Central banks dominate headlines worldwide as they exercise immense influence over the global econom

Central banks dominate headlines worldwide as they exercise immense influence over the global economy. Using various monetary tools — such as adjusting interest rates, conducting open market operations or employing quantitative easing — central banks aim to steer their economies toward stability and growth. Despite their critical role, many remain unaware of the fundamental functions and complexities of these institutions.

Central banks, often known as Reserve Banks, National Banks, or Monetary Authorities, form the bedrock of a nation’s financial system. These public institutions manage a country’s currency, money supply and monetary policy to ensure economic stability and public confidence in the financial system. Unlike commercial banks, central banks hold a monopoly on modifying the monetary base, giving them unparalleled authority to shape the financial landscape.

Beyond monetary policy, central banks supervise and regulate financial institutions to maintain system stability, prevent crises, and combat financial crime such as fraud, money laundering, and sanction evasion. By requiring minimum reserve balances, they provide a critical anchor for the financial system’s stability.

Finally, they also serve as trusted advisors to governments by delivering economic insights, macroeconomic forecasts, and policy recommendations based on extensive research and analysis.

In addition to monetary policy, regulation, and advisory responsibilities, central banks play an indispensable role in managing payment flows, both domestically and internationally. They often oversee or supervise domestic payment systems and facilitate interbank money transfers (i.e. transfer of funds between banks). Acting as Payment Market Infrastructures (PMIs), central banks ensure efficient and secure transaction clearing and settlement, serve as trusted intermediaries, and uphold the irrevocability and legality of transactions.

Examples of central bank payment systems include:

• Federal Reserve (US): Fedwire, FedACH and FedNow
• Bank of England (UK): CHAPS
• Bank of Israel (Israel): ZAHAV
• Bank of Japan (Japan): BOJ-NET
• South African Reserve Bank (South Africa): SAMOS

The central bank’s involvement in payment systems shows its dual role in the financial system as both a regulator and participant. When acting as a PMI, it focuses on clearing and settlement, ensuring smooth operations (security, efficiency, and accuracy) of the payment scheme. Conversely, its broader role as a central bank involves direct interaction with governments and banks to maintain monetary stability.

The role of Central Banks in the payment flows is fulfilled by the obligation for every commercial bank to have an account with the central bank. These so-called reserve accounts are the accounts where banks keep their central bank money. Only financial institutions holding a banking license—granted after demonstrating sufficient capital, a robust business plan, and compliance with all regulatory standards—are eligible to maintain a reserve account at the central bank.

Transacting on these accounts occur in various ways:

• Interbank Settlements: When a payment is made from one bank to another, the amount is aggregated and netted with other payments. The central bank facilitates this by debiting the reserve account of the sending bank and crediting the reserve account of the receiving bank. In the case of cross-border payments, central bank currency never physically leaves the country. Instead, the bank facilitating the cross-border transaction is credited in the sender currency on its central bank account in the sender’s country, while its account is debited in the beneficiary currency in the recipient’s country. This ensures that currency always remains within the central bank system.
• Physical Cash Transactions: Commercial banks can interact with the central bank to manage physical cash (banknotes and coins). When ordering cash, the reserve account of the commercial bank is debited for the amount delivered, which is then distributed via ATMs or other means. Conversely, banks can deposit excess or defective cash (e.g. damaged or unfit currency) to the central bank, in which case the reserve account is credited accordingly.
• Securities operations: Central banks may engage in buying or selling government securities (bonds) with commercial banks as counterparties. These transactions typically occur during open market operations or as part of liquidity management. As a result, the reserve account of the commercial bank involved is credited or debited, depending on the nature of the transaction.
• Central bank lending: Commercial banks can borrow from the central bank through mechanisms such as the discount window. When lending, the central bank credits the reserve account of the borrowing bank in exchange for a discount rate and sufficient collateral (e.g. high-quality assets like government bonds). This lending can support intra-day liquidity needs or longer-term requirements but is typically considered a measure of last resort.

The balance on a commercial bank’s reserve account at the central bank is influenced by several factors, with customer deposits being a primary driver. While banks can use these deposits to issue loans or invest in assets like securities to generate revenue, they are required to maintain a portion of their deposits — known as the reserve requirement — in their central bank account.

This mandatory minimum balance is determined by the central bank and serves as a key lever for influencing liquidity, economic activity, and financial stability. Lowering the reserve requirement allows banks to allocate more of their deposits toward lending and investments, injecting additional liquidity into the economy and boosting financial sector revenues. However, this approach also increases the potential risk to financial stability. Conversely, raising the reserve requirement can reduce risk, curtail liquidity, and help cool down an overheated economy.

Central banks play a pivotal role in the financial landscape, and their responsibilities continue to evolve. In the coming years, central banks will face emerging challenges and technological advancements that will further shape their role:

• Combatting Financial Crime: There is increasing pressure to address financial crime. While much of the implementation lies with commercial banks, central banks will play a critical role in setting rules and requirements, developing tools (e.g. platforms for exchanging financial crime information) and supervising proper execution.
• Enhancing Cross-Border Payments: Initiatives to connect domestic instant payment systems aim to make cross-border payments faster, cheaper, and more reliable. Central banks are expected to act as correspondent banks, holding accounts with other central banks. This will expose them to larger, even if temporary, foreign currency holdings, requiring effective management of these risks.
• Central Bank Digital Currencies (CBDCs): The rise of CBDCs could significantly reshape central banking. By possibly enabling individuals and businesses to hold accounts directly with central banks, CBDCs could redefine their relationship with end consumers, transforming their role from "banks of banks and governments" to entities interacting more directly with the public.

The role of central banks will undoubtedly continue to evolve and as these developments unfold, they are likely to become even more influential and central to the global financial ecosystem.