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Monetary Policy

If intermediation is undertaken in an efficient manner, then deposit and credit demands can be met at low cost, benefiting the parties concerned as well as the economy overall. In addition to these on-balance sheet activities, banking organizations have long engaged in traditional off-balance sheet operations, providing loan commitments, letters of credit, and other guarantees that help counterparties plan for future investments, and in some cases gain access to alternative sources of external finance p. They also provide an expansive range of various derivative contracts that allow counterparties to hedge their market risks.

In recent years, this simple conceptualization of banking business has radically changed. These major developments on the product side have also been matched by the emergence of a diverse array of new funding sources. Driven by securitization, particularly of residential mortgages, banks have become less constrained by their deposit bases for lending. On-balance sheet assets have increasingly been bundled and sold into the market to release capital to finance expansion. Off-balance sheet vehicles such as Structured Investment Vehicles SIVs , SIV-lites, and conduits have been created to enable banks to collateralize assets funded by the issue of short-term paper, not only generating trading profits, but also enabling them to raise resources to finance growing funding gaps loans minus deposits.

Small and medium-sized institutions have also actively participated in diversifying their product and funding features. The phenomenal growth in structured credit products has been a major recent feature of modern banking business. The investors could choose to hold different tranches reflecting their risk-return preferences. Up until mid, the demand for structured credit products boomed. Investors were attracted to these securities because they typically appeared to offer higher returns than equivalently rated company bonds.

Banks were also attracted to the business as it allowed them to reduce their regulatory capital charges by transferring credit risk to other parties. In general, the view was that the new structured credit products were beneficial as they allowed greater risk to be shared across a broader spectrum of investors, or, to put this another way, banks no longer had to be the major holders of credit risk.

At the peak of the credit cycle in , around one-fifth of US mortgage originations were of the subprime variety, and 75 percent of these were securitized of which around 80 percent were funded by AAA-rated paper IMF, Holders of investments backed by subprime mortgages did not know what they were worth, and banks became wary of lending to each other because they also did not know the extent of losses held in structured credit vehicles. In addition, real estate prices tumbled in the US adversely affecting prime and subprime borrowers alike who increasingly defaulted, further putting downward pressure on the value of securitized mortgage products and bank loan books Foote, et al.

All in all, this culminated in a liquidity freeze in interbank markets and the subsequent credit crunch Crouhy, Jarrow, and Turnbull, ; and Hellwig, As the meltdown in credit markets continued, banking sector traumas have been experienced around the globe. The first high-profile casualty surprisingly was not in the US but in the UK, Northern Rock, one of the country's largest mortgage lenders experienced a run on its deposits the first since Victorian times and had to be rescued nationalized by the government in September The main cause of failure was cited as a reckless business model, overdependence on short-term wholesale funds, as well as failings in regulatory oversight HM Treasury, There then followed further bank collapses.

On 16 March , Bear Stearns became the largest casualty of the credit crunch to that date when the failing investment bank was purchased by J. Morgan Chase to acquire In addition, the Federal Reserve extended safety net arrangements to ensure that J. Morgan Chase would not suffer significant losses on loans extended to Bear Stearns. This followed a public warning about the bank from Senator Charles Schumer.

On Sunday, 13 July , Treasury Secretary Henry Paulson announced a plan to insure that both organizations would continue to support the housing market. This consisted of a proposal that the Treasury would p. September witnessed further turmoil by the demise of Lehman Brothers and the sale of Merrill Lynch to Bank of America. The two remaining large investment banks, Goldman Sachs and Morgan Stanley, converted to bank holding companies.

Morgan Chase. In addition to the aforementioned problems, various UK banks also were experiencing severe financing difficulties. The UK government waived its competition rules making the deal possible. On 29 September, Bradford and Bingley Bank was nationalized. A major feature of the crisis or turmoil that has engulfed banks from September onwards has been growing market concerns about their capital strength, particularly in the US and Europe. This is despite the fact that many banks have sought to boost solvency by a variety of means.

