The Role of Financial Intermediaries and Financial Markets - Essay Example

The Role of Financial Intermediaries and Financial Markets 2009 Financial intermediaries play the role of connecting real and financial sectors. The most important financial intermediaries are banks that provide checking accounts to the public. Commercial banks are fundamentally businesses that earn profits for their owners by providing certain services for customers in return of payments from them. In contrast to other businesses, the balance sheet of a commercial bank has reserves on the assets of its balance sheet. These are cash on hand or funds deposited by the bank with the central bank. Some reserves are held for day-to-day business needs, but most serve to meet legal reserve requirements. In most countries, a fixed fraction of the banks’ checking deposits, or bank money, is kept as reserves. The central bank determines the quantity of reserves of the banking system. Using those reserves as an input, the banking system transforms them into a much larger amount of bank money. The currency plus this bank money is the money supply, created through multiple expansion of bank deposits, or money multiplier. Assuming that the central bank, or Federal Reserve, buys a $1000 government bond from an individual who deposits $1000 in her checking account at Bank 1. The modern commercial bank does not keep the entire amount in reserves but only a reserve requirement, say 10 percent, as reserves that do not earn interest. So, the bank now has $900 that it can lend out. The borrower deposits this money in Bank 2, creating a checking account of the borrower in Bank 2. Hence, the total amount of money supply becomes $1900. Bank 1’s activity has created $900 of new money in second-generation bank, Bank 2. Thus, a chain of bank activity is set in motion. The process will come to an end once every bank in the system has reserves equal to 10percent that is equal to the new reserves. For every additional dollar in reserves provided to the banking system, banks create $10 of additional deposits of bank money. The money supply multiplier is the ratio of new money created to the change in reserves. This summarizes how the banking system creates money. The entire banking system transforms an initial increase in reserves into a multiplied amount of new deposits or bank money. Fractional reserve banking has the advantage of creating money, thus stimulating business activity, but it also has great risks. The fact that banks cover only a fraction of their deposits opens up the possibility of “bank panics” or “a run on the banks”. Since a bank has only a small portion of money that it owes to its depositors, there is usually no problem. Only a small number of people will want to withdraw their money at one time. But when too many people want their money at once, then there can be a frenzy that is known as “bank run”. In the modern financial system, bank runs are rarer and less dangerous. This is because the federal government ensures that all but the largest depositors will get their money back no matter what happens. Besides, the Federal Reserve takes an active role in being the “lender of the last resort”, providing funds to healthy banks with temporary liquidity problems and making sure that sick banks get liquidated in an orderly way. The actual financial system is even more complicated. It is possible that somewhere along the chain of deposit expansion, an individual who receives a check will not leave the proceeds in a bank checking account. Then, the new reserves would not lead to the amplification of the financial system. Also, if banks decided to keep some of the reserves rather than lend, the entire process of multiple deposit creation would stop. Banks had significant excess reserves during the Great Depression in the 1930s and when short-term interest rates fell to near zero in 1999. The financial system also includes the stock market, where the shares of publicly owned companies, the titles to businesses, are bought and sold. While the return on savings accounts and short term bonds are interest rates, for most other assets, the return combines an income, like dividends, and capital gain or loss, which represents the increase or decrease in the value of assets. Some assets have predictable rates of return while others are risky, leading to the variability of the returns on investment. While individuals want high returns, they also prefer lower risks, being risk-averse. They must be induced with higher returns in order to accept higher risks. Interest rates that banks charge on loans and pay to depositors are essentially a product of the real and monetary economies. Demand and supply of loanable funds intersect to result in interest rates. Credit demand arises from consumers and businesses directly from the capital market or through the intermediation of the banking system. The system becomes all the more complicated as a result of global capital flows. The government, through the issue of bonds, raises capital while foreign direct investment results in the demand for foreign exchange. The same agents, that is, consumers, businesses, government and overseas institutions demand for capital in the money markets. Over the recent past, the financial system has become more and more complicated with the emergence of securitized assets and hedge funds investing across markets in different continents. Hence, to understand the rise in interest rates in all western economies, it is essential to study the developments in the global economy and the inter-linkages between economies. It has been argued by economists that there is the need to have a financial regulator to monitor and stabilize the real economy even though it goes against the spirit of neoclassical economics of free markets so that there is systemic stability in the economy, financial institutions are safe and consumers are protected from sudden busts of the system (Llewelyn, 1999). Since there are possibilities of market failure in the face of market imperfections, there is the need for monitoring and controlling financial institutions so that crises like that erupted as a result of the over-exposure to sub prime accounts do not happen. The global economy is intricately linked through trade and capital flows. Inn such a