Role & Importance of SBP

Introduction
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective counties. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation's legal tender. The primary function of a central bank is to provide the nation's money supply, but more active duties include controlling interest rates and acting as a lender of last resort to the banking sector during times of financial crisis. It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. Central banks in most developed nations are independent in that they operate under rules designed to render them free from political interference. Examples include the European Central Bank (ECB), the Bank of England, and the Federal Reserve System of the United States.

Activities and responsibilities

Functions of a central bank may include: implementing monetary policy determining Interest rates controlling the nation's entire money supply the Government's banker and the bankers' bank ("lender of last resort") managing the country's foreign exchange and gold reserves and the Government's stock register regulating and supervising the banking industry setting the official interest rate used to manage both inflation and the country's exchange rate and ensuring that this rate takes effect via a variety of policy mechanisms

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Monetary policy
Central banks implement a country's chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the IMF), currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for "money" under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of nothing more than a promise to pay the same sum in the same currency. A central bank may use another country's currency either directly (in a currency union), or indirectly (a currency board). In the latter case, exemplified by Bulgaria, Hong Kong and Estonia, the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency. In countries with fiat money, expression "monetary policy" may refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority.

Goals of monetary policy

Price Stability Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation. High Employment The movement of workers between jobs is referred to as frictional unemployment. All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy. Economic Growth

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Economic drawn upon for investment. Interest Rate Stability

growth

is

enhanced

by

investment

in

technological advances in production. Encouragement of savings supplies funds that can be

Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult. Financial Market Stability Foreign Exchange Market Stability Conflicts Among Goals Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.

Currency issuance
In similarity with commercial banks, central banks hold assets (foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding). Central banks earn money generally by issuing currency notes and selling them to the public in exchange for interest-bearing assets such as government bonds. Income from the interest paid by the government on those bonds is referred to as seigniorage. The European Central Bank remits its interest income to the central banks of the member countries of the European Union. When a central bank wishes to purchase more bonds than their respective national governments make available, they purchase assets denominated in foreign currencies.

Interest rate interventions

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. SBP composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies.

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Policy instruments
The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules. 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").

Interest rates
By far 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. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required. 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. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited. Other central banks use similar mechanisms. It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a
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target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced. "The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." Henry C.K. Liu. Liu explains further that "the SBP lending rate is known as the SBP funds rate. The SBP sets a target for the SBP funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market ... a fiat money system set by command of the central bank. The SBP is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market."

Open market operations

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. Conversely, 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: 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. Buying or selling securities ("direct operations") on ad-hoc basis. Foreign exchange operations such as forex swaps.

Banking supervision and other activities

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In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as the SBP Treasury, or an independent government agency. It examines the banks' balance sheets and behavior and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Functions of Central Bank

Function of Central Bank
In the monetary and banking setup of a country, central bank occupies central position and perhaps, it is because of this fact that this called as the central bank. In this way, this bank works as an institution whose main objective is to control and regulate money supply keeping in view the welfare of the people. Central bank is an institution that fulfills the credit needs of banks and other credit institution, which woks as banker to the banks and the government and which work for the economic interest of the country. 1. Monopoly of note issue Note issue primarily is the main function of a central bank in every country. These days, in all the countries where there is a central bank generally it has got the monopoly of the sole right of note issue. In the beginning this was not the function of central bank, but gradually all the central bank gas acquires this function. There are many advantages of the note issue by central banks some important ones are as follow: Central bank controls the credit creating power of commercial bank. By controlling the amount of currency in circulation, the volume of credit can be controlled to quite a large extent. People have more confidence in the currency issued by the control bank because it has the protection and recognition of the government. In the event of monopoly of note issue of central bank, there will be uniformity in the currency system in the country.

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The currency of the country will be flexible if the central bank of the country has the monopoly of note issue because central bank can bring about changes very early in the volume of paper money according to the needs of business, industry and messes.

The system of note issue has some advantages. If the central bank of the country has the monopoly of note issue, all such advantages will accrue to the government.

