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)