Table 1. Growing worries about the capital strength of banks led to a collapse in stock prices and widespread bailouts. The highest profile bank bailout being the November rescue of Citigroup. The preferred stock carried an 8 percent dividend. The Citigroup deal was in certain respects similar to an effort orchestrated by Swiss financial regulators for UBS, another large global bank.

Bank write-downs and capital raised up to December Notes: All the charges stem from the collapse of the US subprime mortgage market and reflect credit losses or write-downs of mortgage assets that are not subprime, as well as charges taken on leveraged-loan commitments since the beginning of They are net of financial hedges the firms used to mitigate losses and pre-tax figures unless the bank only provided after-tax numbers.

Credit losses include the increase in the provisions for bad loans, impacted by the rising defaults in mortgage payments. Capital raised includes common stock, preferred shares, subordinated debt, and hybrid securities, which count as Tier 1 or Tier 2 capital, as well as equity stakes or subsidiaries, sold for capital strengthening. Capital data begins with funds raised in July All numbers are in billions of US dollars, converted at the October exchange rate if reported in another currency.

As the above events clearly indicate, this has been a momentous time for banking and the global economy has not faced such serious financial turmoil since the s. These recent events have shockingly reminded us that the new style of intermediation activity is not without its risks. Banks are among the most leveraged of any type of firm. In the course of business, they rely on scale and various risk management mechanisms to ensure that deposit withdrawals, loan supply, and off-balance sheet obligations can be met.

They use their own internal systems and are obliged by regulators, as well as the market, to maintain sufficient levels of capital and liquidity in order to back their business. Regulators also provide safety nets, such as deposit insurance and emergency lending facilities, in order to bolster confidence in the system. History, of course, tells us that, irrespective of what checks and balances are put in place, any inkling of a lack of confidence in an individual bank, a number of banks, or the markets on which banks depend, can signal potential disaster.

By the beginning of the time of this writing , concerns about the stability of the global banking system had continued to mount. Between the summer of and December , the Federal Reserve, the European Central Bank, and the Bank of England all undertook major refinancing operations aimed at injecting liquidity into gridlocked interbank markets. The turmoil has also brought about a range of measures initiated by individual countries relating to the offer of bank guarantees and various rescue plans the most important of which are summarized below:.

Bank deposit guarantees schemes have been strengthened. The governments of Austria, Denmark, Germany, Hungary, Ireland, Slovakia and Slovenia are among those that have announced unlimited guarantees. Financial Times, 21 Nov. Countries around the globe have enacted similar measures. See also Chapter 32 and Goddard, Molyneux, and Wilson forthcoming , for details of other European country bank rescue plans. At the time of writing, ramifications of the the impact of the aforementioned bailouts and fiscal stimulus rumble on with a strong possibility that the global economy will experience a severe economic slowdown.

Modern developments

The seriousness of the ongoing funding difficulties faced by banks and the potential for significant macroeconomic disruption cannot be understated as identified in the G20 meeting held in Washington, DC on 15 November. Acharya and Richardson produce an edited collection of contributions by prominent academics that offers financial policy recommendations and actions to restore the global financial system.


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Now let us turn the clock back to the start of —how things looked so different then! Banks in the US and Europe had been posting record profits, major risks appeared to have abated, and banking systems had been deregulated, allowing for more competition and innovation. The general operating environment over the preceding decade or so had favored banks: declining interest rates, the stock market bubble of —, and relatively buoyant economic growth fueled to a major extent by booming real estate values and the bank credit that funded this provided the bedrock for the strong performance of banking systems.

In addition to the generally favorable economic climate, banking business has been transformed by deregulation that removed barriers to competition in traditional and new non-banking product areas as well as geographically. Also, the Interstate Banking and Branching Efficiency Act of reduced geographical barriers to competition by permitting almost nationwide branch banking as of although there was a national deposit cap of 10 percent.

