The Central Bank and Financial Regulation

Question 1

What is the central bank?

Answer 1

This is the banker to the government

Question 2

Name the functions of the central government?

Answer 2

Issuing notes and coins
Banker to the government
Banker to the commercial banks
Managing the exchange rate 
Monetary and financial stability
Inflation targeting

Question 3

Explain the central banks role in issuing notes and coins

Answer 3

Printing banknotes and issuing them. It only has a monopoly in England and Wales as in Scotland and NI their commercial banks can issue bank notes.

Question 4

Explain the central banks role in being the banker to the government

Answer 4

Tax revenues and items of government expenditure as well as items of government borrowing and lending are handled by the bank.

Question 5

Explain the central banks role as being the banker to commercial banks

Answer 5

Commercial banks hold deposits at the Bank of England in the form of reserve balances and cash ratio deposits.
The Central bank agrees on an average amount of reserves that commercial banks can borrow per month but if a bank wants to exceed this amount the rate of interest they have to pay is higher than the bank rate.

In the same way, if a bank wants to save beyond the agreed average the interest they receive will be below the bank rate.

Question 6

What is a reserve balance?

Answer 6

These are used as a stock of liquid assets

Question 7

Explain the central banks role in managing the exchange rate.

Answer 7

The BoE holds the UK’s gold and foreign currency reserves, however it is rare for the bank to intervene and generally the pound is allowed to find its own level.

Question 8

What is monetary stability?

Answer 8

When prices are low stable relative.

Question 9

What is financial stability?

Answer 9

This is when there is an efficient flow of money in the economy and there is confidence in financial institutions.

Question 10

Explain the central banks role in encouraging financial stability in the economy.

Answer 10

The Bank of England is the lender of last resort and will lend money to banks if they can’t obtain this money elsewhere in order to make sure that there is enough liquidity in the economy.

Question 11

Explain the central banks role in inflation targeting

Answer 11

In 1997 the Labour government gave the BoE independent responsibility to set interest rates in order to achieve the inflation target. The Monetary Policy Committee is committed to maintaining monetary stability particularly focusing on meeting the governments inflation target.

Question 12

How would the functions of a central bank be different if it wasn’t independent and instead was under ‘government control’.

Answer 12

Our BoE was given independence to set the interest rate in order to meet the inflation target set by the government.

Question 13

What is the bank rate?

Answer 13

The rate of interest on short term loans issued by the bank of England to other banks, this influences the interest rate paid on other financial assets.

Question 14

What are open market operations?

Answer 14

When the central bank buy and sell government securities (a type of long term loan) to influence short run interest rates.

Question 15

What happens when the Bank of England sell government bonds from commercial banks?

Answer 15

They are reducing the amount of money in circulation in the economy in the short term, increasing the interest rate.

Question 16

What happens when the Bank of England buy government bonds from commercial banks?

Answer 16

When the BoE buy government bonds they are essentially issuing cash to commercial banks in return for the bond, increasing the supply of money. Since there is a higher supply the price of loans (interest rates falls)

Question 17

Why would financial institutions borrowing from the central bank put upward pressure on interest rates?

Answer 17

This would increase the amount of cash that the institution has, increasing money supply, causing the quantity of loanable funds to increase and the interest rate.

Question 18

What is quantitative easing?

Answer 18

When the central bank increase liquidity in the economy by buying assets from commercial banks. In the financial crash this was financed by creating electronic money.

Question 19

What are the advantages of quantitative easing?

Answer 19

The BoE buying these assets increases the liquidity of commercial banks when there isn’t enough liquidity in the economy. They potentially provide financial stability and allow banks enough cash to give to depositors that want to withdraw some of their deposit.

They allow the BoE to control the money supply and credit (the amount of loans influences investment)bin the economy

Question 20

What are the disadvantages of quantitative easing?

Answer 20

It causes upward pressure on the inflation rate as consumers have excess cash balances and it causes banks to increase credit in the economy resulting in more loans being taken out.

Question 21

Why are financial institutions regulated?

Answer 21

To make sure that banks do not lend too riskily to the point where what they loan isn’t covered by their capital as this opens up the risk of financial instability.

Question 22

What bodies regulate our financial system in the UK?

Answer 22

The Prudential Regulation Authority (BoE) is responsible for microprudential regulation

Financial Policy Committee (BoE)- responsible for macroprudential regulation

Financial Conduct Authority (not BoE)

Question 23

What is Microprudential regulation and which body in the bank of England is responsible for it?

Answer 23

This is financial regulation to set standards and supervise over 1700 banks, insurers and major investment banks at the level of the individual firm.
This is covered by the Prudential Regulation Authority

Question 24

What is Macroprudential regulation and which body in the bank of England is responsible for it?

