Role of Stock Market and Banking System in Promoting Economic Growth and Ensuring Financial Stability - Assignment Example

? How can stocks & banks promote Table of Contents Introduction 3 Literature review 4 Case studies 10 Conclusion 14 Reference 15 Introduction In the contemporary economic condition, banks as well as stock markets play a crucial role. A nation’s economy can be considered as a growing economy if there is a stable growth in per capita gross domestic production (GDP). Thus, economic growth is measured as the percentage change in the real GDP of the nation. The economists have pointed out several factors that affect the economic growth of a nation, some of them are saving and investment done by the consumers and financial investment done by the government. It is quite usual that with increase in per capita GDP, the purchasing power of the customer increase. They have more money to purchase goods and services. This results in greater liquidity in the market that turns out as a major cause for increasing inflation. No doubt, moderate rate of inflation motivates the producers but a high rate of inflation is like a devil that possesses the power to disturb whole of the economy. Therefore, it becomes the prime responsibility of the government to reduce the liquidity so that inflation can be reduced without negatively affecting the economic growth. There comes the role of reserve bank of the nation; it makes required changes in monitory and fiscal policy. This is a mere single example to reflect role of banks in the economy, in the later part of this project role of bank in the economy will be discussed with much more details. Economic growth and performance of stock market is interrelated with each other. This fact can be evident after considering the recession phase of 2008-09. When the developed countries like US and UK were facing harsh economic recession, almost all the international stock indices declined drastically. The investors lost a huge part of their investment. The stock market is a platform through which foreign institutional investors (FII) can invest in the nation. Such foreign capital provides liquidity in the market and assist in economic development. Even the domestic investors use stock market to invest their saving. Such investments improve capital formation rate and money circulation in the economy increases. Therefore, the stock market influences economic growth of a nation. In the given project different theoretical factors will be discussed to understand how banks and stock exchange influences the economic growth of a nation. After conducting the required literature review, some case studies will be discussed to critically verify the role of banks and stock market. On the basis of this research final conclusion will be drawn. Literature review Walter Bagehot (1873) and Joseph Schumpeter (1912) emphasised on role of banking system in economy growth and productive investment in a nation. However, there are economists like Robert E. Lucas (1988) who stated that “the economists have badly over-stressed the role of financial system” (Levine & Zervos, 1998, p.1). Similarly Joan Robinson (1952) also critically pointed out that banks respond passively to the economic growth. No doubt these critics were not wrong but one cannot deny the role of banks in economic growth. To have a healthy economic growth, it is quite essential for a nation to maintain different businesses and industries operating in a harmonised manner. Bank acts as an intermediary that facilities fast and secure flow of capital within the domestic market as well as in international market. A healthy and well developed banking system is one of the core factors which are taken into consideration by foreign investors while making investment in a country. To attract foreign investment in a country, the government provides special changes in the monitory policy. Cameron (1972), pointed out that banks should vigorously search for ideal funds that can be used, mobilised and circulated in the economy. To attract the investors, high interest rate on deposits is a good tool, as that will attract more saving (Badun, 2008, p.122). Montiel (2003) discussed the role of financial system under three broad categories. At first, banks are responsible for accumulating physical capital; secondly they allocate the capital to the most productive activities; and finally banks reduce the resources that are used in the process of intermediation (Badun, 2008, p.122). Like Montiel, Levine (1997) segregated the role of banks under five main tasks. These are as follows: Facilitation of risk management; Allocation of resources; Monitoring of managers and control over corporate governance; Savings mobilization; Easing the exchange of goods and services. (Badun, 2008, p.122) In a nation, banks maintain a network where the central bank is called bankers bank. It retails the authority to formulate different monitory policies. The main task of these policies is to maintain balance between demand and supply of money. When the market faces a state of high liquidity, the reserve bank increases the prime lending rate. Because of this, funds appear costly to the borrowers. Simultaneously, reserve bank also increased the lending rates to provoke people to park their saving in different banks. These contractionary monetary policies get hold on increasing inflation rate and excessive liquidity in the market. On the other hand, in the phase of slow down in the economic growth rate the market faces liquidity crises and then the central bank (reserve bank) implements expansionary monitory policy. These are just the reverse of contractionary policy. By reducing the bank rate for deposits, bank motivates people to invest in the capital market or to fund different projects. Loans became available at low rate and thus the entrepreneurs get ample fund to invest for