Central banks and why they exist

Since the 2008 financial crisis, central banks have made headlines all over the world.

But what exactly are central banks and how do they work? Here’s a look at the role these banks play. We’ll focus on Canada’s central bank, known as the Bank of Canada (BoC), and the U.S.’s, known as the Federal Reserve (the Fed).

How are central banks different than retail banks?

You can’t walk in and open an account with a central bank. Instead, these banks serve national governments and depository institutions, including retail banks themselves.

Institutions like retail banks need central banks when they’re struggling to earn and manage money and, as a result, serve customers. This can happen during downturns, when economies aren’t growing. Darcy Briggs, vice-president, portfolio manager at Franklin Bissett Investment Management in Toronto, says, “There are some operations that occur between chartered banks and central banks on a daily basis. But the two main functions of central banks are to act as lenders of last resort and to make monetary policy decisions.”

Through monetary policy decisions, a central bank can affect an entire country’s economy. By setting interest rates, for example, they influence:

• the interest rates that financial firms charge you; • how high or low inflation is, which affects the affordability of services and goods (such as groceries); and • how much money is flowing through the economy and stock markets.

Central bank decisions can also affect the value of currency (e.g., how much the loonie is worth versus the U.S. dollar).

How do central bank policy decisions affect me?

The main focus of the BoC’s and Fed’s meetings are to decide whether to hike, lower or maintain interest rates. Central banks control federal interest rates, or the rates that financial institutions use to borrow amongst themselves, says Briggs, who notes the BoC controls Canada’s overnight rate, while the Fed controls the U.S. federal funds rate.

By setting interest rates, says Briggs, central banks set the overall price of borrowing. As a result, “central banks can support growth or delay growth, as needed.” For example, “When they lower rates, they make the cost of money cheaper,” and that makes it easier for you to borrow more through mortgages and loans, or to make investments and buy products.

How are North America’s central banks structured?

The BoC and Fed were started at different times and aren’t structured in the same way (See “Compare the BoC and Fed”). The Fed was created in 1913 after the 1907 Bankers’ Panic, while the BoC was started in 1935 after the Great Depression. But, both banks were started to provide extra support during future financial downturns. On a global scale, the Fed is the most influential central bank, says Briggs. “[It] has more power because the U.S. economy is one of the largest and the U.S. dollar is the world’s reserve currency.

Compare the BoC and Fed

	Current leader	Other members	Who makes monetary policy decisions?	How often are policy decisions made, and what’s the process?
Bank of Canada (BoC)	Governor Stephen Poloz	The Governing Council, which includes: Poloz; Senior Deputy Governor Carolyn Wilkins; and four deputy governors.	This six-person council makes policy decisions that must be unanimous before they’re announced to the public.	Eight times per year; the council takes one or two weeks to make decisions. It takes two weeks at the start of each quarter (January, April, July and October) because these meetings conclude with live press conferences and the release of quarterly monetary reports.
U.S. Federal Reserve (the Fed)	Chair Janet Yellen	A seven-member Board of Governors, which is led by Yellen. Members are appointed by President, with the Senate’s approval. The Fed also has 12 regional Federal Reserve Banks. The leaders of these banks are appointed by the bankers who work in their regions.	The Fed’s Federal Open Market Committee (FOMC) votes on how to support the economy. The FOMC consists of the main Board of Governors as well as five of the 12 regional bank governors (they serve one-year, rotating terms). Decisions do not have to be unanimous, but a majority must agree.	The FOMC is required to meet at least once per quarter , but has met eight times per year in recent years. Attendees include the Board of Governors, all regional bank leaders, and some senior Fed staff members. This group holds two-day meetings before announcing policy decisions publicly. Each quarter, an economic report is released and the Fed leader hosts a press conference.