April 1962
F E D E R A L RESERVE B A N K OF R I C H M O N D
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
APRIL 1962
April 1962
Nature and Characteristics o f . . .
GENTRAL BANKS
In ev ery m ajo r co un try of the w o rld the cen tral
bank is the cen tral arch of the m o netary and finan­
cial system . Its activ ities are essen tial to the proper
functioning of the p rivate econom y and indispensable
to the fiscal operations of the national governm ent.
Y e t the cen tral bank is u su ally taken for gran ted.
Even am ong those who frequen tly come into contact
w ith its operations, only a v ery sm all m in o rity has
a full u n d erstan d in g of w h at a cen tral bank is, w hat
it does, and w hy. Often there are illusio ns and m is­
u n derstan d in gs as to the purposes and functions of
cen tral banks and confusion o r im perfect un d erstan d ­
in g of the differences betw een a central bank and a
com m ercial bank.
T h is article is the first of a series planned for this
Review, the purpose of w hich is to ex p lain in sim ple
term s the n atu re, ch aracteristics, and functions of
cen tral banks and the ratio n ale behind them . A tten ­
tion w ill be centered on broad, gen eral ch aracteristics
and functions. A n y given statem ent m ay not be true
of a p a rticu lar bank since 110 two cen tral banks are
e x ac tly alike. F rom tim e to tim e special attention
w ill be d irected to the F e d eral R eserve S ystem as the
cen tral b an kin g o rganizatio n of the U n ited S tates.
A G LA N CE AT HISTORY
It is reported th at on one occasion W ill R o gers
s a id : “ T h ere have been three g reat inventions since
the beginn ing of tim e : fire, the w heel, and cen tral
b an kin g .” H e m ay have been kid d in g when he said
th is, for it is doubtful if cen tral b an kin g belongs in
such ex alted com pany. B u t it is tru e th at the cen­
tra l bank is one of the m ost useful in stitutio ns m od­
ern m an has developed to help him m an age his col­
lective financial affairs.
A ltho ugh the roots of some cen tral banks go back
2
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
200 y e a rs or m ore, cen tral b an kin g as w e know it
to day is m o stly a recent developm ent. Som e w ould
contend th at it is alm ost e n tirely a product of the
tw en tieth cen tu ry. In 1900 not a sin gle cen tral bank
ex isted in the W estern H em isphere. T h e F ed eral
R eserv e S ystem w as not created u n til 1913 and the
B an k of C an ada did not ap p ear on the scene until
1934. N ow ev ery independent nation in the hem i­
sphere excep t one has its own cen tral bank. A c­
cording to av ailab le inform ation, th ere are now 88
cen tral banks in the w orld. Of those, 47, or slig h tly
m ore than half, have been established since 1940.
S ev eral reasons account for th is rap id grow th in
recent decades. P erh ap s the m ost im portant is th at
there are a g reat m an y m ore independent nations in
the w orld, each w ith its own m o netary and ban kin g
system to be m an aged and sup ervised. Second, the
nations of the w orld have alm ost en tirely abandoned
the in tern atio n al gold stan d ard w hich p rovided some
degree of auto m atic control over a co u n try’s m one­
ta ry system . In the absence of th at auto m atic con­
trol, a cen tral bank is n ecessary to provide some
conscious and d iscretio n ary control o ver m o netary
affairs. T h ird , m o n etary and b an kin g system s are
larg e r, m ore com plex, and m ore technical than th ey
wrere a cen tu ry ago and for th at reason th ey require
closer and m ore effective controls. F in a lly , in ter­
natio nal financial relatio n s are m ore im portant in the
w orld today, and cen tral banks are needed both to
conduct or sup ervise those relatio n s and to deal w ith
an y dom estic disturbances th ey m ay create.
WHAT IS A CENTRAL BAN K?
It is not possible to g ive an y brief definition of a
cen tral bank w hich w ill be both com prehensive and
accurate. To a considerable ex ten t the n atu re of a
April 1962
Board of Governors of the Federal Reserve System
cen tral bank depends on its functions and those func­
tions v a ry from co un try to co un try and from tim e to
tim e. M an y cen tral banks, esp ecially the e a rlie r
ones, accum ulated th eir functions as th ey w ent a lo n g ;
like T opsy, th ey “ju s t g ro w ed .” N evertheless, it is
p roper to say th at to d ay an y full-fledged cen tral bank
m ust perform at least three broad fu n c tio n s: it m ust
be a b an k ers’ bank, it m ust act as fiscal ag en t for the
n ational governm ent, and it m ust m an age the n a ­
tio n ’s m o netary system . T h ese functions w ill be
discussed in some d etail in la te r articles, but they
w ill be b riefly described here.