In Europe, the European Union's Single Market Programme had legislated for the possibility of a universal banking based system and a single banking license in , and the introduction of the euro in further removed barriers to cross-border trade in banking and financial services Goddard, Molyneux, and Wilson ; and Goddard, et al. Inextricably linked to the deregulation trend have been the moves toward the harmonizing of regulations—across countries and different financial service sectors.

In general, there has been a strong policy move to create more uniform regulatory structures so that no jurisdiction or sector of the financial services industry has an unfair competitive advantage. This is best reflected in European Union harmonization of financial services regulation under the Single Market Program as well as capital adequacy regulation under the Bank for International Settlements Basel I , and the more recent updated Basel II , that p. Virtually all developed countries' banking systems, and most others, currently adhere to Basel capital standards.

Technology has been another important element in transforming the banking industry. Banks are major users of IT and other financial technologies. Technological advances have revolutionized both back-office processing and analysis of financial data, as well as front-office delivery systems. Evidence suggests that the former has led to significant improvements in bank costs and lending capacity whereas the latter has improved the quality and variety of banking services available to customers Berger, Possibly the most substantial impact of technology on the banking system has been on the payments system, where electronic payments technologies and funds transfers have replaced paper-based payments cash and checks and paper recordkeeping.

The reduction in costs from such changes has been significant Humphrey, et al. Developments in financial technologies, including new tools of financial engineering and risk management, coupled with the growth of new and broader derivatives markets, were also believed up until recently at least to have improved banks' risk management capabilities.

During the s, banks shifted more of their activity toward non-interest income as a source of revenue, including trading revenue. As such, they increasingly adopted new e. Similar risk measurement financial technologies, which link capital requirements to credit risk have been incorporated into Basel II. Advances in new technologies have been inextricably linked to financial innovation Molyneux and Shamrouk, ; and Frame and White, The meteoric growth in asset securitization stands out as a key example.

Here the financial innovation element relates to the creation of synthetic liquid, tradable securities p. Advances in technology enable the efficient monitoring and analysis of information related to the performance and operation of the asset pools. A key aspect of this process relates to advances in credit scoring technology. The emergence of alternative assets including hedge funds, private equity, REITs real estate investment trusts , commodities, and their respective indices means that both retail and professional investors now have access to an extensive range of investments that seek to hunt out absolute alpha returns.

These are complemented by the rapid recent growth in index trackers—such as Exchange-Traded Funds ETFs —that provide beta returns tracking a myriad of indexes—either long or short. The latter are increasingly competing with actively managed mutual funds Economist , 1 Mar. It is widely recognized that factors including the buoyant economic environment, deregulation, and technological and financial innovation have transformed the banking landscape. However, less has been said about the changing strategic focus of banks. The aforementioned forces have resulted in generally more competitive banking systems and this also has meant that banks now have to compete more aggressively than ever before for their key resource—capital.

It is uncertain as to why banks wish to maintain capital resources well in excess of their regulatory minimum. According to Berger, et al. Some banking organizations may also hold excess capital in anticipation of a crisis in order to cover a significant portion of losses, and to allow more lending and off-balance sheet activities than would otherwise be the case under such conditions, gaining market share on their less-capitalized competitors Berger and Bouwman, b. Whatever the motives, it is a fact that many banks have held capital resources well in excess of their regulatory minimums and that higher capitalized banks also tend to be better performers.

The motives noted above, of course, are not mutually exclusive and it has been primarily the strategic desire of banks to manage their p. This simply means that banks have increasingly focused on strategies that seek to generate risk-adjusted returns in excess of the opportunity cost of capital Fiordelisi and Molyneux, Corporate restructuring practices commonplace in the non-financial sector have become widespread in the banking industry.

Business process re-engineering, outsourcing, open architecture providing third-party products and services , joint ventures with high tech firms, third-party processing, and the drive for mega-scale in key sectors credit cards, global custody, treasury activities have primarily been motivated by the desire to generate risk-adjusted returns in excess of the cost of capital in order to boost returns and value for shareholders. Markets are not only more important for the business that banks do, but also for gauging their performance, especially as they all seek to raise costly capital from an ever-widening group of investors.

