Module 2

Functions and Operations of Central bank/ Regulation and Supervision of Financial

Institutions

Introduction:
This module deals with the functions and operations of central bank, and the different monetary tools used
by central bank in attaining its objectives. It also includes the meaning of regulation and supervision of
financial institution and its comparison, as well as its purpose and benefits.

Content Exploration

About the Bank

The Bangko Sentral ng Pilipinas (BSP) is the central bank of the Republic of the Philippines. It was
established on 3 July 1993 pursuant to the provisions of the 1987 Philippine Constitution and the New
Central Bank Act of 1993. The BSP took over from Central Bank of Philippines, which was established on 3
January 1949, as the country’s central monetary authority. The BSP enjoys fiscal and administrative
autonomy from the National Government in the pursuit of its mandated responsibilities.

Monetary Policy

The primary objective of the BSP's monetary policy is to promote a low and stable inflation conducive to a
balanced and sustainable economic growth.

Price Stability

The BSP's main responsibility is to formulate and implement policy in the areas of money, banking and
credit with the primary objective of preserving price stability. Price stability refers to a condition of low and
stable inflation. By keeping price stable, the BSP helps ensure strong and sustainable economic growth
and better living standards.
Financial Stability

Financial systems play a critical role for consumers – both corporates and individuals – because they
bridge the aspirations of today with the economic fortunes of tomorrow. Historically, financial systems
develop through the banking industry because of the nature of fiat money. In this context, making sure that
banks operate in a safe and sound manner is in the public interest. Banks, after all, manage our savings,
offer critical services in the transfer of funds and the payment of obligations, while providing a venue for
entrepreneurs to pursue their economic plans through credit. Banking authorities nurture this by defining
the regulatory framework that encourages innovation while monitoring that banks operate within prescribed
governance guidelines.
 
The Global Financial Crisis (GFC), however, highlighted how the financial system is more than just the sum
of its parts. There is a unique sense of “systemic-ness” that arises from the way each market player
interacts with another party, creating a network of interconnected and sequenced transactions. This leads
to risk choices being interlinked within the network and as a result, societal outcomes that can differ from
the intentions of private entities. This provides the basis for the global initiative to manage the health of the
financial system as an explicit and separate policy objective. Its focus is on managing so-called “systemic
risks” and this is done through macroprudential policy.

Payments and Settlements

Payment systems are essential to the effective functioning of financial systems worldwide. They provide the
channels through which funds are transferred among banks and other institutions to discharge payment
obligations arising from economic and financial transactions across the entire economy. An efficient, secure
and reliable payment system reduces the cost of exchanging goods and services, and it is an essential tool
for the effective implementation of monetary policy, and the smooth functioning of money and capital
markets. It is this key role played by payment and settlement system (PSS) in the smooth functioning of an
economy in general and its financial and monetary system in particular that gives the central bank (CB) a
strong incentive for ensuring that an effective, reliable and secure payment and settlement system is in
place.

In the Philippines, the BSP takes the lead in promoting an efficient payments and settlements system by
providing:

 a. the necessary infrastructure through the operations of the Philippine Payment and Settlement
System or the “PhilPaSS”; and
 b. a policy and regulatory framework, also known as the National Retail Payment System or NRPS,
to establish safe, efficient and reliable retail payment system in the country.

Monetary Operations

Monetary operations refer to the implementation of monetary policy. To ensure that the monetary policy
decision is transmitted to the financial market and the economy in general, the BSP uses its suite of
monetary instruments to influence the underlying demand and supply conditions for central bank money. 
Monetary Operations under the Interest Rate Corridor Framework

Overnight Reverse Repurchase Facility

 
The RRP facility is the primary monetary instrument of the BSP. The RRP interest rate signals the policy
rate of the BSP. The overnight RRP is offered using a fixed-rate and full-allotment method.

Price Stability - Monetary Operations

Standing Liquidity Facilities

The BSP offers standing liquidity (lending and deposit) windows that help counterparties adjust their
liquidity positions at the end of the day. These standing overnight facilities are available on demand to
qualified counterparties during BSP business hours. The two standing facilities that form the upper and
lower bound of the corridor are set at ± 50 basis points (bps) around the target policy rate (the overnight
RRP rate under the new IRC structure).

