Chapter 14 - commercial and central banks

Question 1

what are the types of banks

Answer 1

1. WHOLESALE BANKS = provide financial services to large organisations
2. RETAIL/COMMERCIAL BANKS = traditional high street banks

Question 2

what are a commercial banks’ aims which may be seen as conflicting

Answer 2

1. PROFITABILITY = must make profit/return for its shareholders. depends on interest rates it charges.
2. LIQUIDITY = bank must have sufficient liquid assets (cash) to meet demands from depositors for cash withdrawals. or near liquid like Treasury Bills but liquid assets = low return
3. SECURITY = charge higher IR on higher risk. if borrowers default on loans = depositors withdrawing deposits from bank

Question 3

explain the process of credit creation

Answer 3

a process where a bank uses a part of its customers’ deposits to offer loans to other individuals and businesses.

the bank can keep depositing and lending as long as the cash reserve ratio is maintained

Question 4

process of increasing the money supply through government action/assets

Answer 4

funds borrowing through issuing financial assets - treasury bills - to financial market

1. banks buy bills and hold them as reserves instead of cash and lend money to gov
2. gov spends borrowed money and recipients put money into bank accounts
3. amount of money has increased by amount gov has borrowed

Question 5

formula for increase in deposits

Answer 5

= initial cash deposit x credit multiplier

credit multiplier = 1 / reserve ratio (liquidity ratio)

Question 6

role of central banks

Answer 6

1. SETTING INTEREST RATES = to support IR policy the central bank may use open market operations (the purchase and sale of securities) which means central banks supply cash to banking system when banks have cash shortages
2. REGULATING BANKING SECTOR = may introduce regulations to reduce risk of financial crises.
3. MAINTAINING FINANCIAL STABILITY = acting as a ‘lender of last resort’ when banking system short of money at suitable IR. may inject liquidity by buying assets from commercial banks - quantitative easing

Question 7

other functions of a central bank

Answer 7

• banker to commercial banks
• banker to central gov
• central note-issuing authority
• holding the country’s foreign currency reserves

Question 8

financial assets ranked in risk

Answer 8

LOW RISK

treasury bills = issued by gov, safe
government bonds = uncertain as will vary on changing market price on bond
corporate bonds = company may go bust or price go down
share/equity = company may fail share price fall or dividends are uncertain

HIGH RISK

Question 9

what is the impact of the central bank on financial market yields

Answer 9

• central banks set short term IR = impact on market rates = impacts base rate of major banks = effect on expected yields of other financial assets
• if interest rates go up following bank intervention = required return will go up and share prices tend to fall

Question 10

effects of an increase in money supply

Answer 10

rate of interest FALLS
levels of borrowing and investment RISES

Question 11

impact of sale of government bonds

Answer 11

commercial banks balances with central bank FALL

money supply FALLS

interest rates RISE

Question 12

if liquidity ratio increases …

Answer 12

credit multiplier FALLS

extent of increase in total deposits from initial deposits FALLS

Question 13

what determines a commercial bank’s ability to create credit?

Answer 13

• amount of cash and liquid assets held by the bank
• the banks required ratio of liquid assets to total assets

Question 14

how to work out the cost of a bank bill with face value/maturity/market price now

Answer 14

change in price:
face value - market price / face value

change in price x 12 / maturity

(12 months in a year)