Page 34 - DMGT303_BANKING_AND_INSURANCE

Unit 2: Reserve Bank of India

2.4.4 Miscellaneous Functions Notes

1. Interest Rate Interventions: The most visible and obvious power of many modern central
banks is to influence market interest rates; contrary to popular belief, they rarely “set”
rates to a fixed number. Typically, a central bank controls certain types of short-term
interest rates. These influence the stock and bond markets as well as mortgage and other
interest rates.

The mechanism to move the market towards a ‘target rate’ (whichever specific rate is
used) is generally to lend money or borrow money in theoretically unlimited quantities,
until the targeted market rate is sufficiently close to the target. Central banks may do so
by lending money to and borrowing money from (taking deposits from) a limited number
of qualified banks, or by purchasing and selling bonds.
2. Monetary Policy Instruments: The main monetary policy instruments available to central
banks are open market operation, bank reserve requirement, interest-rate policy, re-
lending and rediscount (including using the term repurchase market), and credit policy
(often coordinated with trade policy).

To enable open market operations, a central bank must hold foreign exchange reserves
(usually in the form of government bonds) and official gold reserves. It will often have
some influence over any official or mandated exchange rates. Some exchange rates are
managed, some are market based (free float) and many are somewhere in between
(“managed float” or “dirty float”).

Through open market operations, a central bank influences the money supply in an economy
directly. Each time it buys securities, exchanging money for the security, it raises the
money supply. Opposite to this, selling of securities lowers the money supply. Buying of
securities thus amounts to printing new money while lowering supply of the specific
security.
The main open market operations are:
(i) Temporary lending of money for collateral securities (“Reverse Operations” or
“repurchase operations”, otherwise known as the “repo” market). These operations
are carried out on a regular basis, where fixed maturity loans (of 1 week and 1
month for the ECB) are auctioned off.

(ii) Buying or selling securities (“Direct Operations”) as per need.
(iii) Foreign exchange operations such as forex swaps.
All of these interventions can also influence the foreign exchange market and thus, the exchange
rate.

Capital requirements – Capital Adequacy

All banks are required to hold a certain percentage of their assets as capital, a rate which may be
established by the central bank or the banking supervisor. Partly due to concerns about asset
inflation and term repurchase agreements, capital requirements may be considered more
effective than deposit/reserve requirements in preventing indefinite lending: when at the
threshold, a bank cannot extend another loan without acquiring further capital on its balance
sheet.

LOVELY PROFESSIONAL UNIVERSITY 29