situation, financial institutions have various avenues of investment in many markets through a host of instruments. The developments in the capital and mortgage markets and the formation of various derivatives result in the tendency of financial institutions exposing them to uncertain instruments. In a global situation in which much of the capital flows occur through the banking system and the investors are far removed from borrowers, more is the need for such financial regulation so that interest rate stability can be maintained (Hoenig, 2007). Financial instruments pass through many hands in many countries directly as well as through derivatives. In the process, investible funds are managed by large institutions that often have nothing to do with either the original borrowers or the investors. Lack of flow of information to financial institutions and investors often complicate matters. The financial system has become a market-based flow in which perfect sharing of information is crucial. Besides, there may also be externalities in the system that result in market failure. The subprime crisis is much the result of all these problems associated with disintermediation of the capital flows and inadequate information flows. This has occurred with little supervision and regulation (Economist, 2007e). Trillions of dollars of capital have moved from market to market through convertible loans, interest rates and high default risks. So long central banks have been managing inflation through these instruments. At the same time, they have failed to create financial stability. Hence, the monetary policies of raising interest rates have been ineffective in controlling the financial instability. The sub prime crisis that erupted in August 2007 in a way was the result of a prolonged period of low interest rates, which prompted demand for mortgages. Banks found them over-exposed to credit, particularly in the sub prime accounts that had low credit rating. Investors had been buying securities backed by these uncertain assets (Economist, 2007, a). The collaterals were formed when rating agencies clubbed together individual assets that were found to be risky into collateral debt obligations (CDOs) of banks. Defaults in these sub prime accounts in 2007 resulted in a snow balling effect on the entire financial economy as the CDOs were downgraded and banks found themselves burdened with illiquid assets (Economist, 2007,a). Assets that are based on these collaterals became impossible to trade. By October 2007, multinational financial institutions like Merril Lynch had to report huge losses on account of write-down of non-recoverable loans (Economist, 2007, c). In the United Kingdom, Northern Rock faced a similar situation (Economist, 2007d). The developments in structured finance and the increasing sophistication of the credit market resulted in over-burdening of financial institutions with illiquid assets. The same instruments that had assisted central banks to diversify risks and manage inflation earlier became to source of illiquid assets. The effect of the mortgage market on the real and financial economies is not new. The housing market and US monetary policy have been intricately linked with each other for a long time. Particularly in the 2000s, the fed induced a boom in the housing market by keeping interest rates low. This was perhaps a result of the spiraling of housing prices since the mid-1990s at the height of the dot com boom. The housing boom began in 1998 when assets in the west coast cities of Seattle, San Diego, Los Angeles and San Francisco went through the roof (Shiller, 2007). Thereafter, home prices not only spiraled across the United States but also across Europe, the United Kingdom and Asia. Then, with house prices on a rising spree, there was little risk of delinquency on mortgages. However, delinquency and foreclosure began to grow since the mid-2000s, culminating in the sub prime crisis (Taylor, 2007). Since the housing boom could not be explained by rise in construction costs, much of it was in effect speculative bubbles. Besides, with the credit market becoming more and more sophisticated, the housing market developments affect consumer expenditure as well, thereby having an economy-wide effect (Muellbaur, 2007). With the availability of collaterals and liberalization of the credit markets, the housing market has a ‘wealth effect’ through the stock market. For about a decade, availability of housing credit and spiraling of house prices, a large number of families in the United States and the United Kingdom have accumulated significant wealth (Muellbaur, 2007). This has also been supported by developments in information technology in the financial system, sharing of credit history between institutions, development of securitisation and derivatives. As a result, consumers have altered their spending pattern as they got more loans on the housing assets. Although lenders, that is banks and financial institutions have spread their risks across assets and economies, borrowers have increased their vulnerability to changes in the housing market. It has been found that as house prices rise, first-time house buyers have to save hard while existing house owners tend to increase their consumption spending by an amount higher than the increase in the value of the asset. This means that existing house owners increase their exposure by a higher amount purely on the basis of expectation of the continuing spiral. The housing market affects monetary policies, hence interest rates, through direct effects on the user cost of capital, expectations of future movements of housing prices and the supply of housing as well as indirectly through effects on the real economy. The latter influence works through wealth effects of housing prices, credit effects of consumer spending and the subsequent effects on housing demand. The housing sector has the potential to result in overall financial instability both in the real and monetary economies and eventually lead to a situation in which the central banks are unable to stabilize the situation (Mishkin, 2007). Housing wealth has also been accompanied with non-housing wealth through the stock markets. However, consumption spending reacts to housing wealth more than it does to non-housing wealth, as has been found