End-chapter question chapter 2 The Monetary Authorities Flashcards Preview

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1.  Outline how the Bank of England developed its power as a central bank.

1.  Outline how the Bank of England developed its power as a central bank.
 
The central banking system has its roots in the seventeenth century in Europe, where its original function was to raise funds for the government. One of the first central banks, the Bank of England, was established in 1694 to act as the banker for the government. In the 1830s, a crucial step was taken by the British government when it made the Bank of England the sole issuer of notes in England and Wales, with those of other banks withdrawn. This gave the government control over the level of funds (credit) available in the economy because it could control the amount of notes that were issued.  This was later tied to the bank’s stock of gold bullion, which became the basis for the gold standard (valuing currency in relation the value of an ounce of gold).  
At the same time, the Bank of England began to influence the supply of credit in the market through the issuing of interest-bearing securities with no maturity date. This enabled the bank to reduce liquidity by selling consols, which drains funds from the economy, and increase liquidity by buying them back, which puts money into the economy, thus influencing credit conditions in the financial system. The role of the Bank of England expanded further in the 1860s when it became the ‘lender of last resort’ by lending to banks in financial crisis at a penalty rate (Jonsan 1997). This further consolidated the central banking role of the Bank of England as it allowed it to require financial institutions to provide it with information and data on their operations to provide them with this service.

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2.  Why do you think there is debate over the role that central banks should play?

2.  Why do you think there is debate over the role that central banks should play?
 
This debate often centers on the issue of the degree of independence of central banks. Some argue that central banks are more effective when they are independent of government, while others point out that the government (assuming it has been democratically elected) acts in the interests of the people, and therefore should have a high degree of control of their central bank. Central banks around the world do not perform the same functions, nor do they have the same degree of independence from government.

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3.  What are major regulatory bodies in the Australian financial system and what are their main roles?

3.  What are major regulatory bodies in the Australian financial system and what are their main roles?
 
1. The RBA, Australia’s central bank, is responsible for monetary policy, systemic stability and the payments system.

2. APRA is responsible for prudential supervision of financial institutions including banks, credit unions, building societies, and insurance and superannuation companies.

3. ASIC is responsible for enforcement of company and financial services laws, with the aim of protecting consumers, investors and creditors. This includes the responsibility for licensing and monitoring financial markets and advisors, and monitoring the disclosure and conduct of Australian companies and financial services providers.

The three agencies are coordinated by the Council for Financial Regulators (CFR), which acts as a mechanism for sharing information on views and discussion on regulatory issues between the three agencies.

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4.  Outline the development of central banking in Australia from the CBA, formed in 1912, to the RBA as we know it today.

4.  Outline the development of central banking in Australia from the CBA, formed in 1912, to the RBA as we know it today.
 

The Commonwealth Bank of Australia (CBA) was established by legislation in 1911, with the enacting of the Commonwealth Bank Act, and began operations in 1912. The transformation of the CBA from a commercial and savings bank took place over years:

- responsibility for note issuance from the federal treasury in 1920

- responsible for all commercial banking settlements in 1924

- control over gold reserves in 1929

- control over the exchange rate in 1931. 

- control over the operations of the banking system in the early 1940s, including the power to set interest rates and to require private banks to deposit funds with it as part of the minimum liquidity and capital requirements. 

These powers were formalised in 1945 with the enacting of the new Commonwealth Bank Act and the Banking Act, which detailed responsibilities for the administration of monetary and banking policy and exchange control. This led to the CBA delineating its commercial operations and its central banking duties in the 1950s, with the Reserve Bank Act 1959 formally establishing the RBA separately as Australia’s central bank. This took effect on 14 January 1960 and also marked the establishment of the commercial CBA. The next major change to the functions of the RBA occurred as a result of the Campbell Committee inquiry into the financial system in 1979. In the years after this inquiry, the Australian financial system was progressively deregulated. A significant change occurred in 1983 when the Australian dollar was floated and exchange control abolished (the RBA had been setting the exchange rate weekly up to this point). At the same time, the RBA was moving away from direct control of banks to a more market-oriented means of implementing monetary policy (monetary policy is covered in detail in chapter 3), while developing expertise in banking supervision. Recent changes resulted from the Wallis Committee inquiry which took effect from 1 July 1998:

- The supervision of financial institutions was taken from the RBA and vested with the newly created APRA. 

