LS20 - Role of Central Banks

Question 1

how does the role of central banks differ in different countries?

Answer 1

some countries have independence from government, others don’t

Question 2

roles of central banks

Answer 2

• banker to government
• banker to the banks
• implementing monetary policy
• regulation of financial markets

Question 3

banker to the government

Answer 3

• individuals hold accounts with retail banks e.g. HSBC
• Gov hold accounts with central banks
• may be responsible for managing a country’s national debt
• hold a country’s foreign currency and gold reserves

Question 4

bankers to the banks

Answer 4

• commercial/retail banks have to hold cash reserves in central bank account to ensure they are in a safe place and can settle interbank balances at the end of a trading day
• acts as a ‘lender of the last resort’ to prevent banks failing

Question 5

two ways a bank may fail/run into trouble

Answer 5

• liquidity problem
• solvency problem

Question 6

liquidity problem

Answer 6

• banks hold liquid assets e.g. cash/shares but is worth less then illiquid assets e.g loans
• when depositors withdraw money/creditors need repayment banks use liquid assets but a bank may underestimate the liquid assets needed
• can trigger bank run and danger that other banks refuse to lend to it as they think the bank is insolvent
• can’t turn for funds in private sector so go to central bank

Question 7

bank run meaning

Answer 7

when the customers of a bank or other financial institution withdraw their deposits at the same time over fears about the bank’s solvency/failure

Question 8

insolvent meaning

Answer 8

liabilities>assets

Question 9

solvency problems

Answer 9

• banks have financial assets e.g. bonds/shares that can rise/fall in value
• if it falls, then it’s possible the value of the liabilities will exceed assets - insolvency problem
• banks can meet short-term commitments by borrowing from the central bank acting as lender of last resort

Question 10

liabilities

Answer 10

deposits, money borrowed from other financial institutions

Question 11

assets

Answer 11

cash, bonds, loans given to banks

Question 12

advantages of the central bank acting as a lender of last resort

Answer 12

• helps prevent panic in banking system which could lead to bank runs/financial crisis
• reduces chance of bank runs increasing stability of financial system

Question 13

disadvantages of the central bank acting as a lender of last resort

Answer 13

• ability to borrow from central bank may encourage banks to engage in high risk, high profit activities as they know central banks will provide lending in an emergency

Question 14

implementing monetary policy

Answer 14

• central bank manages monetary supply by affecting availability of credit or its cost
• mainly done through interest rates and quantitative easing

Question 15

regulation of financial markets

Answer 15

usually focuses on:
- making financial markets competitive to benefit consumers
- structure of firms & risk management - ensuring they are stable - may be achieved by requiring banks to meet capital & liquidity ratios or preventing them from taking excessive risks
- strengthening rules/principles that financial institutions must abide by or face tough punishments
- identifying systemic risks & finding ways to manage/remove them

Question 16

capital ratio

Answer 16

• measure ratio of bank’s capital to loans
• measure of the risks associated with the bank’s lending & of the bank’s stability

Question 17

liquidity ratio

Answer 17

• measures ratio of highly liquid assets to the expected short-term need for cash
• gives idea of bank’s stability as well as ability to meet short term liabilities

Question 18

systemic risk

Answer 18

• possibility that an event at the micro level of a bank could trigger instability or the collapse of the entire industry thus threatening the economy

Question 19

microprudential regulation

Answer 19

• oversight & financial regulation of financial institutions of financial institutions on an individual basis.
  It aims to:
• ensure individual financial institutions act fairly towards their customers
• prevent financial institutions from taking excessive risks which could lead to bankruptcy.

Question 20

Macroprudential regulation

Answer 20

• the approach to financial regulation that aims to mitigate risk to the financial system as a whole (or “systemic risk”).
• It aims to protect and enhance the resilience of the financial system by reducing or removing system risk.

Question 21

financial crisis causes

Answer 21

• The 2008 financial crisis had multiple causes including weak regulation.
• general consensus among economists was that central banks, such as the FED and the Bank of England, had developed a regulatory framework that was capable of achieving stable inflation but did not possess the same degree of control over financial stability.
• Post the financial crash, this led the UK government to introduce a new regulatory framework that was designed to increase financial stability.

Question 22

UK regulatory changes post financial crisis

Answer 22

• Three new bodies were created to regulate the financial industry. Two were responsible for microprudential regulation and one was responsible for macroprudential regulation
  Two bodies were put under the control of the Bank of England:
  1) Prudential Regulation Authority (PRA) (microprudential): aims to monitor and maintain the financial stability of financial institutions e.g. through supervising firms to ensure that they successfully managed risk.
  2) Financial Policy Committee (FPC) (macroprudential): monitors and protects the financial system from systemic risk e.g. by issuing instructions to the PRA and FCA to tackle problems that threaten the financial system.
• Another microprudential regulator called the Financial Conduct Authority (FCA) was set up to protect consumers and increase confidence in financial institutions and products e.g. by banning misleading adverts for financial products and services. The FCA is an independent body that reports to the Treasury.