Understanding Central Banks Operations and Financials Book

Central banks play a crucial role in maintaining economic stability, and understanding their operations and financials is essential for anyone interested in finance or economics.

Central banks are responsible for managing a country's monetary policy, which includes setting interest rates and regulating the money supply.

The central bank's balance sheet is a key indicator of its financial health, and it typically includes assets such as government securities and loans to commercial banks.

The central bank's liabilities include currency in circulation and deposits held by commercial banks.

Central banks also engage in open market operations, buying or selling government securities to influence interest rates and the money supply.

These actions have a direct impact on the economy, affecting inflation, employment, and economic growth.

Understanding the central bank's balance sheet and operations is essential for making informed decisions about investments and economic policy.

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Central banks are major players in today's economic and financial policy-making. They are respected for their technical acumen.

Central banks are key in times of economic or financial crisis, as they have the power to respond with all available instruments.

Markets are artifacts of language, according to Douglas R. Holmes, who argues that central banks and the people who interact with them shape the economy.

A credible central bank can effectively lead the process of financial sector reform in a developing country.

Central banks have a brief history, which is explored in detail in the book. This history is essential to understanding their role in the economy.

Central banks play a crucial role in the economy by regulating money, credit, and banking. Money is the lubricant of the economy, as Nils Herger explains in his book.

Monetary-policy instruments are a key aspect of a central bank's operations. These instruments are used to control the money supply and interest rates.

The initial and final effects of monetary policy on inflation, output, and unemployment are complex and multifaceted. They are explored in detail in the book.

Central-bank independence is a critical aspect of a central bank's operations. It allows the bank to make decisions without political interference.

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International monetary policy is a key area of focus for central banks. They work together to coordinate monetary policy and maintain economic stability.

The past, present, and future of central banking are explored in the final chapter of the book. This chapter provides a comprehensive overview of the evolution of central banking.

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The Federal Reserve plays a crucial role in the global economy, and understanding its operations is essential for anyone interested in finance.

The Fed has a dual mandate: full employment and stable prices. This means it aims to keep the economy growing and inflation under control.

The Fed's primary tool for achieving its mandate is interest rates, which it uses to influence the economy. It thinks of the economy through the lens of interest rates, and there's a concept called r* (pronounced “r star”), which is the neutral rate of interest at which the economy is neither expanding nor contracting.

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When interest rates are below r*, the economy is expanding, inflation is rising, and unemployment is ticking lower. Conversely, when interest rates are above r*, the economy is slowing, inflation is declining, and unemployment is ticking higher.

The Fed's goal with Quantitative Easing (QE) is to lower longer-term interest rates, with the increase in reserves and bank deposits being a necessary byproduct. QE appears to lift financial asset prices but not necessarily economic activity.

Here's a list of the Fed's primary tools for understanding its operations:

The Fed has also become the world's central bank, as dollars are widely accepted and even preferred to some home currencies. In times of crisis, the Fed has shown a willingness to lend to foreign banks and support the offshore dollar market.

The Fed's emergency Section 13(3) lending powers allow it to lend to anyone, including foreign banks, which has essentially made it the backer of the global dollar system, both within and outside of the U.S.

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Commercial banks face two fundamental problems: solvency and liquidity. Solvency refers to a bank's ability to meet its financial obligations, while liquidity refers to its ability to meet short-term payment needs.

To ensure liquidity, commercial banks must have enough central bank reserves to settle payments with other commercial banks and enough currency on hand to meet depositor withdrawals. A bank that cannot meet payments or withdrawals will likely panic its depositors, even if it is fundamentally sound.

Commercial banks can borrow from other commercial banks or institutional investors if they underestimate their liquidity needs. As a last resort, they can borrow from the Fed's discount window, but there is a stigma associated with this option.

Here's a brief overview of the two main types of commercial bank borrowing:

Unsecured money markets, such as the federal funds market, allow commercial banks to borrow reserves from each other on an overnight unsecured basis. However, this market has largely disappeared due to regulatory rules and Money Market Reform.

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Commercial banks face two fundamental problems: solvency and liquidity. This means they must ensure they have enough central bank reserves to settle payments with other commercial banks and enough currency on hand to meet depositor withdrawals.

A bank that cannot meet payments or withdrawals will likely panic its depositors, even if it's fundamentally sound. This can lead to a loss of trust and potentially even a bank run.

To avoid this, banks can borrow from another commercial bank or an institutional investor if they underestimate their liquidity needs. As a last resort, they can borrow from the Fed's discount window, but there's a stigma associated with this option, suggesting the bank is in dire straits.

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Primary dealers are a group of dealers that have the privilege of trading directly with the Federal Reserve. They are the heart of the financial system and the primary conduit for Federal Reserve open market operations.