business growth (Central Bank of Nigeria, 2006). Beck, Demirguc-Kunt, and Maksimovic (2003) conducted research to analyse the relationship between bank rate with factors like entry and ownership structure of different businesses. As per the finding, a country that has well developed banking system faces less corruption, high financial, economic growth and smooth functioning relation with foreign banks. The banking system of a nation influences the stock market and its economic development. Levine (1991) and Valerie R. Bencivenga, Bruce D. Smith, and Ross M. Starr (1995) developed a model. As per this model, in a market with high liquidity (where the stocks can be traded in a less expensive manner) the investors are more interested in making long term investment. This is because if an investor has an opportunity to sell his/her investment as and when there is a demand for capital, then he/she will prefer to keep the saving invested in the capital market. In this manner the long term projects get ample supply of funds and thus the rate of economic growth increases. Whereas, in a market with poor liquidity the investors cannot sell the held securities on short notice; therefore they prefer to make short term investment. This adversely affects availability of capital for the long term project (Levine & Zervos, 1998, p.2). In the year 1993, Raymond Atje and Boyan Jovanovic conducted a cross country study on stock market and economic growth during 1980-88. They found a strong correlation between volume of stock traded on the stock exchange and the gross domestic production (GDP) of 40 nations (Levine & Zervos, 1998, p.6). Levine and Zervos in 1998 pointed out importance of stock market for small and medium sized companies. By issuing company’s shares in the capital market, these organisations can arrange the required fund for investing in the ongoing as well as new prefects. If the stock mark of a nation is effective enough, it will assist companies to avail capital at comparatively lower rate. An effective stock market provides required liquidity in the market. While the government reduces the bank rate for lending, people prefer to invest in the stock as compared to parking their saving in stock market. Therefore, for the individuals, stock market is an alternative platform to invest and generate high rate of return (Catalyst Institute, 1999, p.10). As compared to bank and other government bonds, the risk associated with stock market investment is comparatively high (Pratt & Grabowski, 2010, p.332-333). The same fact has been provided by capital asset pricing model while takes into account the return generated by a stock and the risk (both systematic as well as non-systematic risk) associated with it (Stopford, 2009, p.340). The investors who are ready to bear high risk for getting high return, they prefer to invest in the stock market. However, whether investors invest in the stock market or they park the funds in banks ultimately this fund enters in the economy. While discussing the role of stock market in an economy how one can neglect foreign institutional investment that enters in a country via stock market. This capital is quite crucial because it increases the liquidity in the market and the domestic investors feel more confident about the future performance of stock market (Thirunavukarasu, 2009, p.124-125). However, high investment of FII do increases the risk associated with liquidity crisis. There have been many incidences where as soon as the FII starts pulling out their investment, the stock market indices starts falling and the domestic investors express their panic. Such situation raise question mark regarding financial stability and economic growth of a nation. Considering such high market risk associated with the stock market, Keynesian thesis described a stock market as a “Casino” (Azarmi, 2005, p.2). Therefore, the government of many nations keeps a sharp eye on flow of FII. To minimise such risk, governments set some limits for foreign investment in the stock market but these measures are not effective enough. Binswanger (1999) argued that the price traded in the stock market may not reflect the fundamental value of the underlying assets. Such incidences are quite common in the phase of speculative bubble. Such situations are generally artificially created to provide wrong information to the investors to misguide them. This information increase the expectation of financial markets and make the market condition quite volatile. The investors who are not much experienced to trade in the capital market fails to realise the hidden fact and end up losing their hard eared saving by making a wrong investment (Yartey & Adjasi, 2007). Figure 1: Financial Institution & Economic Growth (Source: Catalyst Institute, 1999, p.16) The above model given above clearly reflects the role financial institutions (banks and stock market) in economic growth of a nation. As these institutions influence the economy of a nation, simultaneously performance of these bodies also get affected by the economic factors such as the government policies, foreign investment (FDI & FII) and international market condition. Case studies To have a better understanding about influence of banks and stock market on the economic growth of a nation some real life examples has been discussed in this section. These case studies will assist us to realise the inter-relation between different financial institutions and its impact on the economic condition on domestic as well as on international market. One such case study can be the derived from the recently held sub-prime crisis. The root cause of financial crisis was the loose monitory policy followed by the financial institutes of developed country like US and UK. Use of such loose monitory policy has been started from beginning of 2002 onwards. The main aim of the banks was to provide easy loans at