The desire to generate returns sufficient to obtain capital resources at the appropriate cost has encouraged banks into many new areas of business—particularly those areas where capital requirements are less onerous compared with traditional on-balance sheet credits. The securitization phenomenon has been a major spiraling outcome of this trend. The banking industry has been transforming for decades now. A study by Berger, et al. The authors found that virtually all aspects of the US banking industry had changed dramatically over these fifteen years. Over one-third of all independent banking organizations top-tier bank holding companies or unaffiliated banks disappeared over the —94 period, even while the industry was growing.

On the liability side, the industry evolved from a position of protected monopsony in which banks purchased deposit funds at regulated, below-market interest rates toward a market setting in which banks paid closer to competitive prices to raise funds. With respect to individual consumers, electronic p. Over the last decade or so since that study, the structural features of global banking systems have radically altered.

Developed banking markets have all experienced significant declines in the number of banks and industry concentration has generally increased at both the national and regional levels. Substantial declines have also been witnessed in Europe Goddard, et al. The decline in the number of banks, particularly in developed countries, however, has not been matched by a fall in the number of branches, quite the opposite.

Economics Module 10: The Central Bank & Monetary Policy

For example, the number of bank branches in the US increased 27 percent between and , although average branch size measured by the number of employees has fallen Hannan and Hanweck, Evidence from Europe also illustrates the current trend to increased branch numbers: they grew by around 5 percent between and European Central Bank, a. Of course, within Europe there are substantial differences across countries: Germany and the UK experienced declines, while France, Italy, and Spain had substantial increases over the aforementioned period. The US stands out in this respect, as between and , 11, bank mergers took place amounting to mergers annually Mester, Europe has also experienced substantial consolidation both domestically and increasingly on a cross-border basis.

The latter has been motivated by the attractions of Europe's single market as well as the limited growth prospects available in increasingly congested domestic banking systems. Western European banks have also been major acquirers in the transition economies of Eastern Europe, where their financial systems are now dominated by foreign institutions. Spanish banks have a major presence throughout Latin America. The larger US banks have focused on building substantial regional if not national franchises as well as acquiring banks particularly in Mexico and also in Latin America.

Many large banking organizations have acquired wholly or partially a wide range of banks in Asia, with a particular focus on China, India, and, most recently, Vietnam. While the consolidation trend has had the overall impact of reducing the number of banks operating in many large developed markets, this trend is not universal. In many countries there has been an increase in foreign institutions. For example, between and , out of twenty-seven European Union member states, bank numbers increased in Denmark, Estonia, Greece, Latvia, Lithuania, Malta, and Slovakia.

All of these countries, apart from Denmark and Greece, are new members to the European Union that experienced significant foreign bank entry European Central Bank, a. The increase in foreign bank presence in different parts of the world is determined by a number of factors. As noted by Berger , the high proportion of foreign banks in Eastern Europe is mainly a result of state p.

In contrast, foreign banks tend to be less efficient than their domestic competitors in developed countries Berger, et al. The second half of and early also witnessed unprecedented injections of capital by sovereign wealth funds into major banks so as to shore up their eroding capital bases. This trend reflected the strength of emerging markets and the desire of banks and investors from these countries to pursue international diversification strategies by gaining ownership presence in major international banks.

In the light of current market turmoil, the general consolidation trend and the growing presence of foreign banks is likely to continue—perhaps seeing an increasing number of major Western banks being acquired by emerging market institutions. What seems inevitable, however, is that banking systems in developed countries at least will continue to remain concentrated with a handful of banks dominating domestic systems.

One should add, however, that a key difference between banking in the US and in other developed countries relates to the high level of new bank entrants.

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DeYoung notes that in the s, s, and early s, around 3, new banking charters were granted by state and federal banking supervisory authorities—and there is evidence that many of these de novo banks were established in markets where established banks had been acquired Berger, et al. As far as we are aware, no other developed banking system shows anywhere near this level of new entry. In part because of this p. In Europe, out of twenty-seven European Union countries, the asset market share of the top five banks has slightly fallen in over half the member countries since However, national concentration levels remain high—the five bank asset concentration ratio for the monetary union euro countries averaged Levels of concentration are typically much higher for the new member states.