Issuance of BSP Securities

 
BSP Securities are monetary instruments issued by the BSP for its monetary policy implementation and
liquidity management operations to steer short-term market interest rates towards the policy rate and
influence liquidity conditions in the financial system.
Term Deposit Facility
 
The TDF is a key liquidity absorption facility, commonly used by CBs for liquidity management. Currently,
three tenors- 7 days, 14 days and 28 days- are offered in weekly auction.

Systemic Risk Management

The promotion of “Financial Stability” is a formal mandate that is uniquely ascribed to the Bangko
Sentral ng Pilipinas (BSP). This is provided for in the amended BSP Charter (Republic Act No.
11211) which was signed by President Duterte in February 2019.

The objective of “Financial Stability” is to enhance the resilience of the financial system, in its
totality and in its components, from shocks. This is done by managing systemic risks that could
affect the financial system so that finance continues to be a value proposition to consumers in
normal times while remaining resilient when disruptions do arise. This is the overarching global
norm in financial system oversight.

Given its different objective, not all bank-specific vulnerabilities are “systemic” just as
macroprudential issues cover other issues beyond banking. And since macroprudential policy
focuses on interlinked risk behaviors, its concern can extend beyond liquidity or inflation. Welfare
consideration, in particular, is handled differently in macroprudential policy because adverse
outcomes have a greater impact on society than when expected outcomes are likely to be buoyant.

Eight major functions of central bank in an economy are as follows:

(1)Bank of Issue, (2) Banker, Agent and Advisor to Government, (3) Custodian of Cash Reserves,
(4) Custodian of Foreign Balances, (5) Lender of Last Resort, (6) Clearing House, (7) Controller of
Credit, and (8) Protection of Depositor’s Interest.
Functions of Central Bank

Function 1 # Bank of Issue:

Central bank now-a-days has the monopoly of note-issue in every country. The currency notes printed and
issued by the central bank are declared unlimited legal tender throughout the country.

Central bank has been given exclusive monopoly of note-issue in the interest of uniformity, better control,
elasticity, supervision, and simplicity. It will also avoid the possibility of over-issue by individual banks.

The central banks, thus, regulate the currency of country and the total money-supply in the economy. The
central bank has to keep gold, silver or other securities against the notes issued. The system of note-issue
differs from country to country.

The main objects of the system of currency regulation in general are to see that:
People’s confidence in the currency is maintained, (ii) Its supply is adjusted to demand in the economy.
Thus, keeping in view the aims of uniformity, elasticity, safety and security, the system of note-issue has
been varying from time to time.

Function 2 # Banker, Agent and Adviser to the Government:

Central bank, everywhere, performs the functions of banker, agent and adviser to the government.

“The central bank operates as the government’s banker, not only because it is more convenient and
economical to the government, but also because of the intimate connection between public finance
monetary affairs.”

As banker to the government, it makes and receives payments on behalf of the government. It advances
short-term loans to the government to tide over difficulties.

It floats public loans and manages the public debts on behalf of the government. It keeps the banking
accounts and balances of the government after making disbursements and remittances. As an adviser to
the government it advises the government on all monetary and economic matters. The central bank also
acts as an agent to the government where general exchange control is in force.
Function 3 # Custodian of Cash Reserves:

All commercial banks in a country keep a part of their cash balances as deposits with the central bank, may
be on account of convention or legal compulsion. They draw during busy seasons and pay back during
slack seasons. Part of these balances is used for clearing purposes. Other member banks look to it for
guidance, help and direction in time of need.

It affects centralisation of cash reserves of the member banks. “The centralisation of cash reserves in the
central bank is a source of great strength to the banking system of any country. Centralised cash reserves
can at least serve as the basis of a large and more elastic credit structure than if the same amount were
scattered amongst the individual banks.

It is obvious, when bank reserves are pooled in one institution which is, moreover, charged with the
responsibility of safeguarding the national economic interest, such reserves can be employed to the fullest
extent possible and in the most effective manner during periods of seasonal strain and in financial crises or
general emergencies…the centralisation of cash reserves is conducive to economy in their use and to
increased elasticity and liquidity of the banking system and of the credit structure as a whole.”

