4.4.3 - role of central banks

Question 1

State the four key functions of central banks

Answer 1

o implementation of monetary policy
o banker to the government
o banker to the banks – lender of last resort
o role in regulation of the banking industry

Question 2

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

Answer 2

• help gov manage national debt (e.g reduce inetrest paid by issuing gov bonds)
• offer advice to gov on economic matters and help them in their negotiations with other intl financial orgs
• holds country’s foreign currency and gold reserves

Question 3

Describe the central bank’s role as banker to the banker’s lender of last resort

Answer 3

• ## lender of last resort

Question 4

Pros of central bank’s role as banker to the banker’s lender of last resort

Answer 4

• prevent panic and run on the banks/financial crisis
• reduce impact of financial instability due to reduced chance of bank runs

Question 5

cons of central bank’s role as banker to the banker’s lender of last resort

Answer 5

• moral hazard risk as banks take excessive risks
• banks not holding sufficiently liquidity
• unfair that central bank will try to save financial institutions but not non-financial firms

Question 6

How does the bank act as lender of last resort

Answer 6

• banks borrow short term, lend long term so they can face a shortage of liquidity
• if an individual bank that’s solvent faces a temporary shortage of liquidity, central bank can provide liquidity by lending the bank money
• BOE has a predictable and routine scheme vs an emergency one

Question 7

Define solvent

Question 8

describe illiquidity crisis

Answer 8

• An agent is solvent but illiquid when its debt is not unsustainable but it has large amounts of this debt coming to maturity (i.e. short term debt) and it is not able to roll it over (this creates liquidity crisis, rollover/run crisis).
• Illiquidity can lead to insolvency as illiquidity can trigger default. In a liquidity crisis, international institutions may step in to provide emergency funds as a “lender of last resort”

Question 9

insolvent?

Answer 9

liabilities > assets

Question 10

Why might bank have to act as lender of last resort?

Answer 10

banks has enough liquid assets to cover money owed bu these assets cannot be converted into liquid ones easily

Question 11

solvent

Answer 11

liabilities < assets

Question 12

Defien insolvency crisis

Answer 12

• An agent (such as business, individual or a bank) is insolvent when its debtrelative to its income is so high that it will not be able to pay back its debt
  and the interest on it (i.e. there is an unsustainable debt).
• An insolvency
  crisis may require some form of debt restructuring / debt relief to lower
  default risk

Question 13

How can the central bank implement monetary policy

Answer 13

• manages money supply by affecting availability of credit or its cost
• control interest rates or QE
• affects amount of loans banks make by setting capital requirement (reserves of capital bank must keep)
• influence exchange rate thru buying & selling currencies and changing interest rates
• controls issuing banknotes, no counterfeits