All India Management Association (AIMA) 2007 M.B.A Marketing Management Central Banking

In seeking to keep inflation low and stable, Central Banks may also have a tendency to smoothen the economic cycle. It is now well understood that 1 of the most important determinants of modifications in the inflation rate is the extent to which true output diverges from potential output. When true output falls short of what the economy could produce without difficulty where, in other words, resources of capital and labor are underutilized there is a tendency for inflation to fall. Conversely, when the economy is straining to produce more than it can on a sustainable basis, when capital is being used round-the-clock and the labor market is tight, there is a tendency for inflation to rise. For this reason, all Central Banks, even those with no formal mandate to be concerned about output or employment, have to watch carefully about what is happening to keep inflation under control. Indeed, once inflation has been brought down to a low-level, it is not much of an exaggeration to say that keeping inflation low and stable is mainly about trying to keep true output tracking close to potential. Reducing economic and social dislocation caused by booms and busts is a useful contribution which Central Banks can make.
END OF CASELET 2

Caselet 3
learn the caselet carefully and ans the subsequent question:

4. Briefly outline a framework through which a bank can manage its liquidity risk. ( 12 marks)

In the early months of 1999, the directors of US insurer General American slept soundly in the knowledge that they had an Al rating from rating agency Moody's Investors Service, and that a reinsurance strategy was in place to protect the interests of the company's 300,000 policy holders. But a tactic that General American had developed to raise funds in the short-term markets had put the future of the company in the hands of just 37 institutional investors. These investors, mainly money market mutual funds, had lent the insurer nearly $7 billion of funds that they had the right to call back at just a few days' notice. General American had concentrated so much of its funding in these short-term instruments that it had about 60 percent of the seven-day puttable funding agreement market, and 19 percent of the total short-term insurer funding agreement market.
General American could see no cause why its counterparties would call in their funds abruptly and risk ruining what had become a mutually beneficial relationship. But that's what had just happened, in what has become the classic latest example of how liquidity risk can destroy a major institution. First, in spring 1999, investors were spooked by worsening financial conditions at a company that had marketed General American's funding agreement program and that had reinsured a few of the program's liabilities. On July 29, the markets were told that General American would recapture the reinsurance portfolio and presume the whole of the obligations of the funding agreement program, a move that led Moody's to downgrade General American's credit rating on July 30. a different downgrade followed a few days later, as the institutional investors began to scramble to pull their funding back as fast as their contracts allowed them to. Faced with this cash outflow, on August 9, General American admitted it did not have enough liquid assets to honor its contractual obligations and the next day -just 10 days after its cash flow crisis began - it was forced to look to Missouri's insurance regulator for protection.

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