of last resort

The main forms of assistance given by the central bank:

Rediscounting of eligible bills such as Treasury bills, Government securities and Investment Certificates, trade bills and commercial papers

Borrowing from the central bank against collateral

Licenses Licenses are issued by the Minister of Finance

on the recommendation of the central bank

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Issue of currency & management of the nation’s international reserves

Part III of the CBO provides authority to BNM to become the sole issuer of Malaysian currencyThe central bank commenced to issue its own currency on June 12, 1967; replacing the Currency Board as the sole currency issuerUnder the Malaysian Currency Act 1978, the Malaysian dollar and cent were renamed as “Ringgit” and “Sen” respectively

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Cont…

BNM is required to maintain a minimum cover of 80.59% in external assets against its notes and coins in circulationIn practice, BNM always maintained a cover well above 100% of BNM’s currency liabilities, reflecting its commitment to maintain full gold and foreign exchange backing for the Malaysian ringgit

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Cont…The country’s official external reserves are held and maintained by BNMThe central bank’s international reserves comprise of gold, foreign exchange and reserve position with International Monetary Funds (IMF)However, gold and foreign exchange had been the major component of external reserves held by the central bank

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Banker / adviser to the government

BNM advises the government on its loan programmes, including the terms and timing of the loans and issue of new types of securitiesBNM also responsible for trading, registering, settlement and redemption of government securities through its computerised trading and settlement system

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Under CBA, BNM also provide temporary advances, known as “ways and means” advances to the government to cover any deficit in the budget revenueThere are legal limitations to the

amount and the duration of loans that BNM can make available to the government

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Cont…BNM operates as the government’s banker mainly because of the intimate connection between public finance and monetary affairsBNM performs the same functions as the commercial banksProvides cheque facilities, accept funds

and make payments on behalf of the government and undertake the foreign exchange business of the government

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Cont…Close cooperation between the government and BNM is also evident from the centralisation of government’s deposits with the bankGovernment’s receipts, arising mainly from the new issue of government securities, tax and dividend payments are placed with the bank and managed by the bank depending on the liquidity situation of the system

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Further reading:

Bank Negara Malaysia, The Central Bank and The Financial System in Malaysia: A Decade of Change, 1989-1999. Kuala Lumpur, Bank Negara Malaysia, 1999.