Chapter 39 - The central bank and financial regulation Flashcards
What are the roles of the central bank?
- issuing banknotes and coin
- being banker to the government
- being banker to commercial banks and other financial institutions I
- managing the government’s borrowing
- managing the country’s foreign exchange reserves
- being regulator of the financial system
- targeting inflation by influencing interest rates
How does Islamic banking work?
The key difference between banking as it is known in Western countries and Islamic banking is that Islam prohibits the use of interest (or usury, as it is known). This means that Islamic banks cannot charge interest on loans or pay interest on savings. Gambling is also prohibited.
A variety of financial instruments have been developed to allow banks to lend to firms or to households without charging interest. For example, a bank may agree a profit-sharing deal with a firm. The bank lends to the firm and then shares in the profits of the project.
An alternative is a cost-plus-margin agreement. The bank purchases a given property at an agreed price, and immediately sells it to the buyer, stating the cost plus profit margin. The property is then treated as a commodity sold for money rather than an interest- based loan. The client pays in agreed termly instalments.
What are the key roles of the Bank of England?
Its core activities comprise acting as banker to the government and financial institutions, managing the country’s exchange reserves and supply of currency, and regulating the financial system. These have strong implications for the supply of money and credit in the economy. In addition, it has responsibility for meeting the government’s inflation target.
How is the BoE issuing banknotes and coins?
The issuing of notes and coins has long been a core function of the Bank of England, although it does not have a monopoly in the UK, only in England and Wales. Commercial banks in Scotland and Northern Ireland can also issue banknotes, but the Bank of England regulates their issue. It is important to control the issue of banknotes in order to make sure that demands are met without leading to inflation. However, issuing notes and coins does not mean exercising control of the money supply because of the wide variety of other financial assets that are near-money.
How is the BoE banker to the government?
The Bank of England acts as banker to the government, in the sense that tax revenues and items of government expenditure are handled by the Bank, as are items of government borrowing and lending. In the past, the Bank of England also had responsibility for managing government debt by issuing Treasury Bills, but this was transferred to the Debt Management Office (an executive office within the Treasury) when the Bank was given independence to control the interest rate in order to meet the inflation target.
How is the BoE banker to commercial banks?
The commercial banks and other financial institutions hold deposits at the Bank of England in the form of reserve balances and cash ratio deposits. The reserve balances are used as a stock of liquid assets, but also fulfil a clearing role, in the sense that they are used to equalise any imbalance in transactions between the major banks on a day-by-day basis. In normal times, the Bank agrees an average level of overnight reserves that institutions expect to require in the month ahead. If any institution holds reserves out of their agreed range, this attracts a charge. In other words, if a bank needs to borrow beyond its agreed average reserve level, it must pay a rate that is above bank rate. Deposits above the agreed average are remunerated below bank rate. This encourages institutions to meet their requirements in the interbank market, which helps to keep the interbank rate close to bank rate.
How is the BoE managing the exchange rates?
The Bank of England manages the UK’s gold and foreign currency reserves on behalf of the Treasury. However, interventions have been rare in recent years, with the pound being allowed to find its own level in the foreign exchange market.
What is monetary policy?
A situation in which there is stability in prices relative to the government’s inflation target
What is financial stability?
A situation in which there is a sufficient and efficient flow of liquidity in the economy
What is lender of last resort?
The role of the central bank in guaranteeing sufficient liquidity is available in the monetary system
How is the BoE ensure monetary and financial stability?
The Bank’s main mission is ‘to promote the good of the people of the United Kingdom by maintaining monetary and financial stability’. Monetary stability is interpreted in terms of stability in prices (relative to the government’s inflation target). Financial stability means an efficient flow of funds in the economy and confidence in UK financial institutions.
