4.4.3 Role of central banks

Question 1

Roles of the central bank

Answer 1

• Controls monetary policy
• Acts as a banker to the government
• Acts as bank to other banks
• Regulate financial/banking system/industry

Question 2

Monetary policy

Answer 2

The central bank ​controls monetary policy through interest rates and controlling money supply in order to keep inflation low and stable.

Question 3

Banker to the government

Answer 3

The exact nature of the services offered by the bank differs from country to country, for example the Bank of England was previously responsible for managing the national debt but this role was transferred to the Debt Management Office in 1998.
- They often hold the government’s bank account and lend to them, holding government debt, as well as holding gold and foreign exchange reserves

Question 4

Bank to other banks

Answer 4

Banks deposit their money within the central bank and this is often used to balance the accounts of banks at the end of each day, when banks owe each other money because cheques have been paid in by consumers etc.
The most important part of this role is the fact they are a lender of last resort:
- If banks experience liquidity problems, they can turn to the central bank to sell their illiquid assets or to take a loan in the short term.
- If the bank is on the brink of collapse as its assets have fallen too far in value e.g. the financial crisis of 2007-8, then the bank can lend them money to prevent them from collapsing.
Banks tend to lend to each other and so the collapse of one bank will lead to the collapse of other banks; this means that this role is important since as it allows the bank to ensure financial stability.

Question 5

Regulation of financial system

Answer 5

This is important to prevent financial institutions from undertaking activities which harm consumers or engage in risky activities which would lead to collapse and to prevent systemic risk, the risk of the whole system collapsing.
- The financial sector plays a huge role in the economy because it impacts investment and can cause huge externalities if market failure occurs.

Question 6

Financial regulation examples

Answer 6

Can include:
- banning market rigging
- preventing the sale of unsuitable products
- maximum interest rates to prevent consumer exploitation and prevent excessively risky lending
- deposit insurance to protect consumer deposits and increase stability and liquidity ratios, when banks are forced to hold a certain percentage of liquid assets

Question 7

Financial regulation “bodies” (regulators)

Answer 7

There are three key bodies for financial regulation:
o The FPC identifies and reduces system risk and supports government
economic policy (macroprudential).
o The PRA ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action. (microprudential)
o The FCA protects consumers, promotes competition and enhances the integrity of the system by preventing market rigging.