Macro L20 Flashcards
What are the roles of central banks?
1) Banker to the gov
2) Banker to the banks
3) Implementing monetary policy & financial regulation
4) Regulation of financial markets
What does it mean for a central bank to be banker to the gov?
Gov hold accounts with:
- Central banks
- Commercial banks
What does it mean for a central bank to be banker to the banks?
- Lender of last resort
- As they are required to hold cash reserves to prevent banks from failing
What 2 problems can banks face meaning they may have issues?
1) Liquidity problem
2) Solvency problem
Liquid asset (+ examples):
- An asset that can easily be converted into cash in a short amount of time
- Cash and shares
What is a liquidity problem?
A bank has enough liquid assets to cover money owed, but the assets cannot be converted into liquid ones easily (bank run)
Why is the liquidity problem an issue?
- 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
What does it mean if a bank is insolvent?
Liabilities > Assets
What is an solvency problem and how is it fixed?
- When financial assets fall in value, resulting in bank’s liabilities being greater than assets (insolvency)
- Owes more than it owns
Give examples of liabilities in economics:
- Deposits
- Money borrowed from financial institutions
Advantages of central bank acting as lender of last resort:
- Prevents panic in banking system, which could lead to financial crisis
- Reduced chances of bank runs, increasing stability of financial system
Disadvantages of central bank acting as lender of last resort:
May encourage banks to engage in high-risk activities as they are aware central banks will provide lending in emergency
What does the regulation of financial markets usually focus on?
1) Competition
2) Structure of firms and risk management
3) Strengthening rules and establishing punishments
4) Identifying, managing and removing systemic risks
How is the stability of financial markets regulated?
- Requiring banks to meet capital and liquidity ratios
- Preventing them from taking excessive risks
Capital ratio:
- Measures ratio of bank’s capital to loans
- Gives measure of risks associated w/ bank’s lending and stability
- formula: capital/loans
Liquidity ratio:
- 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
Systemic risk:
- Possibility that event at micro level of individual bank could trigger instability/ collapse entire industry
- ‘Too big to fail’
Microprudential regulation:
Oversight and financial regulation of financial institutions on an individual basis
What does microprudential regulation aim to do?
1) Ensure financial institutions act fairly towards customers
2) Prevent financial institutions from taking excessive risks
Macroprudential regulation:
Mitigates risks to financial system as a whole (systemic risk)
What does macroprudential regulation aim to do?
Protect and enhance resilience of financial system by removing systemic risk
What are the 3 bodies created to regulate financial industry and what type of regulation is each responsible for?
1) PRA (Prudential Regulation Authority) –> microprudential
2) FPC (Financial Policy Committee) –> macroprudential
3) FCA (Financial Conduct Authority) –> microprudential
Which 2 bodies are controlled by the BofE?
1) PRA
2) FPC
What does PRA do?
Monitors and maintains financial stability of financial institutions
What does FPC do?
Monitors and protects financial system from systemic risk
What does FCA do and who do they report to?
- Protect consumers and increase confidence in financial institutions and products
- Independent body that reports to treasury
Disadvantage of financial market regulation:
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
Evaluation of financial market regulation:
- 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