Put simply, consolidation would be expected to reduce relationship banking and boost transactional banking leading to a reduction in lending to small firms. To a certain extent, the literature finds that big banks behave differently from small banks. Berger, et al. While the stylized dichotomy between the role of small and large banks in small business lending is widely noted in the literature, in reality the market for small business credit in the US at least is much more complex, reflected in a broad array of different lending technologies with markets exhibiting contestable features Berger and Udell, ; and Berger, Rosen, and Udell, Evidence from the US, in general, does not support the view that consolidation has reduced the quantity or increased the pricing of small business banking services, as other local banks tend to pick up small business credits that are discarded by consolidating banks Berger, et al.

The consolidation trend has also spawned an extensive literature looking at a broad array of features see DeYoung, et al. A recent snapshot of the sort of related issues considered include:. Despite these major structural developments, up until mid there was a general consensus that the US and many other banking systems were sound, particularly because banks appeared to be holding historically high levels of capital bolstered by Basel I and more recently Basel II requirements Berger, et al. There was also evidence that for large banks their strong capital positions complemented their liquidity creation, although for small banks capital strength and liquidity creation appear to move in opposite directions Berger and Bouwman, a.

Having said this, however, in Europe there had been a gradual trend for banks to hold lower levels of capital but more liquidity on the balance sheet compared to US banks, and the level of liquid assets systematically declined albeit from high levels from the s onwards. High capital levels were required to back the rapid credit expansion that occurred from the mids onwards. In the US and UK, credit growth far exceeded core deposit gathering, leaving significant funding gaps that had to be financed via the interbank market and from securitization activity. This new intermediation model worked extremely well with an increasing portion of retail lending by banks shifting from portfolio lending that generated interest income to securitized lending that earned non-interest revenue.

In developed banking systems, cost levels were generally flat if not declining and the increase in total revenues from traditional and increasingly non-traditional sources meant that by the mids, bank profitability was strong in many countries. By early , the general consensus appeared to be that high-performing banking systems, supported by excess capital and state-of-the-art risk management capabilities, bolstered by appropriate market-based regulation, would continue to finance growth at recent historical levels.

Things have now certainly changed! At the time of writing, the prospects for the banking industry are almost diametrically opposed to the view held eighteen months earlier. Commercial and residential real estate values continue to fall, avenues for bank financing via the securitization business and interbank markets have dried up, and major banks have suffered large losses of capital.

Consequently, many of the largest banking organizations have had to raise additional capital as illustrated in Table 1. Banks' funding gaps loans minus deposits remain at historically high levels, with added concerns about the ability of the system to meet substantial off-balance sheet commitments that still may be drawn. Much of this has yet to feed through into the real economy. This handbook aims to provide further insight into many of the aforementioned developments as well as indications of future prospects in the banking business.

This section provides brief summaries of the chapter contents. Part I of this Handbook comprises seven chapters and examines why banks exist, how they function, how they are managed, and their legal, organizational, and p. Particular emphasis is placed on the evolution of banks within the wider financial system. It is noted that the scale, scope, and complexity of banking business have increased as banks have diversified across product and geographic lines.

This has led to changes in the techniques used by banks to manage liquidity, credit, and other risks.

New complex organizational structures have emerged, including large international financial conglomerates that pose new challenges for regulation and supervision. In Chapter 2 , Franklin Allen and Elena Carletti examine the roles of banks in ameliorating informational asymmetries that may arise between lenders and borrowers; providing intertemporal smoothing of risk; and contributing to economic growth in Europe, the US, and Asia. In general, euro area countries have small but rapidly developing stock markets.

