Week 8: Central Banking and Bank Regulation

Objectives of the Lesson

• Understand the rationale for financial and banking regulation.
• Introduce bank capital regulation.
• Explain the crucial role of central banks in the financial system.
• Discuss the monetary policy functions of central banks.

Outline

I. Bank Regulation and Supervision
II. Bank Capital Regulation
III. Central Banking and Monetary Policy

I. Bank Regulation and Supervision

• The financial sector, especially banking, is heavily regulated due to its critical role in the economy.

  • Banking Regulation: Establishes rules for bank managers.
  • Banking Supervision: Monitors compliance with these rules.

• Importance of Banks: Banks are vital liquidity providers but are vulnerable to instability and contagion risks.

  • A singular bank failure can incite a systemic bank run, threatening the broader financial system.
  • Systemic Risk: The risk of panic spreading across financial institutions.

• Bank Runs: Occur when depositors rush to withdraw savings due to fears of bank insolvency.

  • Liquidity is more critical than solvability during bank runs.
  • Banks operate on a fractional reserve system, leading to potential insolvency under stress conditions (e.g., fire-sales).

• Regulatory Rationale: Aims to ensure a stable banking system and protect public confidence.

  • Risk cannot be entirely removed but must be managed (risk transfer is a key function of financial intermediaries).

• Types of Regulation:

  1. Macro-prudential Regulation: Addresses systemic risks (emphasized post-2008 financial crisis).
  2. Micro-prudential Regulation: Focuses on individual institutions' safety and soundness (e.g., asset quality, capital adequacy).
  3. Conduct-of-business Regulation: Reviews the behavior of financial firms with customers (transparency, integrity).

• Financial Safety Net: Comprised of mechanisms like deposit insurance and last-resort lending to maintain stability and minimize panic risk.

• The debate surrounding regulation:

  • Some argue excessive regulation can lead to moral hazards, reducing incentives for sound management.
  • Financial innovation often aims to circumvent existing regulations (e.g., securitization).

• Compliance Costs: Expenses incurred to meet regulatory requirements.

  • May lead to higher financial service costs.
  • Regulatory Arbitrage: When firms exploit loopholes in the regulatory framework.

II. Bank Capital Regulation

• Basel Regulation: A framework for risk-based micro-prudential regulation focusing on capital adequacy.

  • First instituted by the Basel Committee on Banking Supervision to enhance understanding of supervisory issues.

• Capital Adequacy: Connection between risk and required capital buffer; higher risk demands greater capital:

  • Two forms of capital requirements:
    1. Proportional capital to riskiness of operations (minimum capital requirements).
    2. A leverage ratio above a defined minimum, regardless of balance sheet structure.

• Basel I Capital Framework: Categorizes assets into risk classes for capital requirements:

  • Classes range from 0% risk (cash, OECD government bonds) to 100% risk (commercial loans).

• Basel II and III Changes:

  • Expanded risk types, increased flexibility, refined methodologies for assessing risk.
  • New liquidity ratios such as liquidity coverage ratio (30-day stress) and net stable funding ratio.

III. Central Banking and Monetary Policy

• Role of Central Banks: Oversee the monetary system and promote economic growth.

  • Functions:
    • Issue currency (legal tender).
    • Control credit, liquidity, and money supply.
    • Serve as the lender of last resort to prevent crises.
    • Act as the government’s banker and manage foreign exchange/reserves.

• Objectives of Monetary Policy:

  • Achieve price stability and maintain payment system integrity.
  • Influence interest rates, inflation, employment, and economic growth.

• Monetary Policy Tools:

  • Open Market Operations: Buying/selling government bonds to influence liquidity.
  • Discount Rate: Rate charged to commercial banks for loans from the central bank.
  • Reserve Requirements: Mandatory reserves that banks must hold.

• Quantitative Easing (QE):

  • Used when standard tools are ineffective (e.g., near-zero rates).
  • Involves central banks purchasing assets to stimulate money supply.

Recommended Reading

• CGM Chapters 6 and 7 (parts covered in the slides)