The Optimal Role for Central Banks in the Cash Cycle

By Brian Lang

A core role for most central banks is banking supervision - a role that several have clearly not been performing adequately, with their failure to prevent the excesses of the banking industry cited as one of the root causes of the current financial crisis. Another core role is the issuance of currency and this is one where many central banks, conversely, play too great a role. So says Brian Lang, formerly of the Reserve Bank of New Zealand, who argues that the optimal role for a central bank in the cash cycle is a minimal one.

Central banks have a statutory right to issue banknotes and as such have a clear obligation to maintain supply and public confidence in the legitimacy of banknotes in circulation.

A key question is what role should they play in meeting this obligation? My contention is that, in the 21^st century, a central bank's cash operations should be driven by sound business principles, promoting efficiency and cost effectiveness.  The key driver should be ‘minimal intervention'.

Central banks generally have a phobia about ensuring supply, to the extent that branch offices are maintained in population centres for the sole purpose of cash operations. Many central banks still operate significant numbers of branches, although more recent supply models include holding notes owned by the central bank in private sector sites (eg. notes held to order systems and the payment of compensatory interest on stocks of notes held in the private sector).

But are such arrangements necessary to ensure supply? In my view the answer is no!

When I was Head of Currency at the Reserve Bank of New Zealand (RBNZ) in the late 1990's we researched the cash flows between commercial banks and the RBNZ. We found that the maximum net flow on any particular day, apart from around the peak retail trade periods of Christmas and Easter, was never greater than 10% of the total cash holdings of all the commercial banks.

The RBNZ concluded that at most times of the year the private sector should be able to meet demand for cash from their stocks and need only call on the central bank to meet seasonal or unexpected demand.

In reality there are very strong incentives for the commercial banks to maintain sufficient stocks of cash to meet customer demand. Most people believe that the credit balance in their bank account is ‘their money' and if a bank cannot supply on demand, then the bank risks giving a negative perception of its viability (one just has to recall the ‘runs' on some of the industry's better-known financial institutions in 2007 to see where this negative perception can lead).

I believe that central banks do not need to be so phobic about ensuring supply, provided they have sufficient ‘wholesale' stocks of cash that can be released to the commercial banks when demanded. If a particular area of a country runs short of cash then it is because of the poor planning of the commercial banks, as it is their customers that determine demand.

The New Zealand experience since 2001 confirms that a pure ‘wholesale model' operation, with just one central bank site and no special arrangements such as ‘notes held to order' or the payment of ‘compensatory interest' will not prejudice the supply of cash to the community.

In addition, the absence of the RBNZ from the daily supply chain has resulted in the private sector; (banks, security companies and retailers) choosing solutions which minimize costs and provide for the most efficient use of available resources.

Public Confidence

As we know, banknotes need to be of a certain quality to function as an efficient means of payment and, as issuers, central banks has an overriding responsibility for ensuring that the tasks involved in maintaining quality are performed.

But there is no reason why these tasks need to be performed by the central bank itself, particularly considering the technical advances in recent years in the durability, security features and sophisticated processing machines with the potential to remotely provide information on quality to the central bank.

The maintenance of quality and the detection of counterfeits is best performed using processing machines. However there is no logical reason why these need to be located in the central bank. The trend in the 1980s and 1990s was for central banks to purchase processing machines and take on sole responsibility for checking for quality and authenticity and this operational model is still prevalent.

There is, however, is a growing trend for central banks to rely more on the private sector to undertake this task.

The Bank of England was one of the first to close branches and provide incentives to the commercial banks to process banknotes through the distribution cycle. The Reserve Banks of Australia and New Zealand have also restructured their cash operations significantly, closing branches and providing incentives to the private sector to machine process and return unfit notes.

Only Norway to my knowledge, however, has outsourced the destruction process as well to its service provide (NOKAS), thereby saving on notes being processed twice, and on the costs of transport.

There are some obvious risks involved in outsourcing destruction as it is not physically possible to verify at a later time how many notes have been destroyed. A key requirement of the Norges Bank is that authentication and destruction can only be carried out with equipment approved by the Bank and only Norges staff can access the programming of the machines.

I believe that the Norges Bank model is a logical step in the evolution of the role of the Central Bank in the cash cycle.

Summary

In most business environments competition will drive innovation and efficiency. The supply of banknotes is a monopoly activity, and thus the central bank needs to strive to carry out this function with a business focus so the community can be assured that it is performing its role in the most efficient and cost effective manner possible. Applying a business model will reduce the costs of the cash function for the central bank which will enable resources to be diverted to the important policy functions.