Function 4 # Custodian of Foreign Balances:

Under the gold standard or when the country is on the gold standard, the management of that standard,
with a view to securing stability of exchange rate, is left to the central bank.

After World War I, central banks have been keeping gold and foreign currencies as reserve note-issue and
also to meet adverse balance of payment, if any, with other countries. It is the function of the central bank
to maintain the exchange rate fixed by the government and manage exchange control and other restrictions
imposed by the state. Thus, it becomes a custodian of nation’s reserves of international currency or foreign
balances.

Function 5 # Lender of Last Resort:

Central bank is the lender of last resort, for it can give cash to the member banks to strengthen their cash
reserves position by rediscounting first class bills in case there is a crisis or panic which develops into ‘run’
on banks or when there is a seasonal strain. Member banks can also take advances on approved short-
term securities from the central bank to add to their cash resources at the shortest time.
This facility of turning their assets into cash at short notice is of great use to them and promotes in the
banking and credit system economy, elasticity and liquidity.

Thus, the central bank by acting as the lender of the last resort assumes the responsibility of meeting all
reasonable demands for accommodation by commercial banks in times of difficulties and strains.

De Kock expresses the opinion that the lending of last resort function of the central bank imparts greater
liquidity and elasticity to the entire credit structure of the country. According to Hawtrey, the essential duty
of the central bank as the lender of last resort is to make good a shortage of cash among the competitive
banks.

Function 6 # Clearing House:

Central bank also acts as a clearing house for the settlement of accounts of commercial banks. A clearing
house is an organisation where mutual claims of banks on one another are offset, and a settlement is made
by the payment of the difference. Central bank being a bankers’ bank keeps the cash balances of
commercial banks and as such it becomes easier for the member banks to adjust or settle their claims
against one another through the central bank.

Suppose there are two banks, they draw cheques on each other. Suppose bank A has due to it Rs. 3,000
from bank B and has to pay Rs. 4,000 to B. At the clearing house, mutual claims are offset and bank A
pays the balance of Rs. 1,000 to B and the account is settled. Clearing house function of the central bank
leads to a good deal of economy in the use of cash and much of labour and inconvenience are avoided.

Function 7 # Controller of Credit:

The control or adjustment of credit of commercial banks by the central bank is accepted as its most
important function. Commercial banks create lot of credit which sometimes results in inflation.

The expansion or contraction of currency and credit may be said to be the most important causes of
business fluctuations. The need for credit control is obvious. It mainly arises from the fact that money and
credit play an important role in determining the level of incomes, output and employment.

According to Dr. De Kock, “the control and adjustment of credit is accepted by most economists and
bankers as the main function of a central bank. It is the function which embraces the most important
questions of central banking policy and the one through which practically all other functions are united and
made to serve a common purpose.”
Thus, the control which the central bank exercises over commercial banks as regards their deposits, is
called controller of credit.

Function 8 # Protection of Depositors Interests:

The central bank has to supervise the functioning of commercial banks so as to protect the interest of the
depositors and ensure development of banking on sound lines. The business of banking has, therefore,
been recognized as a public service necessitating legislative safeguards to prevent bank failures.

Legislation is enacted to enable the central bank to inspect commercial banks in order to maintain a sound
banking system, comprising strong individual units with adequate financial resources operating under
proper management in conformity with the banking laws and regulations and public and national interests.
Required Reserves
The BSP decides the general lending behavior of the commercial banks. At any time, it may change the
percentage at which banks can lend out of their deposits. With the prerogative as the banker of commercial
banks, the BSP simply requires commercial banks to keep a certain percentage of their deposits in reserve
this is to influence the banks lending behavior. To illustrate, if the BSP decides that lending behavior should
be 80%, the reserves it requires is 20%. The reserve requirement (cash reserve ration) is a central bank
regulation that sets the minimum fraction of customer deposits and notes that each commercial bank must
hold (rather than lend out) as reserves. These required reserves are normally in the form of cash stored
physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is
sometimes used as a tool in monetary policy. Influencing the country’s borrowing and interest rates by
changing the amount of funds available for banks rarely alter the reserve requirements because it would
cause immediate liquidity problems for banks with low excess reserves; they generally prefer to use open
market operations (buying and selling government issued bonds) to implement their monetary policy

Rediscounting

Rediscounting refers to BSP's prerogative to set the limit to the funds that commercial banks can borrow
and to designate the rate of interest at which it lends when commercial banks, on the basis of bank's loan
papers, borrow from BSP. The BSP rediscounts this loan paper and the rate of interest it charges is called
rediscount rate. The rediscount rate provides a signal to the commercial banks on the trend of interest rates
in general, thus it is helpful when BSP seeks to control interest rate. For example, instead of giving up to
85% of the face value of the loans, it may give only up to 65%.

