Central banking 18: Governor and

board members are trustees and not

owners of the central bank
March

30, 2015
A central bank can earn its living by printing money
A central bank is a unique species. It does not have to work in order to earn
its existence. This is because it has been given a power which no one else
in society has. That power is to have all the resources it wants just by
assuming a liability through a mere book entry.
For instance, suppose it wants to lend to the government by buying a
Treasury bill. All it has to do is to debit a Treasury bill holding account in its
books and debit that account and credit the value it has lent to the
government to the governments deposit account which it maintains in its
books.
Then, how does the government make use of the money lent to it by the
central bank? It can do so by resorting to one of the two methods available
to it. One is that it can write a cheque on its account with the central bank
and make payments to somebody in the economy. The recipient of the
cheque will collect cash from his bank which will collect it in turn from the
central bank. Or else, the government can withdraw cash directly from the
central bank and make payments to somebody in the economy. In either
case, the central bank meets its liability by issuing currency which it can
print at its pleasure.
To print a currency note, the central bank does not have to incur a cost
equivalent to the face value of a given currency note. This is because
currency notes today are printed on paper and not made of precious metals
like gold or silver. Hence, to issue a 5,000 rupee note, the central bank
incurs a cost of, say, about 10 rupees. This is a highly profitable business
because it earns a profit of 4990 rupees for the central bank. Such profits
are known in economics as seigniorage.

Monetary
board
headed by governor should live up to the trust placed by public in them
Hence, those who run central banks may be tempted to earn the maximum
seigniorage for them as well as for the political masters who have
appointed them. But excessive seigniorage means excessive printing of
money and excessive printing of money means excessive inflation in the
economy. The real harm which this process would do to an economy was
discussed in a previous paper in this series titled Is a little bit of inflation
necessary for economic growth? (available at:
http://www.ft.lk/2014/02/10/is-a-little-bit-of-inflation-necessary-foreconomic-growth/).
The article has argued that such a policy is a lose-lose policy since both
the government and the members of the public stand to lose at the end.
The biggest loss to the public is the loss of wealth which they have kept in
money form trusting the central bank. Society has placed the
responsibility for preserving that trust in a group of people called the
Monetary Board headed by the Governor of the Central Bank.
Governor and Monetary Board are trustees and not owners
Thus, the governor and the members of the monetary board are simply
trustees and not the owners of a central bank. A trustee has a legal
meaning as well as an economic meaning. The legal meaning is that a
trustee has to take the same care and caution when he handles the assets

of the beneficiaries as when he handles his own assets.

In other words, since he does not allow his own assets to perish but
prosper, he should not allow the assets belonging to the beneficiaries to
decay through negligence but take all measures to enhance their value. In
this manner, the trustees of a trust are bound by a legal obligation and that
legal obligation is known as fiduciary obligation binding them.
Economic trusteeship requires the board to take adequate risk mitigation
measures
The economic meaning of a trustee too derives from the legal meaning but
it goes beyond that. Economics does not recognise that one can always be
successful in his enterprises. He can be a success or a failure depending on
how he organises his enterprise and what sort of market conditions he
faces.
Accordingly, in economics, a person would take a reasonable risk in order to
make an expected amount of profits. These people in economics are called
investors and they differ from speculators. The latter will take excess risk in
order to make super or extraordinary profits. Both investors and speculators
live in an economy and they are found side by side with each other.
Society does not expect the members of the monetary board headed by
governor to function as speculators. Instead, they should function like
investors who know the extent of risk they take and are knowledgeable of
the need for introducing risk mitigating mechanisms in running central
banks.
No imprudent practices in a central bank
There are three prerequisites which governor and the monetary board
members should possess to perform the job of trusteeship cast on them.
One is the constant awareness of the risks they would face if they follow
imprudent practices. The second is the governance practices which both
the governor and board members follow requiring them to answer their own
conscience rather than a legal authority. The third is the knowledge base
which they should acquire in order to function as an economic trustee.
Losses of central banks become a burden to taxpayers
It is the imprudent policy which a central may have adopted that would lead
to its eventual bankruptcy. At this stage, the fact that a central bank can
acquire assets by printing money will not come to its rescue. The rescue
comes to it from following proper risk management in central banks.