The efficient flow of funds requires that there is sufficient liquidity in the economy. In other words, there must be enough liquidity for the financial institutions to conduct their business. The traditional way in which this was done was by the Bank acting as the lender of last resort, being prepared to lend to banks if they could not obtain the funds they needed elsewhere, albeit at a penalty rate. Although this was traditionally seen as a key role, events during the financial crisis made it untenable.
What are open market operations?
Intervention by the central bank to influence short-run interest rates by buying or selling securities
What is the effectiveness of policy measures available to the Bank of England?
Central banks have monetary policy as their prime responsibility, so do not have responsibility for all aspects of the government’s macroeconomic policy objectives. For example, the central bank would not normally be concerned with ensuring an equitable distribution of income (which is more appropriately dealt with through fiscal policy), nor would it focus on ensuring environmental sustainability. A central bank may or may not have the responsibility of managing the government’s debt.
For a country operating under a fixed exchange rate, the central bank’s prime responsibility is to maintain the value of the currency, and it may have limited ability to do much else.
However, for most central banks the main focus is on creating a stable economy in terms of low inflation in conjunction with an adequate flow of credit, which in turn can encourage economic growth and high employment.
The Bank of England has responsibility for monetary policy, which is primarily intended to control inflation. This control is a key part of ensuring a stable macroeconomic environment, which in turn helps to encourage economic growth. However, in setting interest rates the Bank takes into account other aspects of the economy’s performance, so there are occasions when the commitment to controlling inflation is tempered by the awareness of other macroeconomic indicators such as unemployment. In evaluating the effectiveness of policy measures available to the Bank of England, the main focus is on stability in financial markets.
Rates of interest also move around in response to market conditions, and the Bank of England can intervene to make sure that short-run interest rates are kept in line with bank rate. It does this by using open market operations, buying or selling securities in order to influence short-run interest rates.
Suppose there is a shortage of liquidity in the financial system. Financial institutions will need to borrow in order to improve their liquidity position. This puts upward pressure on interest rates, so there is a danger that interest rates will move out of line with bank rate. The Bank of England can intervene to prevent this by providing liquidity in the system by buying securities (Treasury bills or gilts) in the open market. Conversely, if there is excess liquidity in the system, interest rates may tend to fall, and the Bank can prevent this by selling securities in the open market.
Banks in difficulty - Even in 2007, it was becoming clear that a number of banks were facing difficulties, having expanded their borrowing substantially relative to their capital base. The response was to reduce lending, sell assets and look for new capital. Borrowing against property was one of the root causes of the problem, as the expectation that house prices would continue to rise had encouraged mortgage lending. When house prices in the USA stalled in 2005-06, defaults began to rise, putting pressure on lenders. The failure of some institutions prompted fears of recession, and one of the side effects of globalisation was that financial markets were interconnected across national boundaries.
A problem with bank failures is the effect it has on confidence in the financial system. As the crisis developed, it was perceived that some of the banks that were in danger were ‘too large’ to be allowed to fail. The demise of a large financial institution would have such an effect on expectations that the whole financial system might be called into question. Hence the moves by the UK and other governments to bail out banks that were in difficulties, in spite of the effect that this had on public finances
Shortage of liquidity - Instead, it introduced quantitative easing, a policy under which it created central bank reserves electronically, which were used to purchase high-quality financial assets such as government bonds in order to provide additional liquidity. This allowed the Bank to continue to influence interest rates, even with bank rate at such a low level.
Quantitative easing - This is essentially a way of increasing money supply. The problem faced by the Bank in this situation was that the rate of inflation had to be kept under control, but at the same time, the reluctance of banks to lend would affect investment and the growth of the real economy, which was heading into recession. Expectations were weak, threatening to prolong the recession. The UK was not alone in facing this combination of circumstances, and other central banks were adopting similar strategies to deal with the growing crisis.
What is the Prudential Regulation Authority (PRA)?
The decision-making body in the Bank of England responsible for microprudential regulation of deposit-takers, insurers and major investment firms
What is microprudential regulation?