Open Market Operations

The BSP actively participates in the purchase and sale of government securities in active and open money
market. Open Market Operations consist of repurchase and reverse repurchase transactions, outright
transactions, and foreign exchange swaps.

*Repurchase and Reverse Repurchase

This is carried out through the Repurchase Facility and Reverse Purchase Facility of the Bangko Sentral ng
Pilipinas. In Purchase transactions, the Bangko Sentral buys government securities with a dedication to sell
it back at a specified future date, and at a predetermined interest rate. The BSP’s payment increases
reserve balances and expands the monetary supply in the Philippines. On the other hand, in Reverse
Repurchase, the government acts as the seller, and works to decrease the liquidity of money. These
transactions usually have maturities ranging from overnight to one month.

*Outright Transactions

Unlike the repurchase or reverse repurchase, there is no clear intent by the government to reverse the
action of their selling/buying of monetary securities. Thus, this transaction creates a more permanent effect
on our monetary supply. “When the BSP buys securities, it pays for them by directly crediting its
counterparty’s Demand Deposit Account with the BSP.” The reverse is done upon the selling of securities.

*Foreign Exchange Swaps

This refers to the actual exchange of two currencies at a specific date, at a rate agreed upon the deal date
and the reverse exchange of the currencies at a farther ate in the future, also at an interest rate agreed on
deal date.

Selective Credit Control

The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum fraction
of customer deposits and notes that each commercial bank must hold (rather than lend out) as reserves.
These required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or
deposits made with a central bank.
The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's
borrowing and interest rates by changing the amount of funds available for banks to make loans with.
Western central banks rarely alter the reserve requirements because it would cause immediate liquidity
problems for banks with low excess reserves; they generally prefer to use open market operations (buying
and selling government-issued bonds) to implement their monetary policy.

Using this tool, the BSP decides the kind of credit it will give to clients. It prioritizes its lending activity either
to production or consumption. Because, if production is prioritized, credit for consumption is lessened and
gives more funds to production and vice-versa.

It is an important tool in BSP which is a major weapon of the monetary policy used to control the demand
and supply of money (liquidity) in the economy.

Moral Suasion

The BSP may hold sessions with commercial banks and try to persuade or make suggestions to the heads
of commercial banks to redirect their efforts in national development goals. It is the monetary policy tool
that tests the persuasive ability of the monetary board and the governor of BSP.

Non-official tool of monetary policy which governments employ to persuade (instead of coerce through law
making power) financial institutions in following suggested guidelines on the availability and cost of credit.
Moral suasion is used typically by making policy announcements to induce the desired response, before
resorting to mandatory compliance through statutory regulations.

SUPERVISION AND REGULATION

What is banking supervision and regulation?
Bank regulation refers to the written rules that define acceptable behavior and conduct for financial
institutions. The Board of Governors, along with other bank regulatory agencies, carries out this
responsibility. Bank supervision refers to the enforcement of these rules. Regulation is basically undertaken
through review and analysis of reports submitted by a financial institution to a government agency
concerned.
Bank supervision includes not only the issuance of rules and regulations but also the overseeing of
operations of a financial institution. This is to ascertain that such rules and regulations are complied with.
What is the purpose of bank supervision?
The act of monitoring the financial performance and operations of banks in order to ensure that they are
operating safely and soundly and following rules and regulations. Bank supervision is conducted by
governmental regulators and occurs in order to prevent bank failures.
There are three agencies that supervise the different institutions in the Philippine financial system. In
addition to being the monetary authority, the Bangko Sentral ng Pilipinas (BSP) supervises banks and their
financial allied subsidiaries and affiliates (except insurance companies), non stock savings and loan
associations, and pawnshops as provided for in its Charter (R. A. 7653), the General Banking Law (R. A.
8791) and other special laws. The Securities and Exchange Commission (SEC), on the other hand, has
oversight on the domestic capital market and, as such, supervises self-regulatory organizations (SROs),
investment houses, and securities dealers/brokers. It also supervises investment companies, finance
companies and pre-need firms. Finally, the Insurance Commission (IC) supervises insurance and
reinsurance companies, insurance brokers, and mutual benefit associations. In addition, the Philippine
Deposit Insurance Corporation (PDIC) also shares some supervisory powers with BSP over banks
consistent with its role as deposit insurer.