comparative lower rates. As soon as this strategy was introduced, the flow of capital increased and the liquidity position went high. Such a high liquidity position assisted business to avail capital for growth and diversification. The global credit condition was a result of mutual functioning of international markets. From 2001 to 2006 onwards the developed countries adopted a policy of lower interest rate and this was followed by without the fear of inflation rate. Such a loose monitory policy with credit availability at low rate accelerated the rate of economic growth. At that time the industries were performing very well and the GDP was increasing at a healthy rate. The companies registered in developed nation used the cheap (at low interest rate) credit to invest in developing nations like India, China and Brazil either in form of foreign institutional investment (FII) or foreign direct investment (FDI. FDI was investment in the developing countries which resulted in development of infrastructure and industries. FII was investment in the stock market and indirectly this money also entered in the economy of the developing nations. Therefore, the decision of banks to provide credit on easy terms assisted in economic development of both developed as well as of the developing nations. Though the global economy was performing well but on the side the credit growth in the balance sheet of financial institutions also increased drastically. Banks paid less attention towards risk associated with loans at sub-prime rate. They used highly complex hybrid debt instruments without developing a proper method to analyse the risk associated with them (Gorton, 2007). As the price of property was increasing in US, people took advantage of the loans available at sub-prime rate. Again, they had the option of using mortgage loan to purchase houses. Therefore, people took this advantage and the volume of mortgage loan increased a lot. Banks were so keen to in-cash the situation that they were less bothered about the degree of financial leverage. Without making much assessment of creditworthiness of the customers, the financial institutions were giving loans at subprime rate. With time the economic growth went too high but with that the financial risk also increased sharply (Tian, 2009, p.284). The policy of extensive use of sub-prime rates resulted into a bubble that burst in 2007. The economist, Joseph Stiglitz described the reasons behind sub-prime crises as “Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes from 2002 to 2007. Investment banks packaged much of that debt into investment pools that won AAA ratings, the gold standard, from New York-based Moody's and S&P. Flawed grades on securities that later turned to junk now lie at the root of the worst financial crisis since the Great Depression.” (Chacko, 2008, p.31). Banks reported huge amount of toxic waste in the form of bad loans and NPA. On August 09, 2007 the Dutch merchant bank NIBC had discloses €137 million as loss because of the US assets backed securities. Large US banks like Citygroup, Wachovia Corp and Merrill Lynch posted huge losses in the third quarter and they had to written down billions of $ because of sub-prime mortgage losses. Lehman Brothers declared bankruptcy. Because of globalisation, the failure of US banking system had adversely affected EU and many banks in Euro zone declared large losses (Chacko, 2008, p.37-41). The poor condition of many international banks created a state of liquidity crisis in the international stock market. Till mid of 2007, the stock market of US and UK was too bullish. People had ample capital to invest and thus liquid was high. However, as soon as the banks reported about huge toxic assets in their balance sheet, the flow of easy money stopped. People were worried about their funds and they started withdrawing investment done in the stock market; hence performance of stock markets deteriorated in developed countries like US and UK. With FII started drawing money from the developing nations, the stock market in these nations too got affected. The fund in the stock market got eroded with drastic fall in almost all the stock market indexes. Figure 2: Effect of sub-prime crisis on equity market. (Source: Lee, 2008) The failure of the banking system along with decline in the stock market performance created a state of harsh liquidity crisis in international market. The result was economic crisis in developed countries followed by fall in economic growth in developing nations like China, India and Brazil. Figure 3: Liquidity in US market (Source: Dufrenot, et al, 2010, p.38) Conclusion The financial system of a nation has a great role to play in its economic growth. The banking system acts as an intermediary that mobilise the fund from individuals to the enterprises so that it can be used in the different projects and the nation witnesses growth in the economy. Similarly, the stock market is a platform through which the companies can raise capital for the business. It is a gateway for international fund to enter in developing nations. However, there has been many cases in the history were the misconduct or negligence by these financial institutions resulted in drastic economic crisis. Not only the local but the whole global economy has to bear the adverse consequences. Hence, these institutions should be excessive careful while developing a trade-off between risk and retune so that nations can retain their economic growth. Reference Azarmi, T. April 2007. Is The Indian Stock Market A Casino? Journal of Business & Economics Research. Volume 3, Number 4. [Pdf]. Available at: http://www.cluteinstitute-onlinejournals.com/PDFs/2005202.pdf [Accessed on January 12, 2011]. Badun, M. 2008. Financial Intermediation By Banks And Economic Growth: A Review Of Empirical Evidence. [Pdf]. 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