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Bank lending relative to GDP is substantial, and bond markets play an important role in the financial system. The UK has a large stock market and a large banking sector, but the UK bond market is relatively small. The US banking sector is small in relation to the size of the US economy, but both the stock market and the bond market are relatively large. Japan has a relatively large banking sector and highly developed capital markets. The chapter compares the role of bank-based and market-based banking systems and discusses aspects relating to relationship banking and the finance and growth debate.

An interesting finding is that market-based financial systems like the US tend to be more innovative than bank-based systems. Competition among banks, and between banks and non-banking financial institutions and financial markets has intensified in recent years.

This competition has led to the transformation of banks, and the growing complementarities between banks and capital markets. In Chapter 3 , Arnoud Boot and Anjan Thakor examine how banks choose between relationship- and transactions-based lending, and more generally the role of debt versus equity instruments and the economic functions of banks.

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The arguments presented suggest that banks have a growing dependence on the capital market for sources of revenue, for raising equity capital and for risk management, while capital market participants rely increasingly on banks' skills in financial innovation and portfolio management. The increased integration of banks with financial markets raises domestic and cross-border financial stability concerns, which in turn has implications for the design of domestic and international financial system regulation.

Banks are exposed to market risk, interest rate risk, credit risk, liquidity risk, and operational risk. For any bank, the measurement and management of risk is of the utmost importance. Accurate risk measurement enables banks to develop a risk management strategy, using derivative instruments such as futures, forwards, options, and swaps. However, the recent subprime crisis demonstrates that the use of derivative instruments does not by itself mitigate the risks of banking.


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  6. Banks use short-term liquid deposits to finance longer-term illiquid lending, and provide liquidity off the balance sheet in the form of loan commitments and other claims on their liquid funds. In Chapter 5 , Philip Strahan examines the role of banks in providing funding liquidity the ability to raise cash on demand and in maintaining market liquidity the ability to trade assets at low cost , thereby enhancing the efficiency of financial markets.

    Banks dominate in the provision of funding liquidity because of the structure of their balance sheets as well as their access to government-guaranteed deposits and central bank liquidity. There is considerable functional overlap between commercial banks and other financial institutions in providing market liquidity through devices such as loan syndication and securitization. Deregulation and technological innovation have permitted banking organizations such as financial holding companies to capture an increasing share of their revenue stream from non-interest sources.

    The increase in non-interest income reflects in part diversification into investment banking, venture capital, insurance underwriting, and fee- and commission-paying services linked to traditional retail banking services. In Chapter 6 , Kevin Stiroh examines the effects of diversification on the risk and return characteristics of financial institutions. In many cases, risk-adjusted returns have declined following diversification into non-interest earning activities.

    This phenomenon maybe due to a tendency to diversify revenue streams, rather than clients, with the effect that interest and non-interest income are increasingly exposed to the same shocks. Alternatively, managers may have been willing to sacrifice profits to achieve growth through diversification, or the adjustment costs associated with diversification may have been larger than anticipated.

    Under a universal banking model, the services of both commercial and investment banks are provided under one roof. Universal banks provide traditional deposit taking, lending, and payments services, as well as asset management, brokerage, insurance, non-financial business commerce , and securities underwriting services. In Chapter 7 , Alan Morrison examines the evolution of universal banking across countries and over time.

    Universal banking has operated in Germany for many years, but was generally restricted in the US via Section 20 subsidiaries until Congress passed the Gramm-Leach-Bliley Act. Potential conflicts of interests, such as the cross-selling of inappropriate in-house insurance and investment services to bank customers, or the mispricing of internal capital transfers between different parts of financial service groups and so on, are key issues for the universal banking model, which present significant challenges for regulation and for the wider health of the financial system.

    As commercial banks have diversified into investment banking, a number of large international conglomerates have emerged. In Chapter 8 , Richard Herring and Jacopo Carmassi examine the phenomenon of the international financial conglomerate. Typically, conglomerates have complex organizational structures—in some cases comprising hundreds of majority-owned subsidiaries. A subsidiary-based p. However, the very scale and complexity of the largest international financial conglomerates poses new threats to the stability of the global financial system.