2. Bankers, Agent and Adviser to the Government As banker to the government, central bank provides all those service and facilities to the government which public gets from the ordinary banks. It operates the account of the public enterprise. It mangers government departmental undertaking and government funds and where there is a need gives loan to the government. From time to time, central bank advice the government on monetary, banking and financial matters. 3. Custodian of Cash Reserve of Commercial Bank Central bank is the bank of banks. This signifies that it has the same relationship with the commercial banks in the country that they gave with their customers. It provides security to their cash reserves, give them loan at the time of need, gives them advice on financial and economic matter and work as clearing house among various members bank. 4. Custodian of Nations Reserve of International Central bank is the custodian of the foreign currency obtained from various countries. This has become an important function of central bank. These days, because with its help it can stabilize the external value of the currency. 5. Lender of The Last Resort Central bank works as lender of the last resort for commercial banks because in the time of need it provides them financial assistance and accommodation. Whenever a commercial bank faces financial crisis, central bank as lender of the last resort comes to its rescue by advancing loans and the bank is saved from being failed. 6. Clearing House Function

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All commercial bank have their accounts with the central bank. Therefore, central bank settles the mutual transactions of banks and thus saves all banks controlling each other individually for setting their individual transaction. 7. Credit Control These days, the most important function of a central bank is to control the volume of credit for bringing about stability in the general price level and accomplishing various other socio economic objectives. The significance of this function has increased so much that for property understanding it. The central bank has acquired the rights and powers of controlling the entire banking. A central bank can adopt various quantitative and qualitative methods for credit control such as bank rate, open market operation, changes in reserve ratio selective controls, moral situation etc. Other Functions Besides the 7 functions explained above, central banks perform many other functions that are as follows: 8. Collection of Data Central banks in almost all the countries collects statistical data regularly relating to economic aspects of money, credit, foreign exchange, banking etc. from time to time, committees and commission are appointed for studying various aspects relating to the aforesaid problem. 9. Central Banking in Developing Countries The basic problem of underdeveloped countries is the problem of lack of capital formation whose main causes are lack of saving and investment. Therefore, central bank can play an important role by promoting capital formation through mobilizing saving s and encouraging investment.

Case Study
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A critical Study of Roles of the State Bank of Pakistan as Central Bank, in Micro and Macro Finance
The role of central banks in microfinance is related to their broader role in the financial system and in the economy more generally. Hence, any discussion of the role of central banks in microfinance must be informed by the debates that have taken place in recent years on their broader role and objectives. Central banks have a number of objectives, which Chandavarkar (1996) has classified as follows: 1. tactical or macroeconomic objectives (relating primarily to the domestic price level and the exchange rate); 2. long-term strategic objectives of financial sector development (including the development of an effective payments system and other forms of financial infrastructure); and 3. sectoral or microeconomic objectives (such as prudential supervision and deposit insurance). The goals of monetary policy include economic growth, low inflation, and stability of the currency. However, most commentators now believe that the main contribution that monetary policy can make to economic management in the long run is to maintain low inflation. It is generally agreed that low inflation provides a necessary base for sustained economic growth and development. Indeed, in a number of countries, low inflation has proved important for the development of a sustainable microfinance sector. In some cases governments have set indicative inflation targets, with central banks expected to maintain the rate of inflation within a target band. It is also generally accepted that central banks are most effective in maintaining low inflation and in performing their other proper functions when they are independent of government. There has been a trend in a number of industrial countries recently to divide the functions of the central bank between two separate agencies. In this model, the central bank proper retains responsibility for the conduct of monetary policy, stability of the financial system, and regulation of the payments system. A new bank

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supervision agency is established to undertake prudential regulation and supervision of deposit-taking institutions. However, so far at least, this model has not been adopted to any extent in developing countries of Asia. In all but one of the countries included in this study, the central bank retains responsibility for both monetary policy and prudential regulation and supervision of the banking sector. The exception is Indonesia, where responsibility for prudential supervision of licensed financial institutions is to be transferred from the central bank to a separate supervisory agency by the end of 2002.

