4.4.3 Role of central banks

Question 1

Two main roles of a central bank

Answer 1

• Act as a banker to the government
• Help to support banks by acting as a lender of last resort

Question 2

When is a ‘lender of last resort’ needed?

Answer 2

• Because banks borrow short-term but lend long-term, they can sometimes face a shortage of liquidity.
• If an individual bank that’s solvent (i.e. it has enough assets to meet all of its liabilities) faces a temporary shortage of liquidity, the central bank can ‘provide liquidity’ by lending the bank money.
• The Bank of England has different schemes to provide liquidity to banks – a predictable and ‘routine’ need for liquidity is dealt with under one scheme, while ‘emergency’ liquidity problems are dealt with under another.
• The central bank charges a higher rate of interest for emergency funds to create an incentive for the bank to behave more carefully in the future.

Question 3

What can central banks do at times of systemic crisis?

Answer 3

They can provide widespread emergency intervention.

This happened during the 2008 financial crisis – central banks in various countries provided ‘emergency liquidity assistance’ to ensure banking stability.

Question 4

Advantages of central banks as a lender of last resort

Answer 4

• It helps to prevent panic and a run on the banks.
• It helps to reduce the impact of financial instability.

Question 5

Disadvantages of central banks as a lender of last resort

Answer 5

• It can lead to moral hazard, and encourage banks to take excessive risks.
• It can lead to banks not holding sufficient liquidity.
• It can seem unfair that the central bank will try to save financial institutions, but not non-financial firms.

Question 6

How do central banks act as a ‘banker for the government’?

Answer 6

• A central bank can help the government manage its national debt – e.g. by trying to reduce the interest paid. This might involve issuing government bonds.
• It can also offer advice to the government on economic matters, and help them in their negotiations with other international financial organisations.

Question 7

How do central banks help to regulate the financial sector?

Answer 7

• A central bank can impose rules to prevent financial market failure and instability.
• Macroeconomic stability in an economy is unlikely without financial stability.

Question 8

How do central banks implement monetary policy?

Answer 8

• A central bank can manage the money supply by affecting the availability of credit or its cost. This is mainly done through controlling interest rates, but it can also be done thorough other methods, such as quantitative easing.
• It can also affect the amount of loans banks make by setting capital requirements – i.e. the reserves of capital a bank must keep.
• It can influence the exchange rate through buying and selling currencies and changing interest rates.
• It’s also usually responsible for controlling the issuing of banknotes and ensuring that confidence in the currency is maintained (e.g. by working to prevent the counterfeiting of banknotes).

Question 9

Do all central banks perform the same roles across the world?

Answer 9

In general, central banks do similar roles. However, what they actually do varies from country to country – some governments will give certain tasks to particular government departments or to other organisations instead.

• For example, in the UK, it’s the Debt Management Office (not the BoE) that issues government bonds (known as ‘gilts’).