10.4 - The Central Bank

Question 1

1. What is the role of the central bank?

Answer 1

The central bank has multiple roles, including implementing monetary policy, acting as a banker to the government, serving as a lender of last resort to commercial banks, and regulating the financial system. Through monetary policy, the central bank manipulates interest rates, the money supply, and the exchange rate to achieve an inflation target and macroeconomic stability. It acts as a banker to the government by buying and selling government bonds and managing government debt interest. As a lender of last resort, the central bank provides emergency liquidity to commercial banks facing liquidity problems to prevent bank failure and maintain financial stability. Additionally, the central bank regulates the financial system through bodies like the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) to identify risks, prevent bank failure, and mitigate systemic risk.

Question 2

2. What are the pros of the central bank’s lender of last resort function?

Answer 2

The lender of last resort function of the central bank offers several advantages. Firstly, it prevents a liquidity crisis from escalating into bank failure, reducing the potential for systemic risk and a full collapse of the financial sector. This helps maintain confidence in the banking sector, ensuring economic growth and preserving living standards. The provision of liquidity is accompanied by strict regulatory conditions and repayments with interest rates above market levels, limiting the likelihood of a similar crisis in the future. Secondly, this role allows the central bank to advise the government on potential bailout needs, identifying areas of concern in the banking sector and preventing systemic risk and sector collapse.

Question 3

evaluation: What are the cons of the central bank’s lender of last resort function?

Answer 3

The lender of last resort function of the central bank also has some drawbacks. One major concern is moral hazard, as the assurance of liquidity support may encourage commercial banks to take excessive risks, knowing that they will be bailed out by the central bank in case of liquidity shortages. This moral hazard can lead to increased risk-taking behavior in the future. Another argument questions the special treatment given to banks compared to other businesses in the economy. In a market economy, losses and failure typically signal shutdown and reallocation of resources. Treating banks differently raises the question of why they should be exempt from such consequences, especially if a fail-safe mechanism can be established to allow banks to close without causing losses for savers. Additionally, there is a risk of regulatory capture, where close relationships between commercial bank managers and central bank regulators may influence decision-making, potentially favoring the interests of the banks rather than the broader societal interests. This could lead to regulatory failures and an ongoing risk of liquidity crises.