Developmental and Promotional Activities of SBP

A more important issue for the purposes of this study relates to what may be called the developmental activities of a central bank. How central banks see these activities depends to some extent upon the level of maturity and development of each financial system. According to Chandavarkar, In the early days of the central bank the accent has necessarily to be on the development of a banking system to control because this is not only a logical order but also the typical historical sequence (1996, 95). Reference to the relevant legislation, or to the official mandate of a central bank, may not be very helpful as a guide to the character of its current activities. Such legislation tends to be changed infrequently and at long intervals; the actual activities of the bank may diverge from the legal situation increasingly over time. In this context, Chandavarkar makes the distinction between developmental and promotional functions of a central bank. He argues that the exercise of developmental functions is justified, if at all, only in the very early stages of central banking. These functions should be divested over time, and divesting them may be a precondition for central banks to achieve independence of government. Such developmental activities include credit guarantees and insurance, participation in the capital and management of development institutions, priority sector lending, differential interest rates, preferential rediscount rates and facilities, and setting target credit/deposit ratios for rural branches of banking institutions. Government ownership of banks may also be considered as a developmental activity, although such ownership and the activities flowing from it may not necessarily involve the central bank directly. It is important to note that developmental activities are generally intended to contribute to the development of the
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economy as a whole, not to the development of the financial sector itself. In fact, they often contribute to situations of financial repression and are antithetic to financial sector development. However, this need not always be the case. As against these divestible functions, the promotional role of the central bank is: Crucial in financial development in terms of filling the gaps in the financial structure in respect of instruments, institutions, markets and personnel. It should be envisaged in terms of active supply-leading initiatives rather than passive demandfollowing response considering that the financial system is predicated on the dictum that facilities create traffic (Chandavarkar 1996, 120). Chandavarkar further describes promotional activities as measures that generate externalities and reduce transaction and information costs. In this case, the central bank is cast in the role of innovator and catalyst. He sees the promotional role as a continuing one for central banks in developing countries. Promotional activities may include support for pilot projects using innovative approaches to microfinance, the conduct of research, the collection and publication of data, and advocacy and training. The dividing line between developmental and promotional activities is blurred. However, developmental activities are undertaken to affect the allocation of resources directly, often involve long-term programs, and generally require significant financing by the central bank with implications for aggregate money supply. By contrast, promotional activities involve short-term programs, are intended to catalyze unsubsidized and voluntary activity by the private sector, and involve negligible commitments of central bank financial resources.

Financial Repression as a Consequence of Developmental Activities

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Role & Importance of SBP

Financial repression can be defined as distortions of financial prices including interest rates and foreign exchange rates (Shaw 1973, 34). In recent decades central bankers have become much more aware of the dangers of financial repression, due to the works of McKinnon (1973) and Shaw (1973). Nevertheless, in a survey of developing countries central banks conducted in 1995, Fry et al. (1996) noted the continuing operation of the instruments of financial repression. There are several reasons for the persistence of such practices. Governments may attempt, through their central banks, to encourage private investment in what they regard as priority activities. Also, in some developing countries (and some developed ones) governments have limited capacity or fiscal discipline to raise funds from nonbank sources. Under these circumstances, Fry et al. comment that short-sighted governments have in many cases effectively used their central bank as a fiscal milch cow (1996, 9). It is now widely accepted that controlling interest rates and directing credit for developmental purposes have not been effective in achieving their objectives. In fact, such measures have had a negative effect on economic development by discouraging financial intermediation for the following reasons, among others: Below-market rates of interest discourage saving and hold saving and investment below their socially optimal levels. Potential depositors tend to undertake investment projects with relatively low rates of return, rather than depositing their money in a financial institution for onlending to the initiators of projects with higher returns. Directed credit and credit rationing distort the allocation of bank lending between projects, reducing the average quality of investments. Similar criticisms have also been leveled against government ownership of banks and the quasi-fiscal activities of central banks (for example, refinancing and credit guarantees). For example: In many countries, government ownership of banks and other financial institutions has been used deliberately as an instrument of financial repression, to direct subsidized credit to particular favored activities. A recent study by La Porta et al. (2000) found that government ownership of banks is associated with slower

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Role & Importance of SBP

financial development and lower growth in per capita income in those countries where it occurs. Fry et al. (1996) argue that by making central banks responsible for quasi-fiscal activities, developing country governments undermine both the independence of central banks and monetary policy objectives. Fiscal activities reduce central bank profits and may even produce losses. If losses are not met from government budget appropriations, they will eventually lead to an expansion in central bank money, compromising the objective of price stability. These considerations suggest that central banks should not support microfinance through measures such as directed credit programs, interest rate controls, ownership of financial institutions, and quasi-fiscal activities.

