CENTRAL BANKS

The central bank is responsible for stabilizing the national currency in a country or union, prevent high inflation, and maintain financial stability. It achieves this through the use of monetary policy and regulation of commercial banks and financial services. As the world has evolved, the central banks have as well. Through various financial crises, the tools of the central bank have improved, and are now an integral part of any nation.

2.3.1 Monetary policy

Every country wants to have high employment and rapid growth while maintaining price stability. The main instrument for achieving this is monetary policy. The aim is to manage the

size and growth rate of the money supply in an economy. There are multiple tools at the central bank's disposal for altering this supply and maintaining stability in the economy.

Interest rates

Central banks offer a base rate on short-term loans for commercial banks. When commercial banks offer customer loans, it is at a premium above this base rate and is the way they earn profits. If the base rate increases, the cost of borrowing rises for commercial banks, which in turn will result in a higher interest rate for the general public. Therefore, the cost of borrowing increases, which leads to less of an incentive to take out a loan. This measure effectively decreases the money supply. The inverse happens when decreasing the base rate, which lowers borrowing costs and money flows into the economy, increasing the money supply (Corporate Finance Institute, 2018).

When the economy is in distress, the money supply usually shrinks due to the uncertainty associated with the future, as more people hold on to their funds as opposed to investing. To combat this, the central bank usually lower rates and try to stimulate investments. Commercial banks have a deposit account in the central bank where they store excess cash. In some extreme cases of low growth and low inflation, central banks have enforced negative interest rates on these deposits in an attempt to incentivize bank lending. However, there is a limit to how low the interest rates can go called the effective lower bound, ELB, or zero lower bound, ZLB. For Japan and some of the western countries in Europe, this limits their ability to use interest rates to stimulate the economy (Kihara & Koranyi, 2019). The reason there is an ZLB is that if the interest rate is negative, banks would instead hold cash, resulting in the central bank looking towards other tools to stimulate the economy.

Reserve requirements

Every commercial bank is required to hold a percentage of their lending amount as a reserve.

This reserve acts as a buffer and a source of liquidity. If the central bank decides to increase the amount each bank is required to have, the commercial banks have less money to lend, and the money supply decreases. In the US, this ratio is at 10 percent, while in the eurozone, it is one percent (Bennett & Peristani, 2019; European Central Bank, 2016).

Open market operations

The central bank can purchase or sell securities issued by the government in an attempt to change the money supply (Corporate Finance Institute, 2018). By buying government bonds

from banks, they pour money into the banks and the economy, increasing the supply of money.

Conversely, a sale of government bonds to banks decreases the money supply and increases the interest rates.

Expansionary vs. contractionary

When the central bank increases the money supply in an economy, it is called an expansionary policy that aims at stimulating the economy and fuel growth. However, the downside to this is higher inflation. This policy is carried out through decreasing interest rates, lowering reserve requirements, or purchasing government securities. The opposite is contractionary policy aimed at decreasing the money supply and in turn, inflation. This strategy achieves this by raising interest rates, increasing reserve requirements, or selling government bonds. The central bank aims to use these policies to keep financial stability.

2.3.2 Regulating financial institutions

"Financial regulation refers to the rules and laws firms operating in the financial industry must follow" (Central Bank of Ireland, n.d.). The main reason the central bank regulates banks is to ensure financial stability. Reserve requirements are a form of regulation, but other functions include ensuring adequate risk controls and only allowing firms who have shown that they can fulfill specific criteria to operate in this sector. These requirements ensure financial stability but also guarantees that consumer protection is in place. Central banks make sure that firms follow these rules through constant supervision of the financial institutions. There is closer supervision put on larger commercial banks due to the potential risk they pose (Central Bank of Ireland, n.d.). In the event of a bank violating the rules, the central bank has the power to restructure a financial institution completely.

2.3.3 Financial crisis

The central bank also has a unique role in case of a financial crisis. Multiple tools can be useful in stopping a bank run and avoiding a financial crash. A bank run occurs when the liquidity of banks becomes constrained and the public attempts to withdraw their deposits, leading to solvency issues.

Suspension of convertibility

When banks mostly consisted of physical locations, people who feared a default on their deposits would stand in lines to withdraw their funds from the banks. A common tactic used

by the authorities was closing the banks for some time, which prevented people from withdrawing their funds. As banks have evolved and are now mostly digital, this is very rarely the case and only occurs when banks are entirely out of money. Other options, such as borrowing money, has decreased the use of this method.

Coalition of private banks

Banks can band together and form a coalition so that a claim on one bank converts into a claim on this coalition. This measure reduces risk and lowers the likelihood of a full-blown bank run. Another benefit from this is banks monitoring each other, reducing the chances that they are operating irresponsibly. Such a coalition does not work in the case of all banks suffering from a shock and is, therefore, most effective against smaller shocks, not system-wide bank runs.

Government deposit insurance

The central bank can guarantee the deposits of customers through government deposit insurance. This course of action acts as a promise in the event of a bankruptcy, where the central bank promises that it will pay the deposits that would otherwise be lost. While this policy has ended bank runs almost entirely, there is still the risk of the government behind the guarantee running out of money. An example of this is Greece. A solution proposed to combat this is that the entire eurozone backs the banks. If a bank in Greece were to go bankrupt and Greece's central bank was unable to cover the deposits, other members in the eurozone would compensate for this.

Capital requirements

Capital requirements are a specific ratio that the banks must have concerning their debt to equity. Through this requirement, the central bank can decrease the number of banks that are over-leveraged, which in turn reduces the chance of bankruptcy. Regulating commercial banks is central to reducing risks.

Lender of last resort

The central bank can act as a lender in situations where a bank is unable to provide credit from other sources. This measure is a kind of emergency lending which aims at providing funds to calm the public when it believes a bank is running out of liquidity. A problem associated with this is that it might make banks less cautious if they believe they can always receive an

emergency loan. Such excessive risk-taking could potentially lead to higher chances of crisis, but it has been effective against bank runs as a supplement to government deposit insurance.

Government bailouts

In recent times some governments have bought large parts of a bank's toxic assets to remove them and stabilize the bank. This strategy is highly controversial, as the public often perceives this as a reward for a bank's recklessness through the government bailing them out when in trouble. This action is known as the too-big-to-fail policy. Government bailouts were a central part of the financial crisis in 2008, where the US purchased billions of toxic assets in an attempt to stabilize the economy.