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In times of economic crisis, central banks like the Federal Reserve use primary dealers to implement quantitative easing by buying Treasuries. This is done by buying only from primary dealers.

Primary dealers act as financial intermediaries, borrowing from one client to lend to another. This is in addition to making markets for financial products.

The primary dealers buy securities or offer loans using funds they borrow from other clients, usually money market funds. They can also borrow from the Fed.

The terms of the financing offered by the Fed affect the terms they are willing to offer their shadow bank clients. For example, if primary dealers can borrow from the Fed at 1%, then the interest rates received by the broader market won’t be too much higher.

Here's a breakdown of the key characteristics of primary dealers:

Securitisation is a financing structure where a pool of illiquid financial assets is funded by issuing bonds to investors. This allows commercial banks to earn fees by originating loans and selling them to a securitisation vehicle.

Traditionally, commercial banks held on to the loans they originated, so they were careful about who they lent to. But with securitisation, they could focus on originating loans and selling them off, rather than holding onto them.

Securitisation vehicles can buy hundreds or thousands of loans and issue different bonds, each with distinct risk profiles. The principal and interest payments from the loans are used to pay off the bond investors.

Commercial banks were less interested in the loans they originated if they soured, as that was a risk borne by the securitisation bond investors. This shift in business model was driven by the potential for higher fees.

In the ABCP market, investment vehicles borrow short term in the money markets by issuing commercial paper and then invest the proceeds in longer tenor and more illiquid financial assets. This created a risk that would eventually manifest in the market.

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Offshore dollar banking is a significant aspect of the global financial system. The size of the offshore banking system is around $10 trillion as of 2018, accounting for roughly a third of the size of the global dollar banking system.

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A smaller foreign bank can build a dollar loan business, but it will use dollar deposits at a U.S. bank to settle interbank payments. This is essentially creating a fractional banking system built upon a fractional banking system.

The sheer size of the offshore banking system is staggering, with $10 trillion in assets. This is a reminder of the vast and complex nature of global finance.

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The Fed controls short-term interest rates through its control over overnight interest rates, specifically the federal funds rate, which is the rate commercial banks pay to take out an overnight loan for reserves on an unsecured basis.

In theory, the Fed sets a target range for the federal funds rate to exert influence throughout the short-term interest curve. However, this method became obsolete with quantitative easing, which increased bank reserves to a few trillion.

The Fed now controls the federal funds rate by adjusting the interest rate it offers on the Reverse Repo Facility (RRF) and the interest it pays on reserves held in Fed accounts. This effectively sets the minimum overnight interest rate in the market.

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The RRP offering rate is probably a more influential rate than the federal funds rate, as it's available to a wide range of market participants, not just commercial banks.

Longer-term interest rates are determined by the market, taking into account future short-term interest rates, estimates for future inflation, and supply and demand dynamics of Treasury debt issuance.

A common framework for thinking about longer-term yields is to decompose them into two components: the expectations for the path of short-term interest rates and a term premium.

The short-term interest-rate futures market offers a glimpse of what the market thinks short-term interest rates will be in the future, with the Eurodollar futures market being the deepest and most liquid derivatives market in the world.

The yield curve can be used to infer the market's perception of the state of the economy, with an inverted yield curve often seen as a sign that the economy will soon be in recession.

Here's a brief overview of the key factors that influence the yield curve:

The Fed's actions can also shape the yield curve, such as through quantitative easing, which lowers longer-term yields and flattens the yield curve.

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Money markets are where banks and other financial institutions lend and borrow money for short periods, typically overnight. Secured money markets, in particular, are crucial for the functioning of the financial system.

In secured money markets, borrowers put up financial assets as collateral for short-term loans. The two largest segments are the repo market and the FX-swap market. Repo transactions, which are essentially short-term loans collateralized by safe assets, are the lifeblood of the Treasury market, allowing Treasuries to be converted to bank deposits and back again with virtually no cost.

The repo market is massive, with a size of $3.4 trillion and comprised of three major segments: Tri-party, uncleared bilateral, and cleared FICC. The FX-swap market, on the other hand, is a market for foreign currency loans, with transactions similar to repo transactions but using foreign currency as collateral.

Debt capital markets, where companies and governments borrow money by issuing bonds, are another key area. Bonds are essentially promises to repay issued by borrowers in exchange for investors' bank deposits. Credit risk, which takes into account the likelihood of default and the recoverable amount, is a major consideration in debt capital markets.

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There are several types of money that play a crucial role in the money markets and securities. Bank deposits are a type of money created by commercial banks, and they can be converted into government-issued fiat currencies in real time.

In practice, bank deposits are as good as cash. You can withdraw them from any bank or ATM machine. This seamless conversion is a key feature of modern banking.