    Central bank - Wikipedia

    Part II of this Handbook comprises nine chapters and examines the various roles of central banks, regulatory and supervisory authorities, and other government agencies which impact directly on the banking industry. Central banks execute monetary policy, which operates to a large degree through the banking system; act as a lender of last resort; and perform various other functions such as operating parts of the payments system.

    Government agencies provide safety net protection—such as explicit or implicit deposit insurance, unconditional payment system guarantees, and takeovers of troubled institutions—to prevent widespread or systemic bank failure. In part to protect against systemic failure, and in part to offset some of the perverse incentive effects of government safety net protection, government authorities also engage in prudential regulation and supervision, and set policies concerning bank closure.

    Competition and antitrust policy aimed at preventing abuses of market power also impact directly on the banking industry. So too do explicit or implicit government policy concerning foreign entry into domestic markets and foreign ownership of domestic industry. The historical evolution of central banks has been shaped by successive monetary and financial crises throughout the nineteenth and twentieth centuries. Today, the four major tasks of the central bank are: the settlement of interbank payments; bank regulation and supervision; lender of last resort; and the execution of monetary policy.

    However, not all central banks perform all four tasks; in some countries one or more of these functions is delegated to separate government agencies. Future challenges that will influence the further evolution of central banking include securitization, electronic payments, asset price volatility, and the increasing internationalization of the banking industry. In Chapter 10 , Joe Peek and Eric Rosengren examine the role of the central bank in executing monetary policy, and the broader role of the banking sector in monetary policy transmission.

    Monetary policy is believed to affect real expenditure p. The empirical research reviewed using aggregate data suggests that bank lending contracts when monetary policy becomes tighter. The research also suggests that the effects of monetary policy will be influenced by the characteristics of the banking industry. For example, banks' capital constraints may limit their ability to increase lending in response to expansionary monetary policy.

    Various forms of financial innovation such as securitization may reduce the future importance of the bank lending channel. Central banks also play an important role as lender of last resort to banks experiencing liquidity problems. Lending of last resort provides insolvent banks with liquidity and allows them to escape market discipline. In Chapter 11 , Xavier Freixas and Bruno Parigi examine this lender of last resort function, and its relationship with bank closure policy.

    The difficulties in distinguishing liquidity and solvency shocks are highlighted. The lender of last resort function is usually handled by the central bank, while scrutiny of bank closure is commonly the responsibility of a separate agency, often a deposit insurer. The current financial crisis highlights the complexity of the lender of last resort function, which encompasses issues relating to monetary policy, bank supervision and regulation, and the operation of the interbank market. The authors posit that the lender of last resort function should be an integral and interdependent part of an overall banking safety net, which encompasses a deposit insurance system, a system of capital regulation, and a set of legal procedures to bailout or liquidate troubled banks.

    The design of regulatory arrangements for the banking industry can lead to conflicts of interest that have the potential to undermine the quality of supervision and enforcement. In Chapter 12 , Ed Kane explains how in extreme cases, conflicts of interest, combined with intense competition and technological and financial innovation, can give rise to inappropriate behavior on the part of bankers, increasing the probability of a banking crisis. Kane notes that recent technological change and regulatory competition has encouraged banks to securitize their loans in ways that masked credit risks, while supervisors have outsourced much of their responsibility to credit rating agencies.

    It also limits losses to depositors in the event of bank failure, and reduces the risk that a run on one bank might undermine confidence in others through a contagion effect. However, a flawed deposit insurance system might cause more harm than good, if moral hazard results in excessive risk taking or recklessness on the part of banks. Such a system, the authors argue, can be designed as part of an efficient financial safety net system.

    To reduce moral hazard and systemic risk, regulators require banks to hold capital in order to absorb unforeseen risks. Standards developed by the Basel Committee on Banking Supervision via Basel I and Basel II have gone some way to aligning such capital requirements with banks' risk profiles. The authors focus on the theoretical and empirical underpinnings of Basel II, and the challenges in rating the riskiness of assets contained in bank portfolios.