Central Bank and Monetary Policy

Question: Discuss about theCentral Bank and Monetary Policy. Answer: Introduction Central banks play a significant role in ensuring the economic stability and robust financial system of the country. The following report highlights the role of central bank of Australia in regulating the financial system and economic environment within the country and the regulatory requirements imposed on the bank in performing its responsibilities. It further outlines the importance of monetary policy and its impact on the asset value and yields. Further, the importance of leverage in context of banks is discussed along with the role of ADIs and Basel Accords in addressing the risk faced by banks that are inherent in the banking system. Role of Central Bank in Australia in Implementing Monetary Policy The Reserve Bank of Australia acts as the central bank. It has accountable to make the monetary policy. This policy is effective to maintain the tough financial structure. Besides, it makes the regulation to provide the banking services to several public body, overseas banks and authorized institute. Furthermore, the major role of the Reserve Bank of Australia (RBA) is manage the gold and Forex reserves of Australia. Their role and function are regulated by the two different boards named the Reserve Bank Board (RBB) and the Payments System Board (PSB) (Reserve Bank of Australia, 2016). In the section 10 (2) and 11(1), RBB makes obligation about the financial policy. In this way, section 10(2) defines the responsibilities of the RBB. These duties are related to maintaining the constancy in Australian currency, full employment and economic wealth of the Australia. Moreover, section 11(1) of the act explains the requirements to discuss with the Government. In this regards, it can be opined that the RBB occasionally informs the Government about the monetary policy (Gorajek and Turner, 2010). On the other side, in section 10B (3), payments system board (PSB) defined that the payments system policy of the bank facilitates the great benefits to the Australian. Besides this board will controlling the risk in the financial system. It also promoted the rivalry in the marketplace regarding the payment services (Tricker, 2015). Regulatory Requirements Imposed on the RBA in Performing their Responsibilities The Reserve Bank of Australia is itself an apex institution that sets rules and regulations for effective governance of financial and banking system, payments system, and other fiscal matters. However, the decisions of the RBA affect the public and other business, thus, even RBA is accountable. As such certain regulatory requirements are also imposed in the RBA under the Public Governance, Performance and Accountability Act 2013. This act places a positive duty on RBA to cooperate with other entities, and not operate in isolation, to achieve common objectives. Additionally, the Governor has to present a report annually to the Treasurer for presentation to the Parliament (The Parliament of the CommonWealth of Australia, 2013). Moreover, RBA is accountable to The Parliament of the CommonWealth of Australia for its actions and has to consult with the Australian Government regarding monetary and banking policy as per the norms of the Reserve Bank Act 1959. The RBA also has to maintain transparency in its communication (RBA, 2016). Economic Position of Australia, Monetary Policy and its Effects The Australian economy is experiencing an economic growth rate of 3.1% with inflation rate stuck at 1.3% and cash rate of 1.75% (RBA, 2016). The economy is experience economic growth. However, substantially low inflation level is negatively impacting the exchange rates and bond yields. Moreover, there is a fair chance that the economy will get stuck into deflationary spiral (Gerber and Shapiro, 2016). Thus, the monetary policy of the RBA is aimed towards bring the inflation level in the range of 2% to 3% on an average. At this rate, the inflation will be sufficient low that it will not adversely impact the economy. However, as the economy is experiencing low level of inflation, increasing the inflation with the help of appropriate monetary policy will give a short-term stimulus to the economy so as to increase its economic activity. In this regard, the RBA has adopted easy monetary policy and has reduced its cash rate to 1.75 % to support domestic demand in the economy. As such low levels of cash rate, savings are discouraged and spending is encouraged to increase the aggregate demand in the economy (RBA, 2016). The monetary policy implemented by the RBA directly affects the cash rate which in turn affects interest rate in the economy which further affects the asset values. It subsequently affects the wealth and spending decision of the people and firms. Besides this, it is defined that if the interest rates are high, then it can be anticipated that it will lead to decline in the values of various assets. Along with this reduction in prices of assets, it could be anticipated that there will reduce spending as wealth of the people would be less in this scenario. Further, borrowing capacity of those assets that were used as security for loans would be also reduced (Hollifield, et al., 2014). However, these results could be very different in the real world. This is certainly not true that asset prices respond instinctively to modification in interest rates. There are several factors that influence the asset values such as changes in expectations and general business cycle circumstances. Furthermore, the effect of asset prices on spending decisions is also quite variable. The reason behind it is that there are some factors that modify the asset prices (Downes, et al., 2014). Therefore, it can be said that in the initial phase of the asset price cycle, asset prices increase that facilitates to expand the security and increase growth in credit and spending. In this case, these effects are closely associated with the credit supply channel. Importance of Leverage and Impact on Central Bank Practices Leverage holds a significant place in case of banks and financial institutions because borrowing and lending is what they exist for (Gans et al., 2011). Banks are amongst the most leveraged institutions as debt forms greater portion than banks own capital in process of asset financing. A bank lends out money that was deposited by its customers. In views of the Reserve Bank of Australia governor, leverage matters because a high level of leverage increases the risk of loss of depositors money in case of any economic turbulence. It was because of unchecked leverage created by the banks that allowed the relatively small asset class of subprime mortgages to trigger a crisis like that of 2007-2009. Thus, the level of attention paid to leverage ratios has increased since then and banks are being subject to stricter norms related to capital requirements and reserve ratios. There is an increasing pressure on banks to finance its assets through its own capital rather than debt to create greate r shock absorbing capacity in case of loss. Moreover, a