Money, Banking, and Financial Markets - Essay Example

Question The exceptional rise in bank reserves that has been caused by the responses of the central bank to the present financial crisis has brought about a substantial anxiety concerning a potentially uncontrollable and explosive future inflation increment. Practically the same concerns in the Federal Reserve during 1935 promoted an immense rise in reserve requirements for 1936. This led to a sharp recession in the next two years (Cecchetti 34). Hopefully, the monetary policy makers and economists have learned from the similar experience, or the repletion of the untimely tightening may be caused by the misapprehension duty of the bank reserves in the current financial system. In this article, I will analyze the current money neutrality and the creation of reserve without money creation as per the central banking systems. Money neutrality Numerous economics students have been taught the theory of money neutrality and its effect on how people consider the issue of monetary policy. The implications of money neutrality may be summarized as follows: in the long run, the growth of money ought to be neutral in its impact on the production growth rate and ought to affect the inflation rate. The earliest canonical works on the neutrality of money stated the superiority of monetary policy regulations that enabled the participants in the market to envisage the future money supplies. There were no debates in these abstract models for the necessity of an institution like a central bank that may be used to take the actions to apply a policy based on rules (Cecchetti 42). There were also no differences identified between the central bank’s liabilities and money. Theoretically, the gap between the inflation variables and the central bank variables (M1 and M2) are under the transmission mechanism, which is a monetary theory. The Federal Reserve utilizes the open market to withdraw or inject commercial bank reserves. The banks then create money through money multiplier. In a nutshell, banks react to the injection of extra reserves by developing loans that are financed with monetary liabilities like savings deposits and checking (Cecchetti 104). The money multiplier calculates the final adjustment in the supply of money that would be caused by a certain change in the monetary base. Irrespective of the money multiplier value, as long as it is stable, a certain percentage increase in the monetary base would cause a similar percentage increase in money. Therefore, the theory of money multiplier is a brief means of tying a policy rule under the central bank control with inflation and money. Creation of reserve without money The application of the concepts of the money multiplier and money neutrality have made a number of Federal Reserve observers argue that the present financial crisis has been caused by the possible result of inflation. For instance, the Financial Times, Martin Feldstein argued that when the economy starts to recuperate, the Federal Reserve will have to lessen the stock money and prevent the high volume of excess reserves in the banks from creating credit and money explosion. The negative money multiplier may be explained by liquidity creation. For instance, from 1981 to 2006, the average credit market assets that the US financial institutions hold have increased by $ 32.3 trillion. Commercial bank reserves that have been held as deposits by the Federal Reserve had reduced by $ 6.5 billion within the same period (Cecchetti 56). In 2006, the total commercial bank reserves in the Federal Reserve were only $18.7 billion. This amount was less than the equivalent amount that was held in banks, in 1951. It is quite clear that not only have the financial institutions depended on a rise in reserves held at the Federal Reserve to increase credit they have also increased credit by 744 percent as the reserves diminished. Therefore, the subsidiary money multiplier of the augmented bank reserves has been either irrelevant or highly negative. The following figure indicates the relationship between inflation and bank reserves from 1950 to 2007 (fig. 1). Figure 1. Five year annual average growth rate of financial institution deposits at the Federal Reserve. Substitution of public reserve with the private reserve The second source of confidence comes from the creation of the reserve. The immense augmentation in the bank reserves reveals a substitution of monetary base for the vastly liquid government securities in the portfolios of the private sector. While the government securities act as collateral in the private credit market, the size of the market liquidity fulcrum may not change with such operations (Cecchetti 61). Market liquidity conditions stay tight in spite of the augmentation in the bank reserves. While the quantitative reduction that simply swaps bank reserves for US treasury bills augments the monetary base, this does not achieve anything in terms of reduction of liquidity pressures. This only alters the assets composition within a certain sized liquidity fulcrum. In this notion, the open market purchase of the central bank alters the size of the liquidity fulcrum only if it changes monetary base for assets that may not be appreciated at complete value as guarantee in the market. Such moves go past a change of private reserves for public reserves and alleviate effective liquidity by augmenting the market liquidity fulcrum (Cecchetti 67). The stock in the private reserve took an immense hit with the loss of the earlier acceptable collateral assets. Question 2 There were excess loans with faulty credit standards One of the most significant causes of the weak financial regulation and supervision was the development of numerous mortgages for numerous borrowers based on a faulty credit standard and impractical assumptions about the possibility of rising home values and repayment. Unconventional and subprime mortgages Several loans were made for borrowers without a suitable analysis of credit or subprime credit or documentation that supported the loan (Cecchetti 104). Unconventional mortgage goods were available in the marketplace to contain a number of borrowers. Mortgage loans were made for the borrowers for home purchases plus recreation properties. Some mortgages were configured such that they would need refinancing after some years and could not practically be repaid without a stable rise in home values to support refinancing (Cecchetti 78). From 2000 to 2007, subprime mortgages increased by 800 percent and while this period ended, there was already an 80 percent securitization of these mortgages. The policies of the government encouraged borrowing The government policies supported borrowers to take mortgages that were meant for homeownership expansion and subsidize the accessibility of mortgage credit. These included consumer education, tax incentives and programs sponsored by the government to promote home purchasing on credit. Low interest rates and global credit imbalance Refinancing and borrowing by homeowners and homebuyers was supported by low interest rates caused by excess credit flaws into the US economy from countries that export oil and nations with excess savings. Credit Rating Agencies The credit rating agencies brought a significant impact on the financial crisis by issuing faulty investment grade ratings to securities backed by subprime mortgage that hastily reduced in value when the housing market depreciated. The ratings depended on assumptions and risk models that proved flawed plus insufficient consideration of liquidity and in a number of cases were paid