Economics

Role of CB towards Financial Stability

Central bank mandate

The role and structure of Central bank may differ depend on their mandate. There is however a universal agreement that the key functions of a modern central bank is macroeconomic stabilization.

Regardless of whether or not financial stability is explicitly mentioned in the law, implicitly determined under the mandate of preserving macroeconomic stability, or not mentioned at all, the public nonetheless assumes and expects that it is the central bank’s duty to maintain financial stability.

Fundamental to that understanding is the fact that even if the central bank does not supervise financial institutions, the central bank is always the lender of last resort – an indispensable tool for maintaining financial stability.

Central bank’s role in supervision and regulation

So what implications does financial stability mandate have for the role of central banks?

* Central banks have two principal duties under their financial stability objective, namely the prevention of instability, and management of the consequences once the markets become unstable.

* The former involves the formulation of appropriate and sound financial regulations, effective financial institution supervision and management of an efficient payment system.

* On the other hand, to mitigate consequences of instability, the central bank can employ various tools such as lender of last resort, discount window or even reserve requirements and appropriate interest rate policy.

How should supervisory function be organized?

It is true that supervisory function can be organized in many different ways depending on factors unique to each country, such as economic and social environment, the nature of its financial system, legal system and the maturity of political institutions. In other words, there is not a “one size fits all” model.

A credible and effective supervisory function rests on the following four pillars....