Commercial banks can also hold a special type of money called central bank reserves. These reserves are issued by the Federal Reserve and are interchangeable with currency from a commercial bank's standpoint.

Treasuries, on the other hand, are issued by the U.S. government. They can be converted into bank deposits by selling them in the market or using them as collateral for a loan.

Here's a quick rundown of the types of money:

Secured money markets are a type of short-term loan market where a borrower puts up a financial asset as collateral. This is done to mitigate risk and ensure that the lender gets their money back.

The two largest segments of secured money markets are the repo market and the FX-swap market. The repo market is the largest and most important market that most people have never heard of, with a size of about $3.4 trillion.

In a repo transaction, a borrower "sells" a security to a lender while agreeing to buy it back at a slightly higher price in the future. This is equivalent to borrowing money using the security as collateral.

The repo market is the essential link that allows Treasury securities to be "money." It allows Treasuries owned outright to be converted to bank deposits any time for virtually no cost.

Most repo transactions are overnight loans collateralized by safe assets, including U.S. Treasuries and Agency MBS. The slightly higher price paid to repurchase the security is equivalent to the interest on the loan.

The repo market is comprised of three major segments: Tri-party, uncleared bilateral, and cleared FICC. The FX-swap market, on the other hand, is a market for foreign currency loans.

Here are the two major secured money markets:

Unsecured money markets are markets for short-term loans where the promise to repay is backed by nothing other than confidence in the borrower. These loans tend to offer higher interest rates than secured loans because of the higher risk involved.

Commercial banks used to be major participants in the unsecured money markets, but they've largely disappeared. The well-known benchmark rate, 3-month LIBOR, is a benchmark rate for the interest rate a commercial bank would have to pay to borrow dollars on an unsecured basis for 3 months.

The federal funds market is the most well-known unsecured money market, where commercial banks borrow reserves from each other on an overnight unsecured basis. This market is where the Fed sets its policy rate.

Historically, commercial banks borrowed in the funds market to have enough reserves to meet reserve requirements at the end of the day or to meet daily payment needs.

Regulars have put forth rules that make it unattractive for a bank to borrow in the unsecured money markets, causing the interbank unsecured money markets to virtually disappear.

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Debt capital markets are where companies or governments borrow money by issuing bonds, which are essentially promises to repay investors' bank deposits. A bond is a financial instrument that represents a loan made by an investor to a borrower.

Credit risk is a key factor in debt capital markets, and it takes into account the likelihood of the borrower defaulting on the loan. Credit ratings are the single most important determinant of a bond's perceived credit risk, with higher-rated bonds being considered less risky.

Liquidity risk is another important consideration in debt capital markets, and it refers to the ease with which bonds can be sold before they mature. This is a crucial factor for investors who may need to access their money before the bond's maturity date.

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The central bank's role in debt capital markets has changed in recent years, with the ability to directly lower borrowing costs for corporations by buying corporate bonds. However, this has also led to concerns that corporate bonds have become less sensitive to economic fundamentals.

Central banks have several tools at their disposal to manage the economy during times of crisis. One way to do this is through forward guidance, where the Fed verbally commits to keeping its policy rate low for an extended period of time.

This verbal commitment can have a significant impact on the market, causing medium-term interest rates to move lower as investors price out potential rate hikes.

The Fed can also use quantitative easing to control longer-term interest rates by purchasing longer-dated Treasury bonds, which drives the yields of those bonds lower. This can help stimulate the economy by making borrowing cheaper.

In some cases, the central bank may announce specific numeric targets for its interest rates, known as yield curve control.

Basel III made banks safer by forcing them to hold more high-quality liquid assets like Treasury securities and encouraging reliable liabilities.

Regulators classified bank liabilities based on how "flighty" they would be in a time of stress, with retail deposits being the stickiest and unsecured deposits from banks and shadow banks the most unreliable.

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Large domestic banks were subject to the heaviest regulatory burden and pushed out many of their shadow bank clients to increase their footprint in retail banking.

This structural shift was further enhanced by reforms in the Dodd-Frank Act, which changed the way FDIC insurance fees were calculated.

The new assessment regime significantly broadened the assessment base to all assets minus tangible equity and made risk-based adjustments, encouraging U.S. banks to reduce their borrowings from institutional investors in money markets.

The effect of these changes was to shift large amounts of institutional money out of domestic banks and into foreign banks, which are not FDIC insured and thus not subject to FDIC assessment fees.

To illustrate this point, consider the following changes in bank liabilities:

Crisis management is a critical aspect of regulation, and the Federal Reserve has several tools at its disposal to manage economic crises.

Forward guidance is a way for the Fed to extend its control of interest rates from short-term rates to medium-term rates. By verbally committing to keep its policy rate low for an extended period, the Fed can influence medium-term interest rates.

