4.4.3 Role of Central Banks

Question 1

What are examples of central banks?

Answer 1

• Bank of England (UK)
• European Central Bank (ECB) for member nations of the Euro Area
• United States Federal Reserve
• Bank of Japan
• Bank of Canada (CAD)
• Reserve Bank of Australia (AUD)
• Reserve Bank of New Zealand (NZD)

Question 2

What does the central bank do?

Answer 2

• Monetary policy function
• Financial stability and regulatory function
• Policy operation functions
• Debt management

Question 3

State how the central bank has monetary policy functions

Answer 3

o Setting of the main monetary policy interest rate
o Quantitative easing (QE)
o Exchange rate intervention (managed/fixed currency systems)

Question 4

State how the central bank has financial stability & regulatory functions

Answer 4

o Supervision of the wider financial system
o Prudential policies designed to maintain financial stability

Question 5

State how the central bank has policy operation functions

Answer 5

o Lender of last resort to the banking system
o Managing liquidity in the commercial banking system
o Overseeing the payments systems used by banks / retailers / credit card companies

Question 6

State how the central bank has a debt management function

Answer 6

o Handling the issue and redemption of issues of government debt (bonds)

Question 7

What is monetary policy?

Answer 7

• Monetary policy involves changes in interest rates, the supply of money & credit and exchange rates to
  influence the economy.

Question 8

Explain how the BoE uses monetary policy in the UK

Answer 8

• The Bank of England has been independent of the UK government since 1997
• The main aim of the Bank of England is to promote monetary and financial stability
• Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the
  Government’s inflation target, which the Bank seeks to meet through the decisions taken by the Monetary
  Policy Committee (MPC)
• The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation
  target is set by the UK government. Base interest rates in the UK have been below 1 percent since 2009.

Question 9

What does the MPC do?

Answer 9

• The Monetary Policy Committee does a thorough assessment of the UK economy 8 times a year
• They look at a range of demand/supply-side indicators
• The interest rate decision is taken after this
• Key issue is the strength of inflationary pressures and the inflation forecast for the UK over the next two years
• Inevitably there is a lot of uncertainty
• Monetary policy affects both the demand and the supply-side of the economy. It does not operate in isolation

Question 10

Explain expansionary monetary policy

Answer 10

Question 11

Explain deflationary monetary policy

Answer 11

Question 12

Explain the case for maintaining very low interest rates

Answer 12

1. Inflationary pressures in many advanced countries have remained weak giving little justification for raising
   interest rates to control inflationary pressures
2. Some economists argue that the Phillips Curve has flattened, i.e. the trade-off between unemployment and
   inflation has weakened, this implies that an economy can operate at a higher level of aggregate demand and
   employment without risking an acceleration of inflation
3. Maintaining low interest rates help to stimulate capital investment which increases a country’s long-run
   productive potential
4. Low interest rates as part of an expansionary monetary policy have been helpful in supporting aggregate
   demand and output during an era of fiscal austerity in many developed countries.
5. Keeping interest rates low may have helped to reduce the risks of price deflation and also contributed to
   maintaining a competitive currency which has helped export industries

Question 13

Explain the arguments for advanced economies benefiting from rising interest rates

Answer 13

1. A rise in monetary policy interest rates would help to control demand for credit, softens the growth of the
   money supply and therefore helps to control demand-pull inflation especially when unemployment is very
   low
2. Increased mortgage rates may cause a slowdown in house price inflation and therefore help to make property
   more affordable over time especially for hard-pressed young families who struggle to rent as well as but
3. Higher interest rates will increase the return to saving – raising effective disposable incomes for retirees
4. Higher interest rates reduce the risk of mal-investment by business that only goes ahead because of the cheap
   cost of capital
5. Interest rates need to rise moderately now so that central banks can cut them in the event of a negative
   external shock. They need to give themselves some policy leeway when the economy next experiences a
   recession

Question 14

What are the risks from raising interest rates?

Answer 14

• High levels of unsecured debt – there is a risk of a significant slowdown in consumption if retail credit becomes
  more expensive to service e.g. expensive credit cards
• Higher interest rates might choke off much needed business investment e.g. in new house-building and
  renewable energy capacity
• Rise in interest rates might cause the sterling exchange rate to appreciate thus making exports less
  competitive, leading to an export slowdown and a worsening external deficit
• Higher interest rates make government debt more expensive
• Higher interest rates might lead to a economic slowdown which could hit share prices, pension fund assets and dividend incomes

Question 15

What is the one of the main aims of quantitative easing?