Answer 24

Financial regulation to reduce risk to the financial system as a whole.
The Financial Policy Committee in the BoE is responsible for this.

Question 25

What is the Financial Conduct Authority?

Answer 25

Separate from the Bank of England, this body regulates financial services firms that are not regulated by the (PRA) including asset managers and hedge funds.

It also ensures that relevant financial markets are working well.

Question 26

What is wrong with having a financial system that is not regulated?

Answer 26

It increases the likelihood that banks won’t hold enough liquid cash as they’ll lend to large a proportion of deposits out as loans meaning they’re in danger if people ask to withdraw their deposit.

They’ll give more risky loans, beyond what they have capital to cover.

Question 27

What can the Financial Policy Committee do to help regulate the financial stability of the macro economy?

Answer 27

It can use the countercyclical capital buffer- this is when banks, building societies and large investment banks can be required to hold extra loss absorbing capital

Can impose Sectoral Capital requirements - if the FPC perceives a risk to the stability of the financial system, firms can be required to meet additional capital levels.

Question 28

What are Sectoral Capital requirements

Answer 28

When the FPC perceives a risk to the stability of the

financial system, so firms are required to meet additional capital levels

Question 29

What is the countercyclical capital buffer

Answer 29

this is when banks, building societies and large investment banks can be required to hold extra loss absorbing capital. This is to help them absorb unexpected bad debts.

Question 30

What is the meaning of prudent?

Answer 30

Being careful at times of uncertainty.

Question 31

Why is financial stability important?

Answer 31

When there is enough liquidity in banks it enables firms to finance investment, which causes economic growth which allows economic development and increased living standards.

Question 32

Why is monetary policy important?

Answer 32

Low and stable inflation means that firms and consumers can make expectations about the future, meaning our country is seen as safe to invest in. This results in economic growth which allows living standards to rise.

Question 33

What is the primary objective of the Financial Policy Committee in the BoE?

Answer 33

To reduce the risk to the financial system as a whole.

Question 34

What is the secondary objective of the Financial Policy Committee in the BoE?

Answer 34

To support the government’s economic policy and helping the government to facilitate growth and unemployment.

Question 35

Why is there sometimes a conflict between the BoE primary and secondary objectives.

Answer 35

In the financial crash the BoE had to bail out commercial banks to try to achieve financial stability but this resulted in high public sector debt which is bad for the macroeconomic and can reduce consumer and firm confidence in our economy.

Question 36

How did globalisation contribute to the 2008 financial crisis?

Answer 36

Since financial markets across countries became more interconnected, this increased the likelihood of contagion, that a financial crisis in one country would spread to another.
This is why international cooperation in regulating financial markets has become more important.

Question 37

Name the three organizations that regulate and coordinate financial markets on an international scale.

Answer 37

Bank for International Settlements (BIS)
International Monetary Fund (IMF)
World Bank

Question 38

What is the role of BIS

Answer 38

The Bank for International Settlements acts as a banker to 60 central banks and sets standards for regulation of banks that are accepted globally .

Question 39

What has BIS done to improve financial regulation between countries?

Answer 39

In 1982 the Basel Committee was set up and this committee created a credit risk measurement that is now accepted globally. This was to prevent a nations central bank from defaulting and failing to meet obligations on international debt.

Question 40

What is the Basel III agreement?

Answer 40

This is the most recent agreement on international credit risk requirement set by the Basel Committee in the Bank for International Settlements.
It specifies internationally recognized capital adequacy requirements for central. banks

Question 41

What is the International Monetary Fund?

Answer 41

An organization that helps to maintain the stability of the interconnected global financial system.

Question 42

Who does the IMF lend to?

Answer 42

It offers short term assistance to countries
experiencing Balance of Payment problems, however the country has to implement certain restrictive monetary and fiscal policies to deal with the deficit.

countries at risk of sovereign default (nation doesn’t meet obligations of international debt).

Governments that need to bail out commercial banks in their country

Question 43

What is the role of the World Bank?

Answer 43

To provide longer term loans for projects that will promote development. This is generally done at commercial interest rates.

Question 44

Why is the World Bank seen as more important for LDCs?

Answer 44

Often in these less developed countries, financial markets are undeveloped so it is difficult for people to take out loans as the only option is a local money lender that charges an extremely high interest rate.

The loans from the world bank are often at a commercial interest rate and this relatively low interest rate allows funding for projects that promote development and help alleviate poverty.

Question 45

What evidence is there that BIS, World Bank and the IMF haven’t done enough to regulate financial markets internationally?

Answer 45

Crises have still occurred such as the Asian financial crisis of 1997 and the 2008 global credit crunch

The HIPC Initiative is what caused the World bank to consider debt forgiveness rather than just the rescheduling of debt.