4.4.3 Role of Central Banks

Question 1

The four roles of central banks?

Answer 1

• Banker to the government
• Banker to the banks
• Implementing monetary policy
• Regulation of financial markets

Question 2

Banker to the government?

Answer 2

• Governments hold accounts with central banks
• May manage national debt (not BoE since 1998, now UK Debt Management Office)
• Hold a country’s foreign currency and gold reserves

Question 3

Banker to the banks?

(Lender of last resort)

Answer 3

• Commercial banks required to hold cash reserves in central bank
• Prevents banks from failing
• Liquidity problem and solvency problem (lender of last resort)

Question 4

Liquidity problem?

Answer 4

• When banks underestimate the amount of liquid assets they need to hold
• Depositors may withdraw more money than expected
• Other banks may refuse to lend (may believe bank is insolvent)
• So central bank acts as a lender of last resort

Question 5

Solvency problem?

Answer 5

Liabilities > assets

Question 6

Advantages of central bank acting as lender of last resort?

Answer 6

• Prevents panic in banking system which could lead to bank runs and financial crisis
• Reduced chance of bank runs = increased stability of financial system

Question 7

Disadvantages of central bank acting as lender of last resort?

Answer 7

• May encourage banks to engage in high-risk, high-profit activities

Question 8

Implementing monetary policy?

Answer 8

• Central bank manages money supply by affecting availability and cost of credit
• Through interest rates or quantitative easing

Question 9

Regulation of financial markets?

Answer 9

• Competition (to benefit consumers)
• Structure of firms and risk management (to ensure firms are stable), may require banks to meet capital and liquidity ratios or prevent excessive risk-taking
• Strengthening rules and make financial institutions face tough punishments if they dont abide by them
• Identifying systemic risks

Question 10

Capital ratio?

Answer 10

• Ratio of bank’s capital to loans

Question 11

Liquidity ratio?

Answer 11

• Ratio of highly liquid assets to short-term need for cash

Question 12

Systemic risk?

Answer 12

• Possibility that event at micro level of an individual bank could trigger instability of entire industry and threaten the economy

Question 13

Microprudential regulation?

Answer 13

• Oversight and financial regulation of financial institutions on an individual basis
• Ensures they act fairly towards their customers
• Prevent them from taking excessive risks which could leave to bankrupcy

PRA (monitors and maintains financial stability of invidividual financial institutions) and FCA (protects consumers)

Question 14

Macroprudential regulation?

Answer 14

• Mitigates risk to financial system as a whole by removing systemic risks

FPC (monitors and protects financial system from systemic risk by issuing instructions to PRA and FCA)