Financial regulation intended to set standards and supervise financial institutions at the level of the individual firm
What is the Financial Policy Committee (FPC)?
The decision-making body of the Bank of England responsible for macroprudential regulation
What is microprudential regulation?
Financial regulation intended to mitigate the risk of the financial system as a whole
What is the Financial Conduct Authority (FCA)?
A body separate from the Bank of England responsible for conduct regulation of financial services firms
What is the evaluation to the response to the financial crisis?
The financial crisis highlighted the importance of the financial system for the real economy. Monetary stability is important because low and predictable inflation helps economic agents to form expectations about the future. This encourages firms to invest and allows households to plan their consumption. This in turn can promote economic growth and improvements in the standard of living. However, the crisis demonstrated that financial stability is also crucial, as this enables the flow of funds needed for firms to finance their investment.
The period before the crisis was characterised by monetary stability, with the inflation target being met, and economic growth proceeding at a steady rate. However, the inadequacy of regulation led to a build-up of pressure, which finally erupted in financial instability. This disrupted the financial system and had spillover effects for the real economy, resulting in recession and rising unemployment.
The main manifestations of this were in the failure of liquidity. The interbank market was unable to deliver the liquidity that was needed, and the Bank of England’s role as lender of last resort could not be sustained with bank rate at 0.5%. In this situation, the Bank resorted to expansion of the money supply through the process of quantitative easing to supply liquidity while still keeping inflation within its target range.
The need for financial stability was tackled by the creation of new decision-making bodies with the responsibility for maintaining financial stability through enhanced regulation of the financial system and by monitoring developments in financial markets.
In seeking to maintain its primary objectives of both monetary and financial stability, the Bank needs also to maintain balance with its secondary objective of supporting the government’s overall macroeconomic policy stance. This is no mean feat when the need to bail out failing banks has left a legacy of high public debt.
What is the International Monetary Fund (IMF)?
Multilateral institution that provides short-term financing for countries experiencing balance of payments problems
What is the World Bank?
Multilateral organisation that provides financing for long-term development projects
What are some examples of what the IMF do?
The International Monetary Fund (IMF) was set up with a specific brief to offer short-term assistance to countries experiencing balance of payments problems. So, if a country were running a deficit on the current account, it could borrow from the IMF in order to finance the deficit. However, the IMF would insist that, as a condition of granting the loan, the country put in place policies to deal with the deficit - typically, restrictive monetary and fiscal policies.
In the twenty-first century, the IMF continues to play an important role in maintaining the stability of the interconnected global financial system. In particular, it has provided loans to prevent default by a government. An example is the loan provided to Greece in 2010. The IMF has also provided loans to governments needing to bail out private banks that had become insolvent because of exposure to risky loans. Recent examples include loans to the governments of Hungary, Ireland and Latvia.
What are some examples of what the World Bank do?
The International Bank for Reconstruction and Development was the second institution established under the Bretton Woods agreement. It soon became known as the World Bank. The role of the World Bank is to provide longer-term funding for projects that will promote development, rather than being directly involved in regulating the financial system.
The World Bank is especially important for developing countries, where internal financial markets are undeveloped or dysfunctional. It has a presence in most developing countries, being involved in a variety of projects to promote development and alleviate poverty. It has also undertaken research into ways of improving access to finance for people and firms in developing countries. Access to finance can be a substantial impediment for firms wanting to expand, and for households in need of small loans to improve their income-earning potential.
What are the 10 core policies of the Washington Consensus?
At a conference in 1989, John Williamson drew up a set of ideas about economic policy that he believed represented accepted views. These ideas became known as the Washington Consensus. The ten core policies were:
- fiscal discipline
- reordering public expenditure priorities
- tax reform
- liberalising interest rates
- a competitive exchange rate
- trade liberalisation
- liberalising inward foreign direct investment
- privatisation
- deregulation
- secure property rights