This was explained in a previous article in this series titled Even mighty
central banks can go broke if imprudent policies are adopted (available at:
http://www.ft.lk/2013/12/02/even-mighty-central-banks-can-go-broke-ifimprudent-policies-are-adopted/). It was pointed out that a central bank
should not get into speculation of currencies and exchange rates or into
heavy foreign borrowings since the outcome would be an incurrence of
embarrassing losses for the countrys taxpayers.
Three widely-publicised cases were discussed in the article. The first related
to Bank Negara Malaysia speculating on the British pound in early 1990s
and losing an estimated $ 5.5 billion. The second was how the Bank of
Thailand sought to protect Thai Baht insanely in 1990s and lost $ 25 billion
in the process. The third involved the Central Bank of the Philippines
borrowing heavily to finance governments loss making capital projects and
becoming bankrupt in 1993.
In all these cases, the losses were borne by taxpayers and therefore the
governing boards of the respective central banks had failed to discharge
their trustee obligations properly. Hence, proper risk management in a
central bank is a must and the Governor and the board members should
establish proper risk management mechanisms in them.

Good governance in central banks is important on three grounds. First, society looks
up to central banks as model institutions to emulate. If they do not have good
governance practices, then, the place of the central bank in society is grossly
undermined. Second, central banks insist that all banks and financial institutions that
are being supervised and regulated by them should have good governance practices. If
the regulator does not have good governance practices, then, it cannot impose its will
on banks. Third, good governance improves the internal management of a central bank
and establishes a proper accountability mechanism in it
Both the governor and Monetary Board members should possess a clear and high
knowledge of economics, banking, finance, etc. They should have a very wide global
outlook. They must be aware of the emerging global conditions and make suitable
changes to the domestic monetary and financial policies to mitigate the risks involved.
Above all, as Exter had highlighted, they should be people of unquestioned integrity
and responsibility. What this means is that if anyones integrity has come to be
questioned, he does not fit to hold the high post of governor of the Central Bank or
become a member of its Monetary Board. The same requirement holds equally for the
senior career officers of the Central Bank too
Good governance a must for a central bank
Good governance in central banks is important on three grounds. First,
society looks up to central banks as model institutions to emulate. If they
do not have good governance practices, then, the place of the central bank
in society is grossly undermined. Second, central banks insist that all banks
and financial institutions that are being supervised and regulated by them
should have good governance practices. If the regulator does not have
good governance practices, then, it cannot impose its will on banks. Third,
good governance improves the internal management of a central bank and
establishes a proper accountability mechanism in it.
These issues were discussed in detail in the article titled Governance of
central bank boards published in this series (available at:
http://www.ft.lk/2013/08/19/principles-of-central-banking-2-governance-ofcentral-bank-boards/). As the article has argued, governance principles that
stipulate clearly the relationship which the monetary board has with its
stakeholders help it earn market confidence, establish financial integrity
and promote economic efficiency.
Governance components in a central bank

There are several components of governance requirements which a central

bank should follow. First it should address failures of market information
flows, bad and incomplete communications and non-recognition of the risks
faced by a central bank. Second, action should be taken to improve the
quality of management of central banks at all levels.
Third, it should make the best use of banks assets, resources
and intellectual capital. Fourth, it should develop appropriate
risk mitigation mechanisms inside central banks. Fifth, it should
continuously communicate with the stakeholders the
performance of the bank through regular and pre-announced
communication actions. These are essential ingredients which
Governor and the board members should master if they are to
serve as trustees of people.

Handling proper money is the responsibility of the monetary

board
The monetary board headed by governor deals with money and it is
therefore different from the board of a corporation. John Exter, the founding
architect of the Central Bank of Sri Lanka, explained this in the report he
submitted to the Government for the establishment of a central bank in
Ceylon, known as Exter Report, as follows: The word monetary in its
name emphasises again that the Board is intended to be very much more
than simply the board of directors of another bank. It is a Governmental
agency responsible for the determination of a particular kind of policy
monetary policy and the regulation of a particular kind of economic
activity money, banking and credit (p 11). Thus, it is imperative that the
governor and the board members are people with knowledge on money and
monetary policy.
Governor and board members should have rich experience and knowledge
This is the reason for filling the governing boards of central banks with nonexecutive members drawn from a pool of experience and knowledge in
banking, economics, trade, commerce and industry. The objective is to draw
on the rich experiences of each other to steer the policy of central banks
towards the effective attainment of their goals and objectives.
However, in some cases, deputy governors who are full-time executives of