Financial Liberalization
Since the pioneering analyses of McKinnon and Shaw, it has been widely accepted that central banks can contribute to economic development by eschewing financially repressive (developmental in Chandavarkars parlance) activities in favor of financial liberalization. There is considerable empirical evidence that rapid financial development (resulting largely from legal and policy changes to liberalize the financial system) has been associated with rapid economic growth in many developing countries. Levine (1997, 720) found in a recent survey of the literature that: A growing body of empirical analyses, including firm-level studies, industry-level studies, individual country studies, and broad cross country comparisons, demonstrate a strong positive link between the functioning of the financial system and long-run economic growth. More recently, however, there has been some reassessment of the efficacy of rapid financial liberalization in light of the East Asian financial crisis. While rapid liberalization and the associated financial development can contribute to economic growth, it can also create the conditions for financial collapse unless it is accompanied by complementary legal, regulatory, human resource, and informational reforms. Moreover, such complementary reforms may be very difficult to achieve. For instance, Demirguc-Kunt and Detragiache (1998) examined the relationship between financial liberalization and banking crises in 53 countries between 1980 and 1995. They
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found that, after controlling for other factors, financial liberalization had a non-trivial negative effect on the stability of banking systems. While this effect was moderated by the presence of strong institutional environments, they noted that governments cannot create strong institutions overnight. The researchers concluded that the path to financial liberalization should be a gradual one, and that there should be more research on the design and implementation of prudential regulation and supervision in developing countries. In similar vein, Cole and Slade (1999) note that in Indonesia, many millions of dollars and technical assistance were provided to improve the legal, accounting, and prudential regulatory infrastructure in that country, but it has remained weak. Notwithstanding this reassessment, most commentators would still accept that central banks can and should contribute to the development of microfinance through careful and appropriately sequenced financial liberalization. Liberalization enables the financial system to reach some households that would otherwise not have access to formal financial services. This study considers some important ways in which liberalization can contribute to the development of a sustainable microfinance sector, such as through deregulating interest rates and removing barriers to entry of new institutions into the formal financial system.

Promotional Activities of Central Banks

Financial liberalization by itself is not a sufficient condition for ensuring that large numbers of poor households have access to financial services on a continuing basis. The formal financial system reaches only a small proportion of households in developing countries. And while this proportion may be higher in some countries that have undertaken extensive financial liberalization, even in these countries there are still large numbers of poor households that are not served by the formal financial system. According to Fry et al. (1996), overcoming financial repression involves not only the removal of impediments on financial institutions and markets, but also positive encouragement, by the central bank and other relevant authorities, of financial markets. These measures of positive encouragement are the promotional activities described by Chandavarkar. This suggests a possible role for central banks in promoting financial systems able to reach poor households on a sustainable basis.
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As noted, promotional activities may include support for pilot projects using innovative approaches to microfinance, as well as research, collection and publication of data, advocacy, and training. Central banks can do these things by virtue of their role as apex bodies for their financial systems, which equips them to exercise leadership and provide coordination. The extent of central bank involvement in such activities in any country will depend on the central banks comparative advantage with respect to other institutions, reflecting considerations such as the state of development of the financial system and the microfinance subsystem.

Activities of Central Banks in Practice

Central banks should generally limit their activities to monetary policy, the prudential regulation and supervision of licensed financial institutions, and promotional activities to encourage the development of the financial system, including microfinance. However, in practice the role of the central bank is generally much broader than this. In most countries, the mandate of the central bank supposes or requires an active role in fostering economic growth and development. More importantly, central banks have acted on such mandates and undertaken a wide range of developmental activities. These expanded in the 1950s and 1960s, when the nature and consequences of financial repression were not well understood. And while the focus of central banks on developmental activities has diminished gradually over time, in many countries they have persisted throughout the 1970s, 1980s, and 1990s and are still an important feature of the financial landscape. The focus on developmental activities has perhaps been most pervasive, among the twelve countries in this study, in the three economies in transition, although all three have reduced the emphasis on developmental activities in recent years. In PRC the central bank served as a monobank until 1978. There were no separate commercial banks, and the central bank was the sole financial entity and provider of credit. The central bank was directly involved in developmental activities on behalf of the government, extending loans at administered interest rates to particular industry sectors and state-owned enterprises in accordance with the centrally determined credit plan. The Chinese banking system was re-established after 1978, but the central bank continued to perform certain commercial banking activities. The current legislation for the central bank
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was promulgated in 1995, and takes domestic price stability as its primary objective. However, the central bank still has responsibility for some developmental activities. For instance, the list of legislated central bank functions includes the power to administer financial institutions and to control financial markets.

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