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Benjamin Geva

The chapter examines the role of central banks in addressing risks _in payment systems. Providing first an overview of payment systems and traditional central banking, the chapter moves on to outline the policy discussion that led to fastening on central banks the role of payment system regulators. It further endeavours to curve a territory for central banks' specific role in addressing payment system risks in the broader context of their role as guardians of financial stability. Proceeding to discuss legislation governing central banks' powers in relation to payment system risks in the UK, Canada, Australia and South Africa, the chapter assesses the efficacy of this legislation. In conclusion, the chapter highlights the assignment to the ESCB of the responsibility for the smooth operation of the payment system as capturing the essence of the regulatory role of central banks in payment systems.

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Saule T Omarova

This chapter examines financial sector structural reform as a critical, though largely under-appreciated to date, dimension of central banks’ post-crisis systemic risk prevention agenda. By limiting the range of permissible transactions or organizational affiliations among different types of financial firms, structural reforms alter the fundamental pattern of interconnectedness in the financial system. In that sense, the chapter argues, reforming the institutional structure of the financial industry operates as a deeper form of the currently evolving macroprudential regulation. The chapter identifies three principal models that form a continuum of potential financial sector structural reform choices and applies this conceptual framework to analysis of post-crisis structural reforms in the UK, EU and US. It further examines how deeply issues of financial industry structure are embedded in central banks’ regulatory and policy agenda and, in light of this connection, discusses potential implications of current structural reforms for central banks’ post-crisis financial stability mandate.

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Rosa María Lastra

The lender of last resort function of central banks has been badly neglected in policy and scholarly debates compared to its monetary-policy twin. That is a bad thing given that, when wheeled out, the LOLR profoundly affects social welfare and the incentives of financial intermediaries. This chapter outlines some of the principles that should underpin the LOLR in healthy democracies. Above all, it argues that the counterpart to the ‘no monetary financing’ edict of an independent monetary policy should be ‘no lending to fundamentally unsound firms’. This is made feasible by the advent of more credible resolution regimes for distressed and unsound firms, remedying the central banker’s curse. Beyond that vital constraint, the chapter proposes legislating a statutory purpose for the LOLR; discusses policy on collateral and lending to shadow banks; and suggests decisions should be taken by committees of equals.

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Forrest Capie and Geoffrey Wood

In this chapter we examine how the Bank of England’s objectives emerged through a mix of evolution, instruction, and reaction. All three were involved. The monetary objective evolved from the Bank’s initial obligation to be able to convert its notes into gold on demand. This was formalised in 1844, and thereafter the numerous changes did no more than change the form of the monetary objective. The financial stability objective was adopted by the Bank in response to outside argument and the pressure of events; but it had from time to time stabilised the system before that, on an ad hoc basis and without formal explanation or justification. It then drifted into being involved in the workings of the banks that comprised the British banking system, and then through legislation acquired increasingly formal and detailed responsibilities for the conduct of these banks. A further complication must be added. The ideas that guided the Bank’s actions may appear to have come from the private sector or government, but there was often discussion and a flow of ideas between Bank, government, and private sector, before a mutually satisfactory conclusion and policy was reached.

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Max Raskin and David Yermack

Central banking in an age of digital currencies is a fast-developing topic in monetary economics. Algorithmic digital currencies such as bitcoin appear to be viable competitors to central bank fiat currency, and their presence in the marketplace may pressure central banks to pursue tighter monetary policy. More interestingly, the blockchain technology behind digital currencies has the potential to improve central banks’ payment and clearing operations, and possibly to serve as a platform from which central banks might launch their own digital currencies. A sovereign digital currency could have profound implications for the banking system, narrowing the relationship between citizens and central banks and removing the need for the public to keep deposits in fractional reserve commercial banks. Debates over the wisdom of these policies have led to a revival of interest in classical monetary economics.

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Iris H.-Y. Chiu and Iain G. MacNeil

‘Shadow banking’ refers to a range of activities that have bank-like character, that is, credit intermediation, liquidity and maturity transformation, and that are undertaken outside the regulated banking system. This can mean activities carried out by non-bank entities that mimic bank-like activities, but can also refer to activities carried out by banks and other regulated firms that do not always operate within the established fabric of regulation they are subject to. Although such activities may be seen as a form of financial innovation, the relationship between innovation and regulatory arbitrage remains uneasy. The former is often viewed more positively than the latter, although it is clear from history that the former has often driven the latter (for example, the emergence of the Eurobond market). The Financial Stability Board (FSB) has provided leadership in developing international surveys of shadow banking activity around the world and policy thinking to govern these areas. In 2013, the FSB set out in a policy document the need to consider how shadow banking activity affects financial stability, but its focus was inevitably on known areas whose risks have played out in the global financial crisis of 2007–09. The spotlight on these areas has nevertheless led to regulatory reforms in many parts of the world, discussions of which are canvassed in this volume, but issues remain outstanding in relation to the effectiveness and scope of reforms.