- The Reserve Bank Act was amended to establish the Payment System Board, with a mandate to promote the safety and efficiency of the Australian payments system.
 

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5.  Outline the key functions and responsibilities of the RBA.

5.  Outline the key functions and responsibilities of the RBA.
 

The primary functions of the RBA are:

• the determination and implementation of monetary policy

• issuing Australian currency notes

• overseeing the payments system and facilitating its operation

• acting as the government’s banker and issuing securities on its behalf

• issuing and providing the market for Commonwealth treasury securities

• managing financial system liquidity and the government’s holding of foreign exchange.
The primary statutory responsibilities of the RBA are now embodied in the Reserve Bank Act section 10(2) and are often referred to as the RBA’s charter:


It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank… are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

a. the stability of the currency of Australia;

b. the maintenance of full employment in Australia; and

c. the economic prosperity and welfare of the people of Australia

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6.  The RBA has two boards. Identify these and outline the role of each.

6.  The RBA has two boards. Identify these and outline the role of each.
 
The RBA is managed and overseen by the Reserve Bank Board. The board meets 11 times a year (the first Tuesday of each month except January) and its main business is monetary policy. Central to these meetings are decisions on changing the RBA target cash rate, which influences interest rates charged and paid on financial products.  The second is the Payments System Board (PSB), which is responsible for the stability and safety of the payments system. The PSB meets once a quarter and is also required to inform the government of its policies and provide an annual report to parliament.

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7.  What is the payments system?

7.  What is the payments system?


The payments system is the mechanism by which the funds are transferred from one party to another to settle financial transactions that occur in the economy.
 

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8.  Outline APRA’s role in the Australian financial system.

8.  Outline APRA’s role in the Australian financial system.
 
APRA’s mission is ‘to establish and enforce prudential standards and practices designed to ensure that, under all reasonable circumstances, financial promises made by institutions we supervise are met within a stable, efficient and competitive financial system.’ APRA’s specific functions include: the development and implementation of prudential regulation that supervised entities will have to abide by (this is discussed in detail in chapter 17) monitoring regulated entities to ensure that they are complying with the relevant legislation and prudential policies. This includes powers to force institutions to comply and remedy any noncompliance advising the government on the development of regulation and legislation affecting regulated institutions and the financial markets in which they operate.
 
 

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9.  Outline the broad responsibilities of ASIC in the regulation of financial markets.

 9.  Outline the broad responsibilities of ASIC in the regulation of financial markets.

It is charged with responsibility for enforcing company and financial services laws to protect consumers, investors and creditors. The specific responsibilities of ASIC are formalised in the Australian Securities and Investments Commission Act 2001. This act gives ASIC a broad role in terms of applying the law, ensuring market participants are fully informed and improving the performance of the financial system and the entities within it.
 

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10.  Discuss the importance of the role of the BIS.

 

10.  Discuss the importance of the role of the BIS.
 
The BIS plays a crucial role in the ever more global financial system, supporting various central banks and their currencies through a variety of crises, such as in Mexico in 1982 when heavy debt effectively bankrupted the country. The bank has also been at the forefront of regulatory supervision, with the widely adopted 1998 Basel Accord on credit risk management and Basel II, which is currently being developed.
 

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11.  What is the role of the US Federal Reserve system?

11.  What is the role of the US Federal Reserve system?
 
The passage of the US Federal Reserve Act in 1913 was designed to establish:

1. a monetary authority that would expand and contract the nation’s money supply according to the needs of the economy, 

2. a lender of last resort that could furnish additional funds to banks in times of financial crisis, 

3. an efficient payment system for clearing and collecting cheques at par (face value) throughout the country

4. a more vigorous bank supervision system to reduce the risk of bank failures.

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12.  Is it true that Hong Kong does not have a central bank? If so, how then does it control its financial system?