leverage target helps to regulate the volume by naturally limiting the amount of loans made because it is rather difficult and expensive to raise capital than it is to borrow funds (Haswell, 2016). In conclusion, the Reserve bank of Australia uses leverage and capital adequacy ratios to check the level of leverage. These ratios indicate the financial health of banks and show the amount of free equity with the bank to deal with crisis (Lannin, 2015). To ensure that assets are financed with banks own capital, including common equity tier one assets like equity and reserves, rather than borrowed capital, the banks are aiming core equity tier one ratios of 8.5% so as to increase the financial strength of the banks and reducing the risk of losses that would fall to the shareholders and the RBA plays a significant role in ensuring that adequate leverage is maintained by the banks (Carney, 2013). Role of ADIs in Dealing with Risks Authorised Deposit-taking Institutions (ADIs) are institutions sanctioned to accept deposits from customers under the Banking Act 1959. These institutions include banks, building societies and credit unions. As they accept and lend money to their customers/members, they are subject to risks arising out of such transactions. These risks include credit, liquidity, operating and interest rate risks. Credit risk is defined as the risk in which borrower fails to meet their contractual obligations related to making the interest and principal payments at the scheduled time. Therefore, they are unable to meet the terms and conditions of the loan agreement (Turner, 2011). To reduce this risk, ADIs use risk-weights on its assets and exposures for capital adequacy purpose. These risk-weights are based on credit rating grades provided by external credit assessment institutions on the probability of default on the part of other party (APRA, 2013). Operating risk is defined as the uncertainties that may occur in the actual operations of the banks due to inadequate internal procedures, people and arrangements or from external affairs (BIS, 2011). Hence, ADIs acts in accordance with the several prudential standards set by APRA. It includes standards with respect to the acceptable governance, risk management and internal control arrangements. Besides this, ADIs sets out the prudential standards that specify the minimum capital requirement based on their risk profile. Thus, they are required to maintain an adequate internal capital buffer to withstand adverse shocks posed by operational risks to protect its creditors (Turner, 2011). Liquidity risk arises when the bank does not know about the borrower request and also unaware that when and how depositors withdrawn the money. It is stated that to deal with liquidity risk in ADIs, APS210 was established in 1998. Under this framework, each bank is required to maintain the given percentage of liabilities in the form of government securities, cash and deposit with the RBA (Hull, 2012). In this way, it includes a different strategy to manage the liquidity such as setting a limit on maturity mismatches, holding liquid assets, diversifying liquidity sources and developing assets sales strategy. Interest rate risk arises due to fluctuations in interest rate in the Australian economy. In this case, ADIs deal with the problem to match the asset and liabilities structure. Besides this, it attracts the longer-term depositors and reduces the asset maturity in order to deal with the interest rate risk. Another approach used by the ADIs is to set up loans with variable interest rates in building society loans for housing (Akhter and Hasan, 2015). Role of BASEL Accords in Dealing with Risks The Basel Committee on Banking Supervision was formed in 1974 by the governors of central banks of the G10 countries in the wake of breakdown of the Bretton Woods system of regulated exchange rates in 1973. The committee was established as a forum for regular cooperation on banking regulatory affairs with the purpose to improve the quality of banking supervision around the globe. For this, the committee formulates standards, guidelines and recommendations for sound banking practices. These standards are popularly known as Basel Accords. Until now, the committee has provided three Basel norms namely, Basel I, Basel II and Basel III. These Accords help the banks in mitigating different risks associated with banking practices like credit risks, liquidity risks, etc. (BIS, 2015). Basel I: In 1988, the committee published a set of minimum capital requirements for banks, the Basel Capital Accords to address the problem of credit risk. This Accord called for minimum capital ratio of 8% to be implemented by banks by the end of 1992. Further, in 1996, the committee incorporate a capital requirement for the market risks as a result of banks' espial to foreign exchange, commodity derivatives and options within the Accord to address market risks. Basel II: In 1999, the committee proposed a new capital adequacy structure to succeed the 1988 Accords with a view to provide significantly more risk-sensitive capital requirements. The revised framework now incorporated three pillars related to minimum capital requirements, supervisory process and disclosure and market discipline. The new Accords standardized the banking rules and regulations for international banks. Along with addressing credit and market risks, these Accords also addressed operational risks and disclosure norms (Porter and Chiou, 2013). Additionally, it mandated the use of credit rating provided by external rating agencies to set the risk weights for various claims. Basel III: The poor governance and risk management on the part of banks led to mispricing of financial risk, and excess mortgage growth. To remove the flaws of Basel II that emerged during the 2008financial crisis, the committee proposed Basel III norms in 2010. The objective of the new Accords was to endorse a more strong banking system by focusing on criteria such as capital, debt,funding and liquidity. It also helps in addressing systematic risks. The new Accords defined the new capital and liquidity standards and strengthened the three pillars given by Basel II. Thus, Basel Accords are very helpful in mitigating the risks that the financial system is exposed to due to the nature of its work. Conclusion Reserve Bank of Australia plays a significant role in implementing monetary policy which is aimed at bringing the inflation rate in the country in the range of 2% to 3%. Moreover, the RBA is answerable to the Parliament for all its conduct and decisions. Also, the bank has to cooperate with other entities for achieving common objectives as per the regulations of the PGPA Act 2013. Additionally, it can be concluded that leverage is important in context of banks as it holds key to the safety if the shareholders money. Thus, banks are required to maintain adequate levels of debt and equity in their portfolio. Further, ADIs mitigate its financial risks by maintaining proper leverage ratios, using credit ratings and other tools. 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