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Joseph Tanega and Viktoria Baklanova

Money market funds since the financial crisis of 2008–09 have been the focus of heated debate and, with the introduction of the proposed European regulation on 4 September 2013, more controversy ensued. By the summer of 2017, a political agreement has been reached regarding the new regulation. We do not consider what specific details should be incorporated; our focus is merely to present the diverse European money market fund industry and to recommend the adoption of the Office of Financial Research’s (OFR’s) monitoring system for the promotion of transparency in the money market funds system. The fragmentation of the industry has been viewed as not only a source of confusion for investors, but also as a significant challenge in fostering a single market for financial services. We contend that the European money market fund industry rests on the outcomes of two divergent trends: further harmonization of investment products toward the convergence of investment and regulatory practices, and a desire for product differentiation. These two trends underscore two different types of transformations related to the development of money market funds in Europe: (1) from the very market practices that exist de facto to their capture and replication de jure; and (2) from the de jure ideals of fair rules that encourage further and deeper de facto market developments.

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Xiangmin Liu

This chapter employs the basic framework of modern evolutionary theory to understand the evolution of central banking both around the world and in China. The key mechanism of evolution involves a three-stage process: differentiation, selection, and amplification. This evolutionary algorithm selected previously dominant central banking models around the world, including the ones practiced in China over the past century. The previous paradigm of central banking was that of the "single mandate", ie, the exclusive focus on achieving and maintaining monetary stability. The global financial crisis induced a dramatic change in the environment that central banks operate in, which rendered the single mandate model obsolete and demanded a new and fitter model of central banking to cope with new financial and economic realities. A "dual mandate" model of central banking, which re-focused central banking on financial stability as well as monetary stability, emerged as the new paradigm. Macroprudential policies became the latest weaponry at central banks' disposal to accomplish their newly mandated dual missions. China's reform era central banking development bore the same evolutionary logic: the People's Bank of China evolved from a soviet-style state bank to the country's designated central bank with a heavy planned economy legacy and then to a more modern central bank following and advocating market principles and converging with (but also differentiating from) international practices, reflecting fundamental changes in the country's underlying economic and political conditions and changing demands for central banking. China's latest experiences dealing with its own domestic financial headwinds, in addition to international developments, helped spawn a new round of central banking and financial regulatory reforms there.

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Pamela F. Hanrahan

Shadow banking involves functions of banking being performed by entities or channels other than banks. The Financial Stability Board (FSB) defined shadow banking in 2011 as ‘the system of credit intermediation that involves entities and activities outside the regular banking system’. That definition only takes us so far. How best to capture the nature of shadow banking, so as to mark out a coherent supervisory domain, has been an ongoing issue since the 2007–08 crisis. This definitional issue both informs and is informed by policy responses to the rapid growth of this part of the financial system over the last two decades. Exchange traded funds (ETFs), like many other forms of collective investments, sit at the still-contested frontier of that domain. In its 2012 Green Paper on shadow banking, the European Commission included ‘investment funds, including Exchange Traded Funds (ETFs), that provide credit or are leveraged’ in its list of possible shadow banking entities. Subsequently, the FSB has focused its monitoring efforts on the economic functions performed by shadow banking; and relevant functions include the management of collective investment vehicles with features that make them susceptible to runs. The FSB concluded in 2015 that such vehicles (which include money market funds and hedge funds) represented 60 per cent of all shadow banking, now eclipsing both the size and the rate of growth of the function of securitisation.

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Rosa María Lastra

The chapter examines the legal and institutional contours of central bank independence and focuses on the rough consensus that prevailed in the pre-2008 era of price stability oriented central banks and how the notion of independence is changing in a World in which financial stability becomes ever more relevant. To dissect the notion of independence, the chapter responds to the questions of independence from whom and independence in what, and considers the ‘goal constraint’ and other limitations (ordinary versus extraordinary times). De iure independence is manifested in a series of guarantees or safeguards that should govern the organization and functions of central banks on the one hand and the integrity and professionalism of central bankers on the other hand. The chapter also analyzes accountability in the context of both monetary and supervisory independence and concludes by observing that while too much independence may lead to the creation of a democratically unacceptable ‘state within the state’, too much accountability threatens the effectiveness of independence. The debate about independence and accountability resembles the philosophical debate about freedom and responsibility: independence without accountability would be like freedom without responsibility.