12.  Is it true that Hong Kong does not have a central bank? If so, how then does it control its financial system?


Hong Kong does not have a central bank, rather it has a principal regulator, the Hong Kong Monetary Authority (HKMA), which assumes many of the functions of a typical central bank. The HKMA administers the Banking Ordinance, the regulatory framework for banking supervision. Section 7(1) gives the HKMA the primary function of promoting the ‘general financial stability and effective working of the banking system’.

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13.  Outline the New Zealand central banking system and draw comparisons and differences with the Australian system.

13.  Outline the New Zealand central banking system and draw comparisons and differences with the Australian system.
 
The New Zealand central banking system is similar to the Australian system before the introduction of APRA, in that the central bank, The Reserve Bank of New Zealand (RBNZ), is responsible for monetary policy, systemic stability and prudential regulation. The broad objective of the RBNZ is to promote monetary and financial stability.  Specific functions include:

- To conduct monetary policy 

- Being the sole issuer of New Zealand currency (notes and coins), 

- Being responsible for the registration and prudential regulation of banks

- Managing financial system distress and bank failures and acting as a lender of last resort to the New Zealand financial system. 

- Operation of the New Zealand payments system

- Managing foreign currency reserves.  
 

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14.  Explain the sense in which the RBA is independent of the Federal Government. How independent is the RBA in reality? What is your opinion about the importance of the RBA’s independence for the Australian economy?

14.  Explain the sense in which the RBA is independent of the Federal Government. How independent is the RBA in reality? What is your opinion about the importance of the RBA’s independence for the Australian economy?
 
The term ‘RBA independence’ means that the RBA is free from political and bureaucratic pressures when it formulates and executes monetary policy.  The RBA is not directly under the authority of the Government or the Prime Minster. Whether independence is important is a debated issue. Advocates of independent central banks believe that independence from day-today political pressure allows central banks to better manage their countries’ national economies. By ‘better’ we mean that the central bank can take short-run policy actions that may be politically unpopular but in the longer run benefit the economy’s overall macroeconomic performance. For example, this is often the case when inflationary pressures begin to build up in an economy during a period of rapid economic expansion. To dampen inflation, a central bank will raise interest rates to slow the rate of economic growth and thus dampen inflationary expectations. Needless to say, raising interest rates to slow down an economy rarely wins political applause.


In the short run, the RBA has a relatively high degree of independence because it operates as a bank and does not rely on the Government for funding. In addition the long, up to 7-year, terms of the governors, which insulate them from day-to-day political pressures. Assuming no resignations, an incoming government may have little control over the composition of the RBA Boards.


Over the longer run, the RBA’s independence is constrained with the RBA being fully aware that Parliament created the Central Banking System and that its charter can always be modified by Parliament. Also, the RBA in practice is obliged to consult with the Federal Treasury and the Treasurer in relation to monetary policy. Finally, the RBA is subject to the laws of Australia, which come close to spelling out the economic responsibilities of the federal government. As a result, the RBA is keenly aware of political pressures and of secular changes in economic policy.

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15.  What are the RBA’s primary statutory responsibilities? Where can these be found and how does the RBA operationalise them?

15.  What are the RBA’s primary statutory responsibilities? Where can these be found and how does the RBA operationalise them?
 
The primary statutory responsibilities of the RBA are now embodied in the Reserve Bank Act section 10(2) and are often referred to as the Bank’s Charter:


‘It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank…are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

a. the stability of the currency of Australia;

b. the maintenance of full employment in Australia; and

c. the economic prosperity and welfare of the people of Australia.’

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16.  Discuss the primary functions that the RBA performs in the Australian financial system and how these relate to achieving its overall responsibilities set out in its charter.

16.  Discuss the primary functions that the RBA performs in the Australian financial system and how these relate to achieving its overall responsibilities set out in its charter.
 
The primary functions of the RBA are:

• The determination and implementation of monetary policy

• Issuing notes

• Overseeing the payments system and facilitating its operation

• Acting as the government’s banker and issuing securities on its behalf

• Issuing and providing the market for Commonwealth Treasury securities

• Managing financial system liquidity and the government’s holding of foreign exchange

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17.  Outline the significance of the GFC for financial regulatory authorities around the world. Why has the Australian financial system suffered a lesser impact than other developed economies?

