OCR A Level Economics: Central banks and financial regulation (H460) – Revision Notes

These notes condense the role of the central bank and financial regulation in the financial sector area of study of the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It is macroeconomics content, with no separate stage. Use the study guide for full explanations. Then try the practice questions, the OCR Economics hub, the checklist and the free diagnostics. For instruments such as the liquidity trap and symmetric targets, see the monetary policy notes. All figures here are invented and illustrative.

Key definitions

Term	Meaning
Central bank	Public institution at the centre of the financial system
Operational independence	The bank chooses how to hit a target that the government sets
Lender of last resort	Central bank lends to solvent but illiquid banks against collateral
Solvent	Assets exceed liabilities
Illiquid	Cannot meet immediate demands for cash
Moral hazard	Protection from loss encourages more risk
Systemic risk	One failure spreads and threatens the whole system
Capital ratio	Capital ÷ risk-weighted assets
Leverage ratio	Capital ÷ total assets
Macroprudential policy	Rules aimed at stability of the whole system
Conditionality	Policy conditions attached to IMF loans

Functions of a central bank

• Runs monetary policy (policy rate, asset purchases).
• Issues the currency.
• Acts as the government’s bank.
• Holds settlement accounts for commercial banks and clears payments between them.
• Lender of last resort.
• Supervises or helps regulate financial institutions.
• Holds and manages foreign reserves where required.

Independent versus government-controlled

	Independent	Controlled
Decisions	Experts, committee	Ministers
Target	Set in advance	Can shift with politics
Strength	Credibility, no election cycle effect	Co-ordination, accountability
Weakness	Democratic deficit, may clash with fiscal policy	Short-termism, deficit financing, higher expected inflation

Evaluation hook: independence helps most where institutions are strong, the target is clear and the bank must explain misses. The government can still set the target.

Policy measures

Objective	Measure	Chain of reasoning
Primary: price stability	Higher policy rate	Borrowing costs up, consumption and investment down, AD down, inflation down
Primary	Ending or reversing asset purchases, or forward guidance	Shapes long-term rates and expectations
Secondary: growth and employment	Lower rate, asset purchases	AD up, output up, unemployment down, if inflation is on target
Financial stability	Capital buffers, loan limits, stress tests	Fewer risky loans, stronger banks

Method for pass-through questions.

1. Multiply the policy change by the pass-through share.
2. Multiply by the loan size for the yearly cost.
3. Divide by 12 for the monthly figure.

Reminder: a 1.0 point cut with 60% pass-through gives 0.6 points. On a CU 90,000 interest-only loan, 90,000 × 0.006 ÷ 12 = CU 45 a month.

Effectiveness checklist. Pass-through, time lags, type of shock, low-rate limits, expectations and confidence, and conflicts between objectives.

Inflation targeting

Method for inflation questions.

1. Inflation = (new index ÷ old index − 1) × 100.
2. Compare with the target to find the gap.

Reminder: an index moving from 250.0 to 257.5 gives 7.5 ÷ 250 = 3.0%.

Advantages	Disadvantages
Transparent	Ignores other objectives after a supply shock
Anchors expectations	Backward-looking data, lags
Rules-based, limits political pressure	May miss asset bubbles
Accountable	Missed targets damage credibility

Lender of last resort

Chain. Rumour, withdrawals, liquid assets run low, forced asset sales, losses, contagion. The central bank lends against collateral at a penalty rate and with a haircut.

Reminder. Liquidity coverage ratio = high-quality liquid assets ÷ expected 30-day net outflows. With CU 90m and CU 75m the ratio is 120%.

For	Against
Stops contagion and runs	Moral hazard
Protects payments and credit	Taxpayer risk if collateral falls
Penalty rate limits abuse	Hard to separate solvent from insolvent

Why regulate, and how

• Why. Information asymmetry, externalities and systemic risk, moral hazard, essential payment system, consumer protection.
• Under-regulation. High leverage, risky lending, weak liquidity, opaque products, failures, bailouts, lost output.
• How. Capital requirements, leverage ratio, liquidity rules, stress tests, deposit insurance, conduct rules, ring-fencing, resolution plans.

Reminder: stress test. A bank with capital CU 32m and risk-weighted assets of CU 400m (8.0%) suffers a stress loss of CU 20m. Capital falls to CU 12m, a ratio of 12 ÷ 400 = 3.0%. It falls below a 6% minimum used for this example.

Reminder: leverage ratio. CU 32m of capital against CU 1,000m of assets is 3.2%. The reciprocal, 1,000 ÷ 32 = 31.25, is the leverage multiple.

Reminder: deposit insurance. If cover is CU 85,000 per depositor, someone with CU 120,000 can lose up to 35,000. That keeps some incentive to monitor the bank.

Regulatory change and 2007-08

Link each change to its effect.