Organization of the BSP Supervision and Examination Sector (SES)

The BSP-SES headed by a Deputy Governor is the specific component of the BSP that is responsible for
carrying out its responsibility from bank supervision. The SES is in the process of completing a deep and
sweeping reorganization to effectively implement its risk-based supervisory approach.

The new SES is divided into four major sub-sectors, to provide:

(1) sufficient controls and accountability over specific activities in the supervision process;
(2) specialization and focus in highly technical areas;
(3) consistency in the interpretation and application of supervisory policies and rules and regulations; and
(4) timeliness in the submission of reports of examination and accomplishment of critical supervision tasks.

Adoption of International Standards

Aside from striving to be aligned with the Basel Core Principles for Effective Banking Supervision, the BSP
has also been keeping pace with developments in international standards for capital regulation and
accounting practices. The BSP has actively monitored the crafting of the Basel II standards from the time
the Basel Committee first issued the first consultative document in 1999. BSP even participated in the third
quantitative impact study (QIS) of Basel II and was part of the Non G-10 QIS Group. Simultaneously, the
BSP has also prepared internally for the eventual adoption of Basel II in the Philippines by making
necessary revisions and adjustments to the regulatory framework, and undertaking capacity building and
market awareness programs. Consequently, the BSP successfully adopted the simple approaches under
Pillar 1 of Basel II starting July of this year as well as suitably adopted Pillar 3 guidelines. This was
preceded by more than one year of consultations with all stakeholders before the final implementing
guidelines were issued, and half a year of parallel run with the existing framework. By 2010, the advanced
approaches of Basel II may already be allowed for purposes of computing banks’ capital requirements. The
timing is dictated by the adequacy of available data. Currently, Internal Capital Adequacy Assessment
Process (ICAAP) guidelines are under exposure to the industry and other interested parties for the purpose
of operationalizing Pillar 2 by 2008.
The BSP has likewise adopted the Philippine Financial Reporting Standards (PFRS)/Philippine Accounting
Standards (PAS), which are patterned after the revised International Financial Reporting Standards (IFRS)
and International Accounting Standards (IAS) issued by the International Accounting Standards Board
(IASB). Since 2005, financial institutions have been mandated to fully comply with the provisions of
PFRS/PAS in preparing both their audited financial statements and the financial statements for prudential
reporting. The adoption of the new set of accounting standards has been aimed at enhancing fairness,
transparency and accuracy in financial reporting.
Why is it important to regulate banks?
The most important rationale for regulation in banking is to address concerns over the safety and stability of
financial institutions, the financial sector as a whole, and the payments system. ... Its objective is to adopt
more market-oriented regulatory measures.
Types of Examination
General or Regular Examination. This is undertaken once a year. Such examination covers the verification
of assets, liabilities and capital accounts to determine the stability and solvency of the financial institution.
It also reviews the incomes and expenses of said institution to determine the probable profit that
stockholders would expect from their investment.
Special or Interim Examination . This is conducted as often as necessary. It includes a review of a special
account or groups of accounts such as loans or deposits. Such examination is usually of short duration
since the purpose is limited to a specific are of activity or operation. It follows up findings of previous
examination to determine whether the institution has implemented the recommendations of the BSP or
whether the errors have been corrected as suggested by the BS examiners.
Special investigation. It is conducted when a complaint is received by the BSP from borrower, stockholder,
depositor, or an employee, or even from anybody regarding the operation of a financial institution.

Prepared by:

Evaliza F. Moreno,MABA,LPT
Instructor