17.  Outline the significance of the GFC for financial regulatory authorities around the world. Why has the Australian financial system suffered a lesser impact than other developed economies?
 
Regulatory authorities were put under extreme pressure as a result of the GFC with many believing they were not sufficiently vigilant in monitoring the performance and risk that those under their supervision were bearing.  It is also apparent that the regulators did not foresee the speed with which international contagion could take hold as a result of the level of dependence on global capital flows.  Perhaps most damning are the complex financial products (such as credit derivates and swaps) that proved very difficult to assess and contain.  As a result the regulatory system in many regions of the world (particularly the US and UK) were/are subject to significant reviews.
 
In terms of Australia, there are a number of reasons why there was a lesser impact that other developed countries.  These include:


• A small system characterised by a small number of large institutions that were well capitalised and more closely monitored

• Minimal impact on underlying mortgage assets which placed less pressure on loan portfolios, largely due to under supply of housing and a growing population

• An export led economy (in relation to minerals) that had only  a comparatively short slow down period

• Government action to guarantee deposits and stimulate the economy

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18.  Identify the various retail and wholesale payment instruments used in the Australian payments system.

18.  Identify the various retail and wholesale payment instruments used in the Australian payments system.
 
Payment instruments can be divided into cash and non-cash types.  Cash, or legal tender, is notes and coins issued by the government and represent a store of value. While cash transactions represent a large percentage of total transactions, given that most of these are small in value, it represents only a fraction of the value of all transactions in the payments system.  Non-cash instruments can be further divided into paper and non-paper instruments.  The most important low value paper non-cash payment instrument is cheques.  Non-paper low value electronic instruments include EFTPOS, credit cards and direct entry credits and debits.  In addition to the cash/non-cash distinction, the RBA also divides payments into low value payments (high volume cash and non-cash payments that involve small transfers of value such as cash, EFTPOS, credit card transactions) and high value payments.  High-value transactions are far fewer in number, but account for a majority of the value that is settled in the payments system.  Common forms of high value payment instruments are bank cheques and warrants.

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19.  Outline how the Australian payments system operates. Why is it important for this system to be efficient and reliable?
 

19.  Outline how the Australian payments system operates. Why is it important for this system to be efficient and reliable?
 
The payments system is the mechanism by which the funds are transferred from one party to another to settle these transactions.  The payments system is the mechanism that allows consumers, businesses and other financial market participants to transfer funds to one another to settle these transactions.  An efficient and reliable payments system is therefore a key ingredient to maintaining a stable and effective financial system.

The Australian payments system handles transactions in accordance with their size, ie whether they are high value or low value.  This determines whether a given transaction is settled in realtime or batch processed after the net positions of each institution in the system have been calculated at the end of each business day.  Before this can occur, however the payments must be cleared by the financial institutions involved.
 
 

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20.  What is the 3–6–3 rule? What led to this situation and why was it a motivator for change?
 

20.  What is the 3–6–3 rule? What led to this situation and why was it a motivator for change?
 
The 3-6-3 rule is where banks paid three per cent on deposits, charged six per cent on loans and closed the branch at 3 p.m. This was implemented through interest rate controls enforced through regulation, which aimed to provide stability and certainty in the finance markets.  In practice this resulted in no price-based competition between institutions in terms of attracting funds and limited their ability to lend, hence exposing them to little risk. In response, the regulators liberalised the banking systems to allow price competition between institutions by removing interest rate controls for example. 

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21.  What is prudential supervision and who is responsible for it in the Australian financial system? Why is effective prudential supervision important?

21.  What is prudential supervision and who is responsible for it in the Australian financial system? Why is effective prudential supervision important?
 
Prudential supervision is about controlling the risk taking of financial institutions (for example through taking on too much lending risk without capital to support it should the borrowers default). This aims to improve the safety of depositor’s funds, which in turn acts to provide some stability in the financial system as depositor’s funds represent the bulk of the liquid resources used in the payments system.  Furthermore, a stable system instills confidence in depositors and provides the basis for a strong economy. 