Answer 15

One of the main aims of quantitative easing is to increase the supply of money available for banks to lend

Question 16

Explain how QE operates

Answer 16

• QE involves the introduction of new money into the national supply by a central bank.
• In the UK the Bank of England creates new money (electronically) to buy assets (mainly bonds) from insurance companies, pension funds and commercial banks
• Increased demand for government bonds causes an increase in the market price of bonds and therefore
  causes their price to rise
• A higher bond price causes a fall in the yield on a bond (this is because there is an inverse relationship between
  bond prices and yields)
• Those who have sold their bonds may use the extra funds/cash to buy assets with higher yields such as shares of listed businesses and corporate bonds
• Commercial banks receive cash, and this increases their liquidity. This may encourage them to lend out more money

Question 17

How does QE work on the wealth effect?

Answer 17

lower yields (interest rates) lead to higher share and bond prices

Question 18

How does QE work on the borrowing effect?

Answer 18

QE lowers the interest rate on long term debt such as government bonds and mortgages

Question 19

How does QE work on the lending effect?

Answer 19

QE increases the liquidity of banks and increased lending from banks lifts incomes and spending in the economy

Question 20

How does QE work on the currency effect?

Answer 20

lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation) which helps exports

Question 21

Give arguments in favour of quantitative easing

Answer 21

• Gives a central bank an extra tool of monetary policy besides changing interest rates
• Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE, the fall in
  real GDP would have been deeper and the rise in unemployment greater
• Lower long-term interest rates have kept business confidence higher and given the commercial banking
  system extra deposits to use for lending
• QE can lead to a depreciation of the exchange rate will helps to improve the price competitiveness of export
  industries

Question 22

Explain the Criticisms of quantitative easing (with specific reference to the UK economy)

Answer 22

1. Ultra-low interest rates can distort the allocation of capital and also keep alive zombie companies
2. QE has contributed to a surge in share prices and property values, the latter has worsened housing
   affordability for millions of people and also contributed to increase in rents which has worsened the
   geographical immobility of labour.
3. QE has done little to cause an increase in bank lending to businesses, many commercial banks have become
   more risk averse and charge higher interest rates to business customers.
4. QE has contributed to a decade of ultra-low interest rates which has been bad news for millions of people
   who rely on interest from their savings
5. Low interest rates and bond yields are a worry for pension fund investors because they worsen their deficits.
   If companies must pay more into their employee pension schemes, they therefore have less money to spend on investment which could harm productivity growth in the long run

Question 23

Who are the main regulators of the financial system?

Answer 23

• Financial Policy Committee (FPC)
• Prudential Regulation Authority (PRA)
• Financial Conduct Authority (FCA)
• Competition and Markets Authority (CMA)

Question 24

What are the main aims of financial market regulations?

Answer 24

1. Protect against the consequences of market failure
2. Encourage confidence in the economy & government
3. Allow the Central Bank (e.g. the Bank of England) to perform its other roles such as lender of last resort

Question 25

How do regulators protect against the consequences of market failure as a main aim of financial market regulation?

Answer 25

a. Protect the interest of consumers
b. Limit the monopoly power of commercial banks by encouraging increased competition
c. Protect borrowers from excessively high interest rates on loans e.g. on unsecured credit
d. Improved access to affordable finance services – this is key for growth & development and prevention
of poverty in many countries
e. Balance the interests of uninformed consumers with sophisticated sellers of financial services (i.e.
address problems arising from information asymmetry)

Question 26

How do regulators encourage confidence in the economy & government as a main aim of financial market regulation?

Answer 26

a. Promote capital investment and sustainable long run growth
b. Support trust in the banking system so that people and businesses are willing to save

Question 27

How do regulators Allow the Central Bank (e.g. the Bank of England) to perform its other roles such as lender of last resort as a main aim of financial market regulation?

Answer 27

a. Prevent/mitigate systemic risk within financial markets that might damage the economy

Question 28

What is the FPC main role?