for by the securities issuers (Cecchetti 71). The ratings were depended on by a number of investors and were instrumental in the spread of noxious assets in the financial system. If the credit rating agencies issued credit ratings that were supported by intelligence, the ratings may have reflected the risks of mortgage backed securities and brought more caution for investors. A SEC report on the examination of credit rating agencies got a number of deficiencies. The Credit rating agencies got a unique status in the financial system, in 1975, when they were designated as statistical rating organizations or the NRSROs. Deficiencies in the supervision of banking There were deficiencies in banking supervisions and these caused the financial crisis. These weaknesses came to light when the banking agencies reviewed themselves; there were investigations by the inspector general and also the congress. The process of accountability is continuous and is a positive feature of the regulatory system in banking (Cecchetti 137). The deficiencies in the supervision of the banking system may be caused by developments and innovations in the marketplace that outpaced the process of risk management in their supervisions and financial institutions. There were deficiencies in risk management The banking supervisors implemented a new approach of risk management to supervision in the 1990. This new approach concentrated on the adequacy of internal risk management and depended on institutions to administer their own activities. The supervisors issued a fixed stream of supervisory guidelines on issues of risk management instead of the strict rules. Banking regulators reported that weaknesses in market risk management and an oversight of credit were not of the same extent prior to the crisis as they were in 2007 (Cecchetti 79). The examiners also found it challenging to identify all the probable weaknesses in risk management. a) The income gap of the bank which is also known as the gap is: GAP=Rate-Sensitive assets – Rate-Sensitive Liabilities =$20 million- $ 50 million =-$30 million If interest rates fall by 3 percentage points, then the profits of next year will if fall as well because the market value of the assets held by the bank will reduce. Many people will rush to the bank to borrow loans because the interest rate has decreased. b) The interest rate risk is the risk the value of an investment is subjected to, due to the absolute level change in the interest rate. In this case, the conversion of $5million from fixed rate assets into rate sensitive assets will lower the interest rate risk. GAP=Rate Sensitive assets- Rate Sensitive liabilities =$5 million- $50 million =-$45 million so that means the bank will suffer a decline of $45 million. c) If the interest rate increases by 2 percentage points, the prices of the securities will drop and this will in turn affect the people in charge of them. This could result to bankruptcy and the collapse of the financial- market. It also leads to the reduction of the value of equity because it attracts the cost of investing in equities (Cecchetti 89). It will also lead to the amount of profits being lowered for the borrowing companies. Question 4 A future contract is meant for selling and buying a certain asset at a fixed price in the times to come (future). The two parties involved in a future contract are the buyer of the contract (agrees to purchase the asset with a fixed price), and the seller of the contract (agrees to sell the asset at a certain period in future). If the asset that is meant for the future contract is not perishable and is traded, one may construct a pure arbitrage if there is a mispricing of the future contract. The basic arbitrage relationship may be derived comparatively easily for future contracts on any asset by an estimation of the cash flows on two strategies that have the same outcome. In the first strategy, one can buy the futures contract, wait till the end of the contract period and purchase the underlying asset in future. In the second approach, one borrows money and purchases the underlying asset today and stores it for future. In both approaches, one ends up with the asset at the end of phase and is exposed to price in that phase (Cecchetti 92). In the first case, since one is locked in future price. In the second phase, it is because one bought the asset at the beginning of the period. Therefore, one ought to expect the cost of setting up the two schemes to precisely the same. Across various future contracts, there are individual details that create a variation in the pricing relationship. There has to be storage of commodities and development of storage costs while stocks may pay a dividend. The difference between perishable and storable commodities is that storable commodities may be obtained at the spot price and stored until the futures contract expires. This is virtually the same as purchasing a futures contract and taking delivery during the expiration. Since the two strategies offer the same outcome, the futures contract ought to cost the same as the strategy of storing and buying the commodity. The two extra costs of the latter approach are as follows: a) Since the product has to be bought now, instead of the expiration, there is an extra financing cost that is related with borrowing the funds required for the current acquisition. b) If there is a storage cost related to storing the product until the futures contract expires, the cost has to reflect in the strategy. There may also be a benefit of having ownership of the product. This benefit is referred to as the convenience yield, and it reduces the futures price. Question 5 a) The bank rate is the upper limit for the overnight rate because beyond that rate the banks will operate at a loss hence growth will be hampered further, and the exchange rate will be more volatile. The bank rate is the interest rate that the central bank charges on loans to financial institutions (Cecchetti 134). It is part of an array referred to as operating band for the overnight rate. The overnight rate is the rate that the monetary institutions lend and borrow funds amongst themselves. The bank rate is usually at the upper end of the operating band, which is half way apart. For instance, if the operating band is between 4.25 and 4.75 % the rate at the bank becomes 4.75 %. The overnight rate target is usually at the center of the band. The lower and upper limits of the operating band are the rates at which the central bank will loan funds that function in the LVTS (Large value Transfer System) (Cecchetti 123). It may also be the rates that the central bank pays interest for funds that are deposited by monetary institutions. b) For instance, if a commercial bank that is a LVTS member requires funds to cover its transactions during the day, it may borrow funds from the central bank at the bank rate. It may also borrow from other monetary institutions that have surplus funds. In various years, the central bank has improved the way it performs monetary policy. Under the past systems, the bank rate was defined in a different way and played a more outstanding function in the monetary rule (Cecchetti 154). For instance, from 1980 to 1996, the bank rate has been defined as the standard yield at the weekly auction of the bank of treasury bills and a quarter percentage points. This rate altered with each auction. Under the current system of the bank, policy changes are clearly indicated by overnight rate target changes. Works Cited Cecchetti, Stephen G. Money, Banking, and Financial Markets. Boston: McGraw-Hill/Irwin, 2006. Print. Read More