A B ank for B an kers U n d e r th e first tw o g ro u p s
of activities, a cen tral bank perform s for the com m er­
cial b an kin g system and for the natio nal governm ent
the basic functions w hich the com m ercial b an kin g
system perform s for in d iv id uals and business firm s.
A s a b an k ers’ bank it holds the reserves of com m er­
cial banks, clears and collects checks, d istribu tes c u r­
ren cy and coins to the banks, m akes sh ort-term a d ­
vances to banks under certain conditions, and acts
as “the lender of last re so rt” (se e this Review, F eb ­
ru a ry 1 9 6 1 ). F u rth e r, the cen tral bank m ay, and
u su a lly does, ex ercise some degree of supervision
and regulatio n over the activities of com m ercial
banks, although this is not essen tial to the cen tral
b an kin g function.
B anker fo r the G overnm en t In its c a p a c it y as
fiscal agen t the cen tral bank receives, holds, tra n s­
fers, and p ays out the funds of the n atio nal go vern ­
m ent. In addition, it receives and allots sub scrip ­
tions to new secu rity issues, m akes exch an ges of se­
cu rities, redeem s in terest coupons and m atu rin g se­
cu rities, and, un der certain conditions, m akes sh ort­
term advances to the governm ent. In alm ost all
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
countries the cen tral bank is the p rin cip al financial
ad v iser or consultant to the governm ent and in some
cases it actu ally m an ages the public debt.
M anager of the M o n etary S ystem P e rh a p s th e
m ost d istin g u ish in g function of a cen tral b an k is con­
trol of the n atio n ’s m oney and b an kin g system . One
au th o rity opens a treatise on cen tral b an kin g w ith
these w o r d s : “T he essence of cen tral b an kin g is d is­
cretio n ary control of the m o n etary system .” In p er­
form ing this function, cen tral banks ex ercise one of
the p rero gativ es and pow ers of the so vereign go v­
ernm ent. T h is m eans th at the pow er m ust be e x ­
ercised p rim a rily for the achievem ent of n atio nal
econom ic goals, and th at a cen tral bank is a public
service o rganizatio n , p lacin g the n atio nal in terest
above an y consideration of its own profit or w elfare.
In actin g as a b an kers’ bank and as m an ager of
the co u n try’s m o n etary system , a cen tral bank fre­
quen tly creates m oney. It does this when it m akes
an advance to a bank or buys securities in the open
m arket. T he m oney thus created is “h igh -p ow ered”
m oney— m oney w hich the com m ercial banks count
as reserves and on the basis of w hich th ey expand
th eir deposits to an am ount several tim es the am ount
created by the cen tral bank.
No Com m ercial B anking T o ro u n d o u t th is b rie f
definition, it is w ell to note one th in g w hich a cen tral
bank does not do. A lth o ugh th ere are exceptions,
cen tral banks o rd in arily do not conduct a com m er­
cial b an kin g business for the g en eral public. In fact,
in d iv id u als and p rivate business firm s (ex cep t com ­
m ercial banks and a few secu rity d ealers) seldom if
ever deal d irectly w ith cen tral banks. T h is probably
is a m ajo r reason w h y the public g e n e ra lly is not w ell
acquainted w ith cen tral bank activities. It is custom ­
3
April 1962
a r ily regard ed as in ap p ro p riate to m ix cen tral and
com m ercial b an kin g functions. T he o bjectives and
the m ethods of the tw o are quite different, and it
m ight be difficult to keep the two a ctiv ities p ro p erly
separated . A s noted below , the cen tral bank places
p rim a ry em phasis on the attain m en t of natio nal eco­
nomic goals w h ile com m ercial banks n ecessarily put
the m ajo r em phasis on run n in g a profitable business.
