4.4.3

• central banks are a banker to the government
• central banks manage a country's national debt
• central banks hold a country's foreign currency and gold reserves
• commercial and retail banks hold cash reserves in a central bank account - so banks have reserves in a safe place - acts as a last resort
• banks hold liquid assets such as cash and shares
• liquidity problem is caused when assets are greater than its debts, but some assets are illiquid - has to borrow from central bank (who acts as a lender of last resort)
• shares and bonds are assets that can rise or fall in value
• if assets fall in value, a banks liabilities can exceed its assets - causes solvency problem
• commercial and retail banks are required to hold cash reserves in a central bank account
• commercial and retail banks hold cash reserves in a central bank to ensure that reserves are safe
• Central banks are the lender of last resort
• central banks being the lender of last resort means that it prevents banks from failing
• a bank might run into trouble through a liquidity problem or a solvency problem
• Banks hold liquid assets such as cash and shares
• the value of liquid assets is far lower than illiquid assets
• banks can easily underestimate the amount of liquid assets they need (e.g. when a depositor withdraws more money than expected)
• banks need to use liquid assets when depositors withdraw their money or someone needs repayment
• A liquidity problem arises when financial institutions lack the cash or liquid assets to meet short-term needs,
• liquidity problem comes around when assets can’t be converted to liquid ones as easily
• For a bank, being insolvent means it cannot repay its depositors, because its liabilities are greater than its assets
• insolvent is when a bank’s liabilities are greater than its assets
• an insolvent bank won’t be able to turn to funds in the private sector
• other banks will refuse to lend to insolvent banks as they find it riskY
• a bank with a short term liquidity problem can get funds by borrowing from the central bank to prevent the problem from getting more severe. This is how the central bank becomes a lender of last resort
• Banks hold financial assets such as bonds and shares that can rise or fall in value
• a bank’s Liabilities are deposits or money borrowed from elsewhere
• if a bank‘s assets fall in value, then the bank’s total value of liabilities will exceed its assets - causes insolvency problem
• banks with a liquidity problem can meet their short term commitments by borrowing from the central bank acting as the lender of last resort
• advantages of central bank acting as lender of last resort:

  • helps prevent panic in the banking system which could lead to financial crisis
  • increases stability of financial system
  • reduces chance of bank runs occurring
• Disadvantages of central bank acting as lender of last resort:

  • banks will become over reliant on the central bank
  • Banks will therefore engages in high risk, high profit activities because they can borrow from central bank in an emergency
• a central bank manages the money supply by affecting the availability of credit or its cost
• a central bank manages the money supply through controlling interest rates and quantitive easing
• Quantitative easing is a monetary policy action where a central bank purchases government bonds to stimulate economic activity
• Regulation of financial markets focuses on:

  • competition
  • The structure of firms and risk management
  • Strengthening rules and punishments
  • Systemic risks
• regulation is used to make financial markets competitive to benefit consumers
• regulation is used to ensure firms are stable. This can be achieved by requiring banks to meet capital and liquidity ratios or preventing them from taking excessive risks
• a capital ratio measures the ratio of a bank‘s capital to loans - measures stability
• a liquidity ratio measures the ratio of highly liquid assets to the short term need for cash
• capital and liquidity ratio measures a banks stability
• Systemic risks is the possibility that an event could then trigger instability or a collapse of the entire industry