by various studies (Mushkin, 2007). Hence, it is essential that monetary policy instruments respond to changes in housing prices, particularly in order to check bubbles. This was what happened in the US and European economies in 2007. Individual borrowers became over-exposed to the mortgage market while financial institutions and banks spread their risks across wide-ranging financial instruments that were ultimately backed by the assets of the individual borrowers. Foreign financial institutions including central banks subscribing to US government bonds supported the flush of liquidity in the US monetary system, without concomitant inflation. The low interest rate regime had been prevalent since the mid-1990s. The dotcom boom had been enabled by low interest rates that enabled new ventures to raise phenomenal amounts of money. As a result, the stock markets spiraled and the new entrepreneurs indulged in free spending (Cassidy, 2002). However, much of the investments made during the boom now looked excessive by 2001 and the pool of available manpower did not support such high investments (Goodfriend). In 2001, real GDP growth continued to fall quarter after quarter although consumer spending held up as a result of non-residential fixed investments, particularly in China, and liquidation of past investments. US capital flew out to non-residential locations and business investment in the United States came to near zero. Hence, unemployment rates began to rise in the manufacturing sector, resulting in a secondary collapse that trickled down to the services sector as well. The September 11 events resulted in a further drop in confidence and hence contraction in manufacturing. The decline in profits led to greater reliance on external funds, which raised the costs of the latter. Since 2004, the Fed has raised the base interest rate 15 times from 1% to 4.5% in order to make investment in US Treasury Bonds as well attractive. However, tightening of monetary policy is fraught with the risk of inflation since this raises the cost of capital and investments in the domestic manufacturing sector becomes more expensive. It is usually considered that a real base rate of interest of 3% per annum is neutral, that is it neither leads to inflation nor to recession. Therefore, more recently the Fed is reconsidering its interest rate hikes to avoid inflation. On the other hand, other economies are providing higher yields than the US. For example, the Chinese central bank announced a hike in its base lending rate by 0.25% to 5.85% in order to curb inflation because of excessive investment, that is in order to ‘sterilize’ the effects of high growth. The European central bank and the Bank of England is also set to increase the rates of interest, following high growth in GDP in these regions. There are concerns that a small shift in the assets away from the US may lead to a heavy toll on the global economy, given the precarious state of the US current account deficit. A flow of capital out of the US economy would result its debt servicing capacity adversely, thereby affecting its economy and imports. Since the US current account deficit is about 2% of the global GDP, a slight shift in the international capital flows will endanger the global economy unless there is rise in demand elsewhere (Beams, 2006). The high growth and possibilities of high yields in the emerging markets has weaned away the capital from the US as a result of the falling dollar. The recession in the early 2000s was largely the result of fall in business confidence over the internet and information technology boom. Hence, the Fed’s attempting to tighten the monetary supply since 2004 was ineffective since it would become all the more inflationary without resulting in any addition to investments. Sticky prices make monetary policies ineffective on aggregate demand. The Fed was not able to bring about increase in the pace of economic activity through intervention in the exchange value of the dollar since the major trading partners of the US has also been experiencing similar downturns. Further, some segments of the industrial sector, computers being the most important, have huge excess capacities resulting from the boom in the previous period. The US government finances turned from surpluses in the 1990s to a deficit, public debt being 64.7 percent of GDP in 2005, close to what it is in other industrialized countries (CIA). This was largely been the result of tax cuts in the past, in order to boost growth since the dotcom bust in 1999-00, as well as increased outlays for defense and military spending necessitated by rise in terrorism at home as well as initiatives in the middle East. Hence, the fiscal policy that spurred economic recovery was faced with rising interest rates that gradually began to crowd out private investments and erosion of productivity growth and fund crunch for welfare measures (Muhlesein & Towe, 2004). Works Cited Economist (2007a), “The game is up: Banks in trouble”. August 16, 2007 Economist (2007b). “Paint it Black: The stockmarket crash of 1987 has lessons for today’s markets”. October 18, 2007 Economist (2007c). “Financial Markets: Spooking investors”. October 25 Economist (2007d). Northern Rock: Soft-touch Regulation. October 11 Economist (2007e). “The World Economy: Pnly Human”. October 18 Forbes, “Update 4: U.S. Dollar Slides Against Euro, Pound”. Available on http://www.forbes.com/fdc/welcome.shtml. Retrieved on January 4, 2008 Goodfriend, Marvin (2002). “The Phases of US Monetary Policy: 1987-2001”. Available on http://richmondfed.org/publications/economic_research/economic_quarterly/pdfs/fall2002/goodfriend.pdf. 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Presented at “Housing, Housing Finance and Monetary Policy”, an economic symposium sponsored by the Federal Reserves Bank of Kansas City on August 31-September 1 2007 Muhlesein, Martin and Christopher Towe (2004). “US Fiscal Policies and Priorities for Long run Sustainability”, International Monetary Fund, January 7. Available on http://www.imf.org/external/Pubs/NFT/Op/227/#overview. Retrieved on January 4, 2008. Stockhouse, Sprott (2007). “Asset Management Outlook for 2007”. Available on http://www.stockhouse.ca/blogs.asp?page=viewpost&blogID=228&postID=9382. Retrieved on January 4, 2008 Read More