F u rth er, if a cen tral bank did engage in com m ercial
ban kin g, it w ould have an u n fair ad v an tage. F o r
exam p le, the cen tral bank m ight have to ex am in e and
sup ervise its com petitors. N a tu ra lly , th is w ould
tend to antagonize the com m ercial banks and w ould
th reaten th eir free cooperation, w hich is v ita lly nec­
e ssa ry for successful cen tral bank operations.
In su m m ary, then, a cen tral bank m ay be b ro adly
defined as a public service o rganizatio n w hich does
not en gage in com m ercial banking, but w hich func­
tions rath er as a b an kers’ bank, acts as fiscal agen t
and ad v iser for the n atio nal governm ent, and m an ­
ages the co u n try’s m oney and credit system .
CHARACTERISTICS OF CENTRAL BANKS
A ltho ugh the ch aracteristics of cen tral banks v a ry
w id ely, there are a fewr essen tial ones wrhich a re p res­
ent in alm ost e v e ry im portant bank. T hese w ill be
discussed u n d er tw o broad h e a d in g s : first, the place
of the profit m otive and, second, relatio n sh ip s w7ith
the n atio nal governm ent.
P lace of the P ro fit M otive O ne of th e m o st im ­
portant ch aracteristics of a cen tral bank, and the one
w hich d istin gu ish es it m ost sh arp ly from a com m er­
cial bank, is th at it m ust subordinate considerations
of profit to its resp o n sib ility for public service. If
a cen tral bank w ere operated p rim a rily for profit it
w ould tr y to stay “loaned u p ,” to m ake ap p ro xim ate­
ly a ll the loans, discounts, and in vestm ents its re ­
serve position w ould perm it. In m an y cases this
w ould be in ap p ro p riate for two reasons. F irst, it
w^ould not allow the bank to give p rim ary attention,
as it should, to m an agin g the co u n try’s m oney s y s ­
tem in accordance w ith the ch an ging needs of the n a­
tio n ’s econom y. It wrould a lw a y s be e x ertin g p res­
sure to keep the m oney sup p ly expanded as far as
the legal provisions w ould allow . Such a policy
w ould alm ost c e rta in ly create serious financial com ­
plications both d o m estically and in tern atio n ally.
Second, if the cen tral bank is to function as a lender
of last reso rt it m ust have some reserve lending
powder— some cushion— to m eet e x tra o rd in a ry situ a­
tions. T h is it could not do if it o rd in a rily stayed
loaned up as far as its reserves perm itted.
4
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
T he fact that cen tral banks do not place p rim a ry
em phasis on m ak in g profits does not m ean th at th ey
do not m ake profits. Q uite the co n trary : the pow er
th ey have to acquire earn in g assets by creatin g
m oney is a m ost lu crativ e source of profits.
D isposition of P rofits If a c e n tr a l b a n k is e n ­
tire ly owned and controlled by the national go v ern ­
m ent, as is freq u en tly the case, th ere is no problem
in cu rb in g the profit m otive, since governm ents do
not conduct th eir operations for the purpose of m ak ­
in g profits. B u t if some or a ll of the cen tral bank
stock is ow ned by p riv ate stockholders, it is u su ally
considered n ecessary to place some lim it on the re ­
tu rn th ey can realize from the stock so as to d is­
co urage them from p u ttin g too m uch em phasis on
earn in gs. T h is u su a lly takes the form of p lacin g
a rig id lim it on the dividends w hich can be p aid on
the stock of the bank. A n y excess earn in g s are
u su ally placed in a reserve fund or paid to the gov­
ernm ent as a ta x or a fran ch ise fee. T h is m ay be
strengthened fu rth er by a provision th at in case the
bank should be liq u id ated , the stockholders w ould
be p aid the p ar valu e of th eir stock and an y am ount
rem ain in g w ould belong to the governm ent. T h is
p revents an y p o ssib ility of stockholders benefiting
from p lacin g larg e am ounts in reserves.