 
In Australia the Australian Prudential Regulation Authority (APRA) is responsible for prudential regulation and other specific functions including:

1. The development and implementation of prudential regulation that supervised entities will have to abide by (this will be discussed in detail in chapter 17);

2. Monitoring regulated entities to ensure that they are complying with the relevant legislation and prudential policies.  This includes powers to force institutions to comply and remedy any non-compliance; and

3. Advise Government on the development of regulation and legislation affecting regulated institutions and the financial markets in which they operate.
 

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22.  Compare the structure of the US Federal Reserve with the Australian central banking system.

22.  Compare the structure of the US Federal Reserve with the Australian central banking system.


The modern-day Federal Reserve System consists of a seven-member Board of Governors, 12 regional Federal Reserve banks (and their branches) located throughout the USA, approximately 3000 member commercial banks, and a series of advisory committees. The structure also includes the powerful Federal Open Market Committee (FOMC), which conducts US monetary policy.


The 12 Federal Reserve banks assist in clearing and processing cheques and certain electronic funds payments in their respective areas of the country. They also issue Federal Reserve notes, act as a depository for banks in their respective districts, monitor local economic conditions, provide advice to the Federal Reserve Board, and participate in the making of monetary policy.  Over time the regional banks have relinquished powers to the Board of Governors.  


This is quite different to the Australian system where the RBA conducts such activities and has no regional, or State and Territory based banks.  Importantly the Reserve Bank Board conducts monetary policy, not a separate board such as the FOMC in the US, which includes representatives of some of the regional reserve banks.

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23.  Discuss the changes that have been made to the financial system in China since the early 1990s. What do you think are the driving factors behind this change?

23.  Discuss the changes that have been made to the financial system in China since the early 1990s. What do you think are the driving factors behind this change?
Major reforms occurred in the early 1990’s in the Chinese banking system.  These changes included:

-The transformation of specialised commercial banks into purely commercial banks with independent responsibility for their financial performance. Prior to this time these institutions performed policy based lending as well as commercial transactions. They also carried nonperforming loans for state enterprises.

- The creation of three policy banks to conduct strategic operations to meet the policy objectives of the Chinese government. These were the State Development Bank, the Import and Export Bank and the Agricultural Development Bank. These institutions took over the non-performing loans that were previously held by the specialised commercial banks.

 

In addition in late 2001, in anticipation of entering the World Trade Organization (WTO), allowed foreign banks to establish branches in the PRC with the enacting of the Regulations and Administration of Foreign-Invested Financial Institutions legislation. 


These changes were motivated by a number of factors including increasing foreign investment that required a more transparent and market orientation financial system.  Other factors include the industrialisation of China, the need to free up capital flows and to improve the efficiency of the financial system so that it could support economic growth. This culminated in the entry of China into the WTO and permission of foreign banks to operate onshore.
 
 

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24.  What are the two main controls that China has imposed over foreign bank branches set up in the region? What do you think is the rationale behind these regulations?

24.  What are the two main controls that China has imposed over foreign bank branches set up in the region? What do you think is the rationale behind these regulations?


The Chinese Government in late 2001 allowed foreign banks to establish branches in the PRC with the enacting of the Regulations and Administration of Foreign-Invested Financial Institutions legislation. This allowed foreign institutions to provide a range of financial services, although they are under the strict control of local authorities. Two key criteria are the requirement to have been operating in China (in the form of a representative office) for a minimum of two years prior to setting up a branch, and the need to have at least total assets of US$20 billion and capital adequacy levels (excess capital over and above risk adjusted financial commitments) of at least 8%.
 
 

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25.  What is meant by the term ‘Special Administrative Region’ in relation to Hong Kong? Does this have any implications for the regulation of the financial system?

25.  What is meant by the term ‘Special Administrative Region’ in relation to Hong Kong? Does this have any implications for the regulation of the financial system?


On 1 July 1997 Hong Kong became a Special Administrative Region (SAR) of China, however Hong Kong exercises autonomy in all respects except for defence and foreign affairs. The PRC does not impose its socialist economic system on Hong Kong, with the Hong Kong Bill of Rights enacted in 1991, which protects the freedoms and common and statute law of Hong Kong.  Accordingly Hong Kong operates its own central banking system that is quite different to China’s