Central banking 18: Governor and board members are trustees and not owners of the central bank

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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 government’s 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-for-economic-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-if-imprudent-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 country’s 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 government’s 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 anyone’s 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-of-central-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 bank’s 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 non-executive 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 Lanka’s 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 governor’s 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 anyone’s 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 [email protected].)

Central banking 18: Governor and board members are trustees and not owners of the central bank

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