P rofits of the F ederal R eserve S ystem T h e p ro ­
visions go v ern in g the profits of the F ed eral R eserve
S ystem are perhaps typ ical of the above a rra n g e ­
m ents. T h e stock of the F ed eral R eserv e B an ks is
owned by the m em ber banks. T h e retu rn on that
stock is lim ited to an an n ual 6 % cum ulative d iv i­
dend. A fter th at dividend is p aid, each R eserve
B an k adds to its surp lus an y am ount needed to b rin g
its su rp lu s up to tw ice the p ar v alu e of its o u tstan d ­
in g stock. A ll earn in g s rem ain in g after this op era­
tion are p aid to the F ed eral G overnm ent. T h is last
paym ent is m ade not under the provisions of a n y law
but un der a regulatio n of the B o ard of G overnors.
In 1961 the gross earn in g s of the 12 R eserve
B an ks w ere $945 m illio n ($ 9 3 8 m illio n from in terest
on U . S. G overnm ent secu rities, $4 m illion from
profit on sales of secu rities, and $3 m illion from earn ­
ings on discounts and ad v a n c e s). C u rren t expenses
am ounted to $161 m illio n, leav in g net earn in g s of
$784 m illion. Of this am ount, $26 m illion w as paid
as dividends on the stock of the R eserv e B an ks, $71
m illion wTas added to th eir surp lus, and $687 m illion
w as paid to the U . S . G overnm ent. T h us, the F ed ­
eral G overnm ent received 73% of the gross earn in gs
and 88% of the net earn in g s of the System . O ver
April 1962
the five y e a rs 1957-61, F ed eral R eserve p aym en ts to
the F ed eral T re a su ry av eraged $712 m illion p er year.
R elationships w ith N ational G overnm en t T h e
relatio n sh ip s of cen tral banks w ith th eir national
governm ents v a ry w id ely but u su ally are broad, close,
unique, and com plex. T h ey v a ry because in m any
cases th ey g rew or evolved rath er than bein g fash ­
ioned acco rdin g to one common p attern. T hus, they
w ere influenced by each co u n try’s conditions and
developm ents. M an y of the e a rly banks w hich p e r­
form ed some cen tral b an kin g functions began as
p riv a te ly ow ned in stitutio ns, o perated for p rivate
profit. W ith the p assage of tim e th ey assum ed m ore
and m ore cen tral bank functions, and the g o v ern ­
m ents then in sisted upon an in creasin g am ount of
governm ent control. In a num ber of cases the go v­
ernm ent assum ed com plete ow nership and control.
A g ain , it m ust be rem em bered th at these close re la ­
tions developed because cen tral banks ex ercise, as
one of th eir m ost essen tial functions, one of the m ost
im portant pow ers of a so vereign governm ent— the
pow er to create m oney.
In all cases the cen tral bank operates un der a
special g ran t of pow er, u su a lly em bodied in a ch arter
w ith v ario u s am endm ents and supplem ents. T h is
legislatio n , of course, is enacted by the n atio nal p a r­
liam en t or congress and thus can be m odified at an y
tim e. On some points th is legislatio n is lik e ly to be
in fa irly broad and g en eral term s, allo w in g some
room for in terp retatio n . F u rth e r, as tim e passes
new situatio n s arise w hich w ere not contem plated in
the o rig in al legislatio n , and some of these m ay not
be covered by specific am endm ents to the law . A s
a resu lt the relatio n sh ip s set forth in the o rig in al
legislatio n are lik e ly to be m odified and supplem ented
som ew hat by in terp retatio n , precedent, and practice,
so th at actual o p eratin g relatio n sh ip s m ay v a ry from
those o rig in a lly established.
O w nership and C ontrol A s n o ted ab o v e , m o st of
the e a rly in stitutio ns w hich perform ed some cen tral
b an kin g functions w ere p riv a te ly owned. In con­
trast, n e arly all of the banks created in recent y e a rs
are owned e n tirely by the governm ent, and go vern ­
m ents have assum ed ow n ersh ip of some of the e a rly
ones. In addition, as related above, governm ents
u su ally in sist upon a la rg e sh are of the profits, in ­
clu d in g the resid u al share. A lso, the governm ent is
u su ally the resid u al claim an t in case the bank should
be liquidated .
R eg ard less of the exten t to w hich the national
governm ent sh ares in ow nership, it in v a riab ly p a r­
ticip ates in control. T h is u su a lly takes the form of
ap p o in tin g the go v ern in g board or several of the top
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
officials. W h ere the governm ent owns the bank com ­
p letely, it, of course, has com plete control and the
only question th at rem ain s is how that control shall
be exercised.
