4.4.3 Role of central banks

Define central bank and include its 6 main responsibilities

A central bank is the monetary authority and major regulatory bank in a country. A central bank is responsible for monetary policy, maintaining financial stability, issuing notes and coins, setting short-term interest rates, managing the country’s gold and foreign currency reserves and issuing government debt.

Define lender of last resort

Usually a function of a central bank, which occurs when financial institutions can obtain money from the central bank to balance their accounts when they are unable to do this from the financial markets in which they operate.

Define shadow banking

Parts of the financial market that are either much less regulated than the norm or are completely unregulated

Define systemic risk

In the context of financial markets, this is the danger that the failure of parts of the financial system will lead to the collapse of the whole financial system.

State the 4 main roles (and 2 less main roles) of central banks with brief descriptions

Implementation of monetary policy: Central banks adjust interest rates to control inflation and promote economic growth

Banker to the government: Most central banks act as banker for the government, with some exceptions such as the ECB.

Lender of last resort: They act as a lender of last resort, providing liquidity to financial institutions in times of crisis.

Regulation of the banking industry: They regulate banks to ensure they are financially sound and to protect depositors.

 

Issuing currency: They are responsible for issuing and managing the country’s currency. This might involve operating with a managed floating exchange rate. (Why central banks don’t like Bitcoin)

Conducting research: They conduct research and provide advice to policymakers.

Define base interest rate

The main interest rate set by a nation’s central bank. This is the rate of interest charged to commercial banks if they must borrow from the central bank when short of liquidity.

State 8 factors the central bank must consider when setting the base interest rate

Rates of growth of real GDP and estimated size of the output gap, forecasts for price inflation, rate of growth of wages and other business costs, movement in a country’s exchange rate, rate of growth of asset prices, movements in consumer and business confidence, external factors such as global energy prices and inflation in other countries, financial market conditions such as rate of growth of credit/money.

What are the three main roles a central bank serves as banker to the government

Issuing government bonds, managing government debt, providing advice

Evaluate the central bank’s role as banker to the government

This role can lead to crowding out, which is when the issuing Of government bonds affects the demand for other financial assets, reducing private sector investment and limiting growth

How do central banks act as banker to other banks

Usually, central banks require large banks in their country to deposit money with them, which is necessary to allow the central bank to balance the accounts of banks at the end of each day.

What are two ways banks can face liquidity crisis

A bank can run out of liquid assets to pay money it owes, even though they have lots of illiquid assets to cover the debt they amounted. This is a short-term liquidity problem and does not signify serious trouble for the bank.

A bank may face fundamental problems if too many of its assets have fallen in value, such as many of their deposits being defaulted on, meaning they are never repaid.

What are the two ways a central bank acts as lender of last resort

Discount window: If a bank amounts a short term debt of liquid assets, the central bank may lend the money the bank needs to cover the short-term debt, or may buy some of the bank’s illiquid assets so they can cover their debt, which is known as the collateral requirements. The loans they provide will come with a slightly high interest rate than the market rate, which is known as the discount window.

Emergency lending: In the case of a serious liquidity crisis due to a fall in asset value, the central bank may become the lender of last resort and provide emergency lending, which is emergency loans which prevents total collapse and limits systemic risk.

Why is the lender of last resort function important?

The importance of this function is because it prevents financial panic. This is as if one bank were to collapse, customers of other banks may attempt to withdraw their money, known as a ‘run on the banks’. This could cause the whole banking system to fail because banks only keep a small fraction of their assets in liquid form.

Evaluate the lender of last resort function

It can be argued this function leads to moral hazard, as banks are aware they can engage in high-risk activities in the short-term because the central bank will bail them out if they made large losses.

Give three recent examples of central banks acting as lender of last resort

2008: During the global financial crisis, the US Federal Reserve acted as the lender of last resort to several financial institutions, such as Bear Stearns, Fannie Mae and Freddie Mac.

2012: The European Central Bank provided emergency ligand to banks in the eurozone to help stabilise the region’s financial system.

2020: During the Covid-19 pandemic, central banks around the world acted as lenders of last resorts to support their economies. For example, the Bank of England provided emergency loans to UK businesses and the Reserve Bank of India provided liquidity to Indian Banks.

What are the three main reasons financial regulation is important asa function of the central bank

It’s needed to prevent harmful practices, to prevent moral hazard, and because systemic risk means one bank taking too much risk can lead to the whole system collapsing

Explain two ways of evaluating financial regulation as a function of central banks

Regulatory capture (main cause of market failure, describes where financial institutions successful lobby regulators and the government to relax their regulations which often leads to financial crisis)

Shadow banking (the growth of these markets is commonly what leads to a financial crisis suggesting government regulation is not effective enough)

What are the 4 main roles of the financial conduct authority (FCA)

Regulation and supervision of firms, consumer protection, direct interventions, market regulation (identifying risks)

What are the two main roles of the Prudential Regulation Authority (PRA)

Prudential supervision, setting and enforcing prudential standards