central banks have been made board members, but they are always being
outnumbered by the non-executive members appointed from outside.
Deputy governors should also be people with knowledge, experience and
maturity
Hence, in banks where the majority rule constitutes the decision making
criterion, the appointment of deputy governors who are a minority, does not
add value to the policy making of a central bank. Thus, in countries like Sri
Lanka where deputy governors are not vote carrying board members but
only in attendance at board meetings, an opportunity is provided for board
members to consult them on important policy issues.
However, for deputy governors to perform this job effectively, they should
be well versed in all aspects of central banking and global developments in
addition to having a detailed institutional memory which the board can tap
whenever it has doubts about any policy action being contemplated.
John Exter: Governor should be of unquestioned integrity
In the case of Sri Lanka, the governor who heads the Monetary Board
should be a person with wide experience and knowledge in economic,
financial and banking matters to lead the Board as well as the Central Bank
in the proper direction.
John Exter elaborated on this in the Exter Report as follows: The governor
should be a man of recognition and outstanding competence in and
understanding of the economic and financial problems of Ceylon, and of
unquestioned integrity and responsibility (p 16).
This is not explicitly laid down in the Monetary Law Act under which the
Central Bank has been set up in Sri Lanka. It is therefore left for the
appointing authority to take it into account when he selects a particular
person as the governor of the Central Bank. However, in many central
banking legislations, as noted by Exter, this has been incorporated as a
guidance to the authority which appoints the governor. This omission by
Exter has led in Sri Lanka to appoint people who do not possess these
qualifications to the post of governor of the Central Bank with subsequent
disastrous results.
Sri Lankas method of appointing governor and board members is defective
The procedure for appointing the governor and Monetary Board members in
Sri Lanka is far from ideal. In the case of the governor, in terms of Section
12 of the Monetary Law Act, the President can appoint anyone as governor

provided he is recommended by the Minister of Finance. In the case of other

Board members, once again the President can appoint any person to the
Monetary Board if he is recommended by the Minister of Finance and the
Constitutional Council set up under the 17th Amendment to the
Constitution gives its concurrence to such appointment. As such, the
qualifications and attributes which the Governor and board members should
possess are seldom taken into account when appointing persons to the
respective positions in the Central Bank. There have been occasions in the
past that political loyalty has played the dominant role in the selection
rather than the knowledge base and other attributes in the selection of
persons to these high positions. It is simply a betrayal of the trusteeship
which the people expect of the two high positions in the bank.
Amend MLA to introduce a better appointment system
Because of the possibility for abusing the appointing power by politicians,
many central bank laws have specified a long head-hunting, screening and
selection process for the post of governor and board members.
In the case of the Bank of Canada, searches for a potential candidate for
governors post begin long before the incumbent governor is due to retire
from the post. A similar practice is being followed by the Bank of England
too.
Even in new central bank laws in Nepal and Bhutan, selection is made from
out of a number of short-listed candidates. In the case of the Chairman of
the Federal Reserve System in USA, the nominated candidate has to face a
screening public interview at the Congress.
These provisions have been made in order to facilitate the selection of the
best candidate for the post of governor since it is in his hands the society
places the responsibility for protecting the monies they hold. It is therefore
an urgent priority under the good governance regime to amend to Monetary
Law Act to provide for a better selection and appointment system for the
post of governor and other board members.
Value comes from knowledge, experience and maturity and not from
political loyalty
Both the governor and Monetary Board members should possess a clear
and high knowledge of economics, banking, finance, etc. They should have
a very wide global outlook. They must be aware of the emerging global

conditions and make suitable changes to the domestic monetary and

financial policies to mitigate the risks involved.
Above all, as Exter had highlighted, they should be people of unquestioned
integrity and responsibility. What this means is that if anyones integrity
has come to be questioned, he does not fit to hold the high post of governor
of the Central Bank or become a member of its Monetary Board. The same
requirement holds equally for the senior career officers of the Central Bank
too.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri
Lanka, can be reached at waw1949@gmail.com.)