Answer 28

• The FPC’s main role is to identify, monitor, and take actions to remove or reduce risks that threaten the
  resilience of the UK financial system as a whole
• The FPC publishes a Financial Stability Report identifying key threats to the stability of the UK financial system

Question 29

What does the FPC have the power to do?

Answer 29

• The FPC has the power to instruct commercial banks to change their capital buffers
• When the FPC decide that the risks to the financial system are growing, they may tell the commercial banks
  and other lenders to increase their capital buffers to help absorb unexpected losses on their assets (bad debts etc.)
• These capital buffers are part of “macro-prudential policy” - prudent means being careful at times of
  uncertainty

Question 30

What is the PRA?

Answer 30

The Prudential Regulation Authority (PRA) is part of the Bank of England and is responsible for the prudential regulation and supervision of
around 1,700 banks, building societies, credit unions, insurers and major investment firms

Question 31

What does the PRA focus on?

Answer 31

• The PRA has a particular focus on the solvency of specific financial markets such as:
  o Insurance providers
  o Buy-to-let mortgage lenders
  o Credit unions
  o Other specialist lenders

Question 32

What is a liquidity ratio?

Answer 32

• A liquidity ratio is the ratio of liquid assets held by a bank on their balance sheet to their overall assets
• Commercial banks need to hold enough liquidity to cover expected demands from their depositors

Question 33

What are capital ratios?

Answer 33

• A commercial bank’s capital ratio measures the funds it has in reserve against the riskier assets it holds that
  could be vulnerable in the event of a crisis.
• Banks must maintain sufficient capital which includes money raised from selling new shares to investors and
  also their retained earnings (i.e. non-distributed profits)

Question 34

Why are commercial banks required to hold capital in the form of buffers?

Answer 34

Commercial banks are required to hold capital in the form of buffers which can be used to absorb losses during an economic downturn, enabling them to continue lending to the economy. Without these buffers, banks are more likely to cut back lending in the face of losses, making any downturn worse. The counter cyclical capital buffer rate for the UK banking system is currently set at 1%. The FPC can raise this when financial risks are rising and relax it when financial risks are easing.

Question 35

What are counter cyclical buffers?

Answer 35

• Upswing in credit cycle – banks required to build up extra capital reserves
• Downswing in credit cycle – banks have more capital to help absorb losses

Question 36

What are micro prudential policies?

Answer 36

Micro-prudential involves stronger regulation of individual financial firms such as commercial banks, payday
lenders and insurance companies. It also seeks to protect individual depositors / borrowers

Question 37

What are macro prudential policies?

Answer 37

Macro-prudential regulation seeks to safeguard the financial system as a whole i.e. protect against systemic
risk. Macro-prudential seeks to make the system more resilient

Question 38

What is the leverage ratio?

Answer 38

The leverage ratio is an indicator of the ability of a bank or building society to absorb losses
Leverage ratio = Capital / Exposures

Question 39

What are stress tests for commercial banks?

Answer 39

Stress tests assess commercial banks’ ability not just to withstand severe shocks, but also to maintain the supply of
credit to the real economy under severe pressure. Stress tests use tail-end risk events i.e. economic outcomes that lie
well outside the mainstream forecasts. A failure to adequately insure against tail-end risk was a major reason behind
the severity of the global financial crisis a decade ago.

Question 40

What interventions can correct externalities arising from financial instability?

Answer 40

Depositor protection for families with savings
Increased capital requirements for commercial banks
Stress tests for commercial banks and other financial businesses
Limits to highly-leverage mortgage lending (LTV ratios)

Question 41

What interventions can correct herd behaviour and speculative bubbles in financial markets?

Answer 41

Financial Policy Committee created to oversee financial stability
Monetary Policy Committee can raise interest rates to reduce the risk of an
unsustainable housing / asset price boom
Possible regulation of use of volatile crypto-currencies

Question 42

What interventions can correct market rigging/monopoly power of banks?

Answer 42

Tougher competition policy for anti-competitive behaviour
Price cap on interest rates charged by pay-day lending companies
More licences to challenger banks to improve contestability

Question 43

What interventions can correct asymmetric information and complexity of financial products?

Answer 43

Penalties / compensation for miss-selling of PPI
Improved financial literacy education in schools and colleges
Auto-enrolment in workplace pensions (mandated choice)