Macro L20

Question 1

What are the roles of central banks?

Answer 1

1) Banker to the gov
2) Banker to the banks
3) Implementing monetary policy & financial regulation
4) Regulation of financial markets

Question 2

What does it mean for a central bank to be banker to the gov?

Answer 2

Gov hold accounts with:
- Central banks
- Commercial banks

Question 3

What does it mean for a central bank to be banker to the banks?

Answer 3

• Lender of last resort
• As they are required to hold cash reserves to prevent banks from failing

Question 4

What 2 problems can banks face meaning they may have issues?

Answer 4

1) Liquidity problem
2) Solvency problem

Question 5

Liquid asset (+ examples):

Answer 5

• An asset that can easily be converted into cash in a short amount of time
• Cash and shares

Question 6

What is a liquidity problem?

Answer 6

A bank has enough liquid assets to cover money owed, but the assets cannot be converted into liquid ones easily (bank run)

Question 7

Why is the liquidity problem an issue?

Answer 7

• If creditors discover this, a bank run may be triggered
• Other banks may refuse to lend if they believe bank is insolvent
• Central bank acts as lender of last resort

Question 8

What does it mean if a bank is insolvent?

Answer 8

Liabilities > Assets

Question 9

What is an solvency problem and how is it fixed?

Answer 9

• When financial assets fall in value, resulting in bank’s liabilities being greater than assets (insolvency)
• Owes more than it owns

Question 10

Give examples of liabilities in economics:

Answer 10

• Deposits
• Money borrowed from financial institutions

Question 11

Advantages of central bank acting as lender of last resort:

Answer 11

• Prevents panic in banking system, which could lead to financial crisis
• Reduced chances of bank runs, increasing stability of financial system

Question 12

Disadvantages of central bank acting as lender of last resort:

Answer 12

May encourage banks to engage in high-risk activities as they are aware central banks will provide lending in emergency

Question 13

What does the regulation of financial markets usually focus on?

Answer 13

1) Competition
2) Structure of firms and risk management
3) Strengthening rules and establishing punishments
4) Identifying, managing and removing systemic risks

Question 14

How is the stability of financial markets regulated?

Answer 14

• Requiring banks to meet capital and liquidity ratios
• Preventing them from taking excessive risks

Question 15

Capital ratio:

Answer 15

• Measures ratio of bank’s capital to loans
• Gives measure of risks associated w/ bank’s lending and stability
• formula: capital/loans

Question 16

Liquidity ratio:

Answer 16

• Measures ratio of highly liquid assets to expected short-term need for cash
• Gives idea of bank’s stability + ability to meet short-term liabilities
• Formula: current assets/current liabilities

Question 17

Systemic risk:

Answer 17

• Possibility that event at micro level of individual bank could trigger instability/ collapse entire industry
• ‘Too big to fail’

Question 18

Microprudential regulation:

Answer 18

Oversight and financial regulation of financial institutions on an individual basis

Question 19

What does microprudential regulation aim to do?

Answer 19

1) Ensure financial institutions act fairly towards customers
2) Prevent financial institutions from taking excessive risks

Question 20

Macroprudential regulation:

Answer 20

Mitigates risks to financial system as a whole (systemic risk)

Question 21

What does macroprudential regulation aim to do?

Answer 21

Protect and enhance resilience of financial system by removing systemic risk

Question 22

What are the 3 bodies created to regulate financial industry and what type of regulation is each responsible for?

Answer 22

1) PRA (Prudential Regulation Authority) –> microprudential
2) FPC (Financial Policy Committee) –> macroprudential
3) FCA (Financial Conduct Authority) –> microprudential

Question 23

Which 2 bodies are controlled by the BofE?

Answer 23

1) PRA
2) FPC

Question 24

What does PRA do?

Answer 24

Monitors and maintains financial stability of financial institutions

Question 25

What does FPC do?

Answer 25

Monitors and protects financial system from systemic risk

Question 26

What does FCA do and who do they report to?

Answer 26

• Protect consumers and increase confidence in financial institutions and products
• Independent body that reports to treasury

Question 27

Disadvantage of financial market regulation:

Answer 27

1) Promotes moral hazard –> incentivise risky decisions
(Gov failure):
2) Asymmetric info (between bank + regulator)
3) Info gap
4) Unintended consequences –> shadow banking
5) Administration & enforcement costs

Question 28

Evaluation of financial market regulation:

Answer 28

• Balance is needed to both protect consumers and against systemic risk, BUT also to maintain bank profitability
• Regulation promotes equity w/out damaging efficiency
• Should be cost benefit analysis