The market's belief in the Fed's commitment is crucial, as it would price out any rate hikes from the present to medium term. This is a key concept to understand, as it shows how the Fed's words can have a significant impact on interest rates.

Quantitative easing is another tool the Fed uses to control longer-term interest rates. By purchasing longer-dated Treasury bonds, the Fed drives the yields of those bonds lower.

Yield curve control is a more direct approach, where the central bank announces specific numeric targets for its interest rates. This approach is more explicit and provides a clear direction for market participants.

These tools are not mutually exclusive, and the Fed may use a combination of them to manage a crisis effectively.

Modern Monetary Theory (MMT) is a game-changer in understanding how governments manage their finances. It postulates that a government issuer of fiat currency is not constrained by taxation or debt, but only by inflation.

MMT views taxation and debt issuance as tools to manage inflation, rather than as constraints on government spending. This is in stark contrast to conventional economic thinking, which tends to negatively view deficit spending and high government debt levels.

The government can simply print more money to fund its spending, as it does not need to borrow or tax. This means that deficit spending and high debt loads are not a source of concern, but can actually be good for the economy, provided inflation is under control.

Here's a quick summary of the key points of MMT:

Modern Monetary Theory (MMT) is a concept that challenges conventional economic thinking. It postulates that a government issuer of fiat currency is not constrained by taxation or debt, but only by inflation.

Taxation and debt issuance are merely tools that the government uses to manage inflation. Proponents of MMT argue that a country with a high debt load doesn't necessarily have to increase taxes on future generations to repay the debt.

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Conventional economic thinking views a country like a household, where living beyond one's means and going into debt means leaner times ahead. But MMT suggests that the government can simply print more money to fund its spending.

The government doesn't need to borrow or tax, but it should use those tools to combat inflation. In fact, proponents of MMT argue that deficit spending can actually boost economic growth by creating money and spending it on goods and services.

Deficit spending and high debt loads are not a source of concern and can be good for the economy, provided inflation is under control. This is a key difference between MMT and conventional economic thinking.

Here are some key takeaways from MMT:

About one-quarter of the world's central banks apply IFRS, with another quarter seeking guidance from IFRS where local standards fall short.

Central banks have unique mandates and operations, leading to significant variation in practice, style, and financial disclosures.

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There's no one-size-fits-all approach for central banks, as they often don't have local practices to follow.

Major accounting firms have created model disclosures for commercial banks, but these aren't always suitable for central banks.

The application of IFRS across central banks differs based on the central bank's mandate and the accounting profession's capacity in the jurisdiction.

Each central bank following IFRS has largely developed its own disclosures, with limited reference to others.

External auditors have provided significant input, but often based on their commercial bank experience rather than central bank specifics.

Auditors sometimes overemphasize non-material items and overlook key disclosures specific to central bank functions.

Financial reporting is a crucial aspect of a central bank's transparency and accountability. Approximately 50 central banks worldwide complied with IFRS for their external financial reporting in 2020.

Transparency in financial reporting contributes to a central bank's accountability, and applying an internationally recognized standard like IFRS adds to its credibility. Central banks need to tailor their financial disclosures to better inform readers of their operations and financial implications.

A central bank's external reporting of its financial position is a fundamental component of its transparency and accountability, and it should be done in a way that strikes a balance between transparency and confidentiality.

Central banks' external reporting of their financial position is a fundamental component of transparency and accountability. This includes applying an internationally recognized reporting standard such as IFRS, which adds to the credibility of their transparency.

In 2020, approximately 50 central banks complied with IFRS for their external financial reporting, demonstrating its successful adoption by central banks worldwide. This shows that IFRS can be adapted to meet the unique needs of central banks.

A central bank's transparency is an integral component of its accountability, and they are expected to explain and justify their actions and decisions. This includes giving an account of the use of the resources entrusted to them.

External accountability arrangements cover how the central bank reports, explains, and justifies its decisions and actions, as well as to whom the central bank reports.

Materiality plays a crucial role in financial reporting and accountability. It helps investors and stakeholders make informed decisions by highlighting the most relevant information.

The concept of materiality is often subjective, but it's generally considered to be information that would affect the decisions of investors or creditors if omitted or misstated. This is why companies must carefully consider what information is material and include it in their financial reports.

Materiality is not just about the size of a transaction or event, but also its significance to the company's operations and financial situation. For example, a small transaction might be material if it's related to a significant business decision or a major risk.

The Financial Accounting Standards Board (FASB) provides guidance on materiality, stating that information is material if its omission or misstatement could influence the decisions of investors or creditors. This means that companies must be transparent and provide clear information about their financial situation and operations.

In practice, materiality can be subjective and may vary depending on the industry, company, and stakeholder. However, by considering the significance and impact of information, companies can ensure that their financial reports are accurate and informative.

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