Question

a) What are the main functions of central banks? Explain.

b) Explain what a bank run is. What is the relationship between a bank run and liquidity risk?

c) Why would advocates of free banking claim that there is no need in the Lender of Last Resort? Do you agree with them?

Answer 1

a) What are the main functions of central banks? Explain. (20 marks)

1) An Issue Bank - Only Central Banks can issue money, print it, mint it and circulate it

2) Holder of Foreign Currency Reserves - Central bank is a holder of cash reserves. It is only fair, safe, legal and best suited for the central bank to be the house for foreign currency reserves. Moreover, by making the central bank the official foreign currency holder, the government can promise economic disciple.

3) Holder of Cash Reserves - It is custodian of cash. Banks in all countries reserve some percentage of their deposits with the central bank. This makes the central bank, the legal and the most safest holder of cash reserves.

4) Credit Controller - The central bank works on the control and modification of credit rates and the control of inflation.

5) Advises the Government - It is the most trustworthy bank for the government. Also, the central bank is vested upon by the government to be their advisor in terms of financial and monetary crisis.The central bank is the government’s advisor, agent and banker

6) Protector of Depositor’s Interests - The central bank has much variety of depositors. Some of the most important depositors are the commercial banks and the government itself.

7) Lender of Last Resort - When everything with a bank’s functioning, seems to be going down and under-performing,the central bank is ready to rescue. When the commercial banks are unable to lift themselves up from a crisis, they take to the last resort.

b) Explain what a bank run is. What is the relationship between a bank run and liquidity risk? (20 marks)

A bank run means a large number of customers of a bank or other financial institution withdrawing their deposits together due to concerns of the bank's solvency. As many people withdraw their deposits, the bank's probability of default increases, prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals.

Liquidity is the ability of a bank to pay its debts without suffering disastrous losses. Hence, liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss. When bank run happens, bank faces severe liquidity shortage. It may be forced to sell of its investment or borrow at a higher rate to pay off the depositors who want to withdraw their funds.  

c) Why would advocates of free banking claim that there is no need in the Lender of Last Resort? Do you agree with them? (10 marks)

Free banking is a monetary arrangement where banks are free to issue their own paper currency and there are no special regulations apart from those applicable to most enterprises.

The market forces control the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of fiat money issued by a central bank.

Advocates of free banking claim that there is no need in the Lender of Last Resort as under free banking, banks are allowed to operate and even to issue bank notes under no restrictions beyond compliance with general company law. A bank may enter the field without special permission if it can show profit prospects, raise sufficient capital, and win public confidence in itself and its notes. It has the same rights and responsibilities as other business enterprises. Its notes are “promises to pay,” redeemable in whatever the basic money might be. No bank could keep irredeemable notes in circulation by having them declared legal tender. Any bank suspending redemption would be declared bankrupt and liquidated, its assets being applied to meet the claims of its creditors. Stockholders would lose all or part of their investment.

I do not agree with free banking philosophy because:-

1) Bankruptcy of any 1 bank can lead to free run.

2) Trust of public in financial institutions can be lost

3) In absence of any regulations, banks would operate as they wish and hence put people's money under huge risk

4) Managing money, printing and minting it would be free and could cause many problems.