Question

1. The sources of financial de-stability are originated from the financial system itself. Explain.

2. How a central bank is to ensure the stability of its financial system?

Answer 1

Financial stability generate from the back bone of financial systems. So central banks play a vital role in financial stability of a country. Because these banks control the money flow in a country.

How the Central Bank Influences an Economy
A central bank can be said to have two main kinds of functions: (1) macroeconomic when regulating inflation and price stability and (2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences
As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy. The central bank performs open market transactions (OMO) that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation. To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and prices.

Microeconomic Influences
The establishment of central banks as lenders of last resort has pushed the need for their freedom from commercial banking. A commercial bank offers funds to clients on a first-come, first-serve basis. If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits.

Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves functions as another means to control the money supply in the market. Not all central banks, however, require commercial banks to deposit reserves. The United Kingdom, for example, does not, while the United States does.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. The use of the discount rate can be restricted by making it unattractive when used repeatedly.

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