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Central Banks and the Financial System

The role of central banks and governments in regulating the financial system

A Central Bank is an institution that manages a state's currency, monetary supply and interest rates. They also usually oversee the commercial banking system within the state. The UK's central bank is the Bank of England and the US' is the Federal Reserve. 

The main functions of a Central Bank: 
  • Monetary policy. Central banks usually implement this by raising/lowering the base interest rate for example. 
  • Acting as a banker to the government - so carrying out exchange, remittance, etc. on behalf of the government. 
  • Acting as a banker for other banks - the central bank will often supervise commercial banks and will act as a 'lender of last resort' to them. 
  • Regulating the financial system - will regulate the system to ensure stability. 

Liquidity

Liquidity is how easily assets can be traded. Cash is the greatest liquidity as it can be immediately traded for any good. 

 A balance sheet of a commercial bank depicts the bank's assets and liabilities. Its assets are what it owns and what its creditors owe it and its liabilities are what the bank owes (aka its debt). 

 Assets include liquid assets (e.g deposits at the Central Bank, bonds, cash in the vault, etc) and illiquid assets (e.g loans to customers, physical assets like buildings, etc). 

 Liabilities include customers' deposits, borrowed funds (e.g interbank loans, bonds the bank has sold, etc.) and shareholder equity, which is what is left over - the total assets minus the total of the other liabilities. It is the measure of the net worth of the bank. 

 The bank needs to make sure these two balance out - its assets must be equal to its liabilities. This can be hard because bank deposits can be withdrawn immediately but the majority of the banks assets are illiquid. 

 If loans aren't paid back, the bank has to write them off, which reduces the value of its assets and of the shareholder equity. When there is no remaining shareholder equity, the bank becomes insolvent.  

 The leverage ratio of a bank is its total assets over its shareholder equity. This will give a whole number, which is the number of times its assets is greater than its actual worth. The greater the assets the greater the liabilities must be (as these should balance). So a company with a higher whole number ratio (or lower percentage ratio) is less secure than one with a lower whole number ratio. 

 Managing liquidity 

Central banks help provide liquidity to financial institutions in two main ways:

  1. They use deposit accounts that banks hold with the central bank to facilitate interbank lending: banks can easily borrow from one another by moving funds between their central reserve accounts. 
  2. They act as lenders of last resort, providing banks and other financial institutions in danger of collapsing with funds.  

Regulating financial institutions and markets 

The financial system needs regulation due to:
  • Asymmetric information which leads to adverse selection - financial institutions have incentives to sell consumers products that may harm them financially. 
  • The 'too big to fail' problem: financial institutions' failure creates significant externalities; the expectation of bailouts creates moral hazard. 
  • Systemic risk: the failure of one bank/institution can lead to the collapse of the whole system (e.g the cyclical nature of bank runs) 
Regulation in the UK: 

The Financial Policy Committee (FPC) and the Bank of England 
  • Determines the level of shareholder capital that commercial banks must hold (the greater the SC, the greater the buffer) 
  • 'Macro-prudential' regulation designed to reduce systemic risk
  • Conducting 'stress tests' - hypothetical situations to see what would happen in the financial system if certain negative events took place
UK Prudential Regulation Authority (PRA) 
  •  This is another part of the Bank of England. It monitors the solvency of insurers, credit unions and other specialised lenders. 
  • 'Micro-prudential' regulation focussed on ensuring individual firms fo not collapse
Financial Conduct Authority (FCA)
  • Aims to secure consumer protection in the financial industry. 
  • Investigates claims of market rigging, mis-selling and other misconduct. 
  • Promotes effect competition in the interests of consumers. 
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