Change	Effect
Looser rules on activities	Banks combine safe deposits with risky trading
Securitisation	Risk spread and hidden, weaker lending standards
Shadow banking	Activity outside capital and liquidity rules
Reliance on ratings and models	Underestimated correlation of defaults
Firm-by-firm supervision	System-wide build-up missed

Outcome: falling asset prices, losses, loss of trust between banks, frozen lending, recession, bailouts and then tighter rules.

Benefits and importance of regulation

• Benefits. Fewer failures, more confidence, protected savers, fewer bailouts.
• Costs. Less lending when capital rules tighten, compliance costs, activity moving to lightly regulated firms.
• Cost reminder. With CU 32m capital, supportable assets are CU 400m at 8% and CU 320m at 10%, so CU 80m less.
• Judgement. Importance rises with the size of the financial sector and the harm of past failures. Timing matters: tightening in a downturn deepens it.

The IMF and World Bank

	IMF	World Bank
Main work	Surveillance, lending for balance of payments problems, capacity development	Long-term development finance and advice
Role in the system	Monitors risks, crisis support, advice	Supports institutions and reform
Criticisms	Conditionality, weighted voting	Conditions, project focus

Neither regulates individual banks. National authorities do that. Evaluation points: size of resources, whether governments follow advice, speed of response, and side effects of conditions such as spending cuts.

Quick self-test

1. Name three functions of a central bank.
2. A price index rises from 160.0 to 166.4. Calculate inflation.
3. State the difference between insolvent and illiquid.
4. A bank has capital of CU 45m and risk-weighted assets of CU 500m. Calculate the capital ratio.
5. Explain one cost of lender of last resort support.
6. Give two reasons for a lower expected inflation rate under an independent bank.
7. A bond pays a coupon of CU 5 and its price is CU 100. After asset purchases the price is CU 104. Calculate the new yield to two decimal places.
8. Name two tools of macroprudential policy.
9. State one criticism of IMF conditionality.
10. Which body supervises individual banks: the IMF or the national authority?
11. Distinguish the capital ratio from the leverage ratio.
12. A bank has CU 300m of deposits and CU 36m of liquid assets. If 15% of deposits are withdrawn, calculate the shortfall.

Answers

1. For example: monetary policy, issuing notes, banker to government and banks, lender of last resort, supervision.
2. (166.4 ÷ 160.0 − 1) × 100 = 4.0%.
3. Insolvent: liabilities exceed assets. Illiquid: assets are enough but cannot be turned into cash quickly.
4. 45 ÷ 500 × 100 = 9.0%.
5. Moral hazard, or taxpayer risk if collateral loses value.
6. Rates are set free of the election cycle, and the commitment to a target is credible, so wage and price setters plan on lower inflation.
7. 5 ÷ 104 × 100 = 4.81% (previously 5.00%).
8. For example: capital buffers, loan-to-income limits, stress tests.
9. For example: spending cuts can deepen a downturn, or terms are imposed from outside.
10. The national authority.
11. Capital ratio uses risk-weighted assets as the denominator. Leverage ratio uses total assets.
12. Withdrawals 300 × 0.15 = CU 45m. Shortfall 45 − 36 = CU 9m.

Must-know distinctions

• Primary versus secondary objective. Price stability comes first. Growth and employment are supported only while the target is safe.
• Operational independence versus target independence. The bank usually chooses the means. The government usually sets the target.
• Capital ratio versus leverage ratio. The first uses risk-weighted assets. The second uses total assets, so it cannot be gamed by low risk weights.
• Capital versus liquidity. Capital absorbs losses. Liquidity meets withdrawals.
• Microprudential versus macroprudential. The first looks at the health of each firm. The second looks at risks across the whole system.
• IMF versus World Bank. Short-term balance of payments support and surveillance, against longer-term development finance.

Worked evaluation chain

Question type: “Evaluate the case for an inflation target when a supply shock raises prices.”

1. Define the target and the shock: costs rise, so prices rise without excess demand.
2. Argue for: a firm target keeps wage and price expectations anchored, so a one-off price rise does not become a spiral.
3. Argue against: raising rates to bring inflation back quickly cuts output and employment, so the secondary objectives suffer.
4. Qualify: much depends on how fast the bank must return to target. A flexible time frame softens the cost.
5. Judge: the target is worth having for credibility, provided the bank can look through a temporary shock and explain why.

Where marks are usually lost

• Writing about the instruments of monetary policy without linking the chain to the stated objective.
• Treating independence as meaning the government has no say over the target.
• Mixing up illiquid and insolvent banks.
• Describing the lender of last resort without one cost, or both sides.
• Describing what happened in 2007-08 without linking a specific regulatory change to its effect.
• Calling the IMF a regulator of banks.
• Giving the benefits of regulation with no cost, so no judgement.
• Forgetting to convert pass-through, ratios and index changes to the same unit before comparing.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021: the financial sector, covering the role of the central bank and financial regulation.