P osition in the G overn m en tal S tru c tu re T h e e x ­
act position w hich the cen tral bank should occupy in
the governm ent has long been a delicate and difficult
question. Sin ce the bank ex ercises a m ajo r gov­
ernm ental pow er and since the governm ent alw a y s
ex ercises a considerable control over it and often
owns it o utrigh t, w h y should the bank not be a reg u ­
la r governm ent bureau, p resum ab ly in the trea su ry
or the ex ch eq u er? T h at w ould seem to be the direct
and sim ple solution, but h isto ry provides m an y w arn ­
ings ag ain st it.
In the financial field the governm ent ex ercises tw o
m ajo r functions. T h e first is the fiscal fu n ctio n ; it
m ust raise the funds to cover the costs of the m an y
activities it carries on. T h is is u su ally done by ta x ­
ation, but ta x es are un p leasan t and p o litically un ­
popular. T h e second m ajo r function is th at of p ro ­
v id in g an adequate and sound m oney system . T he
governm ent has the sole powrer to control the crea­
tion of m oney. T h e im m ediate effect of in creasin g
the m oney sup p ly is lik ely to be w idesp read e x h ila ra ­
tion and superficial p ro sp erity for n e a rly everyb o dy,
w h ereas in creased tax atio n is lik e ly to have opposite
effects. In the long run, how ever, in flatin g the
m oney sup p ly is a m ethod of taxatio n and h isto rical
experience in m an y countries has shown th at u lti­
m ately it is both in equitab le and d isastro us.
If a sin gle au th o rity w ith in the governm ent has
control over both the fiscal and m oney functions
there w ill ah vays be the tem ptation to cover cu rren t
exp en d itures by creatin g m oney rath er than raisin g
it through taxatio n . If the governm ent is w eak, in ­
com petent, shortsigh ted, or beset w ith stro n g political
forces, it is lik ely to take the easy route of inflation.
T he resu lt is alm ost certain to be a stead ily risin g
m oney sup p ly and an uncontrolled inflation. F in an ­
cial h isto ry affords scores of exam p les of the dan gers
of trea tin g the cen tral bank as ju s t another go v ern ­
m ent bureau.
F u rth er, the h ig h ly specialized and technical
operations w hich cen tral banks en gage in req u ire a
special relatio n sh ip w ith com m ercial banks w hich
fewr, if an y, other governm ent agen cies have w ith
firm s in the p rivate econom y. T hese conditions can ­
not e x ist unless the cen tral bank has some degree of
in d iv id u ality and autonom y.
In addition, there is the fact th at the governm ent
needs ex p ert and p o litically im p artial advice on fi­
n an cial m atters. To provide such advice is one of
5
April 1962
the m ajo r resp on sib ilities of a cen tral bank. M r.
M o n tagu N orm an, reg ard ed as one of the greatest
G overnors of the B an k of E n glan d , stated on one
o ccasio n : “ I look upon the B an k as h av in g the unique
rig h t to offer advice an d to press such advice even to
the point of n a g g in g ; but a lw a ys of course subject
to
the suprem e au th o rity of the govern m en t.”
A n astute observer of the A m erican scene arriv ed
a t m uch the sam e co n clusio n : “ It w ould not be
to lerated to have a cen tral bank . . . in the hands of
p rivate persons as distin gu ish ed from rep resen tatives
of the people. T h e cen tral bank is an in strum en t of
Top: left, Bank of Canada; center, State Bank of Pakistan; right, Banco Central de Venezuela
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
April 1962
governm ent and m ust a lw a y s be so. H o w ever, it
is not an in strum en t of the fiscal au th o rity. W h a t
is needed is th at the tw o auth orities be represented
by persons of equal r a n k ; eq u ality of ran k is essential
for effective cooperation. T h is should be recognized
( 1 ) by the fiscal and m o netary auth orities them selves
and ( 2 ) by C ongress and the P resid en t and the g en ­
eral p ub lic.”
T h e advice, the p ersistence, and the eq u ality of
ran k envisioned in these statem ents w ould not be
av ailab le if the cen tral bank w ere an o rd in ary gov­
ernm ent bureau.
Bottom: left, The Central Bank of China (Taiwan); center, Banque de France; right, Banca d'ltalia
Digitized for FRASER
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis