Investments Are Becoming Easier - Case Study Example

The significance of financial intermediaries in the financial system With the advent of globalisation, investment opportunities have been springing left and right and increasingly, an investor from one continent can invest in another continent. But the problem facing many investors and households is how to best carry out their planned investment. But with the use of financial intermediaries, investments are becoming easier. Definition Financial intermediary can be defined as middlemen that act between households and business sectors that have investments to carry out and need the funds to do so.1 The financial intermediary in this case who may be financial institutions as banks, mutual funds, investment companies, or insurance company serves to connect the two sectors. The unique characteristic of the financial intermediary here is that their assets and liabilities are overwhelmingly financial.2 The financial intermediaries succeed by using customer’s savings (who save in order to maximise the savings but with minimal risk) to lend to investors (who fights to get the money at the cheapest rate as possible but with less strings attached) with the aim of making a return on their investments for themselves and their customers. Their main role can be said to be channelling of customer’s savings to investors who so need the money to make meaningful investments that give rise to an economic growth and development for the society.3 The financial intermediary strives to make the better deal of a large profit as possible from these savings as to keep the institution running. (See appendices 2) According to J.O. Sanusi (2002), availability of investible funds for investment in any economy can be said to be the key factor in the growth process of that economy especially as it is realised that these funds are a necessary condition for output production and employment growth. Efficient financial intermediaries through the role they play in any economy are of course seen as the best means of achieving higher levels of output production, employment, and income which invariably enhance the living standards of the population. It cannot be argued therefore that countries that have enjoyed or are enjoying economic prosperity such as the Western countries are having such an efficient mechanism for mobilising financial resources and allocating same for productive investment.4 Banks long ago were considered as the best intermediary since they are able to provide an important positive means of mobilising the savings from customers, and allocating these funds to the investors for finance investment projects at affordable low interest rates, and act as the sole providers of liquidity in the whole monetary system and payment services, and helps in the implementation of monetary policies by influencing the savings – investment process that help accelerate the rate of economic growth and poverty reduction. Therefore, with a efficient banking system, bank credit can be controlled and directed to areas of the economy that required these credit to make an economic growth. Central banks who have the effective control of the activities f these banks and financial intermediaries should help them perform their duties well by putting in place a sound, stable, and efficient banking sector through effective surveillance and enforcement of prudential standards using a licensing procedure that places an emphasis on a fit proper paper criteria that should make the banks trustworthy. But in last decade, most economies have witnessed increasing cost of financial intermediation (such as cost of acquiring information, enforcing contracts between parties, and exchanging goods and financial claims) due to the current high lending rates caused in part by the expansionary fiscal polices of Central Banks, which are of course fuelling inflation and tightening monetary policies around the world, and on the other hand by the oligopolistic structure of the banking system where some large banks take advantage of the information they have to block competition and protect some firms at the detriment of others, and the inadequacies of infrastructural facilities in certain cases to meet the high demand for investment funds. Some large banks who have very few restrictions on their activities at times also collude with some firms against other creditors to block efficient corporate governance. With these discrepancies, many are those who tend to shift their ideas from a bank based system to a capital market based system to provide a good financial intermediary for stimulating economic growth. Why capital markets than banks for financial intermediary? Over the past 35 years especially with the setback suffered by the Japanese banks in the nineties, banks have been having tough times to capture family wealth especially as markets have been realized as having that broader access to finance investors beyond the banks.5 This trend can be found more in the industrialized nations and even though it is gradually entering emerging markets. But some firms after all still prefer to use retained earnings than debt to finance their investments. In a research by Ross Levine (2001) to determine whether the banks or the bond markets can be the best stimulus of economic growth, he collected information from some 48 countries for the period 1980 to 1995 and used several regression analysis techniques to be able to explain the per capita average growth rate in terms of different measures of the relative importance of markets to banks. Variables such as ratio of market capitalization to private sector credit and the ratio of trading turnover to loans were used. It was found that there was no significant difference in whatever financial system used as what really matters was the total financial depth irrespective of the division between markets and banks. Allen and Gale (2004) in a separate paper believed that, a “symbiotic” relationship actually exists between banks and the capital markets because banks are there to provide the savings and credit instruments in the early stages of development of investors, while the capital markets instruments only come in when the financial depth of the investors increases, with new corporate requirements arising and the degree of sophistication for both the investors and financial agents grow as a result of the symbiosis. (See appendices 1) To conclude, the significance of the financial intermediation, whether it is a bank or the capital market for bonds and equity cannot be underestimated when it comes to stimulating of economic growth and development in any one particular economy. Banks and holders of non-tradable claims like venture capitalists are there to provide the advisory service in the early period of business for investors, something that the markets cannot do especially as the opportunity cost of capital for the venture capitalists is generally small. They are all dominate in their different areas of practice and well established firms will resort to the markets for funding since markets act mostly using good rating of firms, whereas, new market entrants and newly created firms with low or no rating on the market will obviously use the banks and venture capitalists for funding and advice. This is to say, capital market financing serves as a back up to firms. Markets only become attractive to corporations when the risk-free rate or bank profits decline. Corporations now will see the debt market for financing as the good source of finance especially as the fall in the tax-free rate reduces the cost of borrowing on the debt market. Functions of the Central Bank Central Banks (CB) around the world all perform almost a unique function ranging from issuing the currency for the country to regulating the functioning of the economy. All of this is done through the use of their fiscal and monetary policies – Open market operations, Reserve requirements, and credit deposit requirements. This authority is vested with the power to manage the economy of a country or a group of countries (e.g. The European Central Bank for European countries, The Central Bank of England, and the Fed for the USA). Broadly speaking, they perform functions such as implementation of monetary policy, managing currency stability, low inflation and full employment. Implementation of Monetary policy The Central Bank as issuer of currency: The Central Bank has the sole authority to issue notes and coins that are used as legal tender. But in some countries, the government issues notes and coins of smaller denomination that act as legal tender, while the CB issues notes of larger denominations. The CB determines the amount of currency that it has to issue especially as too much money in the economy can lead to inflation while too small money in the economy may stifle the economy. Whenever any new currency is issued, it is the CB who decides the time at which the currency should enter into circulation. It also organises money circulation and regulates the amount of currency in circulation using the monetary policy of compulsory reserve requirement. The CB reserve requirements are used to put a check on the ability of financial institutions to “create” chequebook money through loans or investments. In this way, the financial institutions are limited on the amount of money they can hold and use for loans or investments. The Central Bank as State’s bank: The CB does not only limit operations to financial institutions, but also provides banking services to the government, by holding the accounts of the government and other state institutions, state special-purpose funds, as well as government entities, and executes their payment orders e.g. payments on public contracts awarded by the state to private contractors and also raises money for the government via instruments like bonds or T-Bills. Setting of interest rates: Setting interest rates which include the interest rate and Cash Reserve Ratio (CRR) (ratio of all deposits that commercial banks are mandated to keep with the Central Bank) amongst other instruments are important monetary policy instruments of the CB. The interest rates are managed by changing the discount rate at which the Central Bank refinances commercial banks. By varying CRR, the Central Bank can automatically change the money supply in the economy and can also use this lever of interest rates to encourage or discourage investment and affect employment levels in the economy. Open Market Operation (OMO): OMO is used to maintain exchange rate stability of the country currency. When they are fears of fluctuations of the local currency, the CB steps in to buy or sell foreign exchange on the currency market. They can also sell foreign currency so as to reduce the supply of currency in the economy. Inflation: To manage inflation in the economy, the CB just needs to twist the interest rate. Interest rates can be cut to ward off fears of a recession as is the case with the Fed in the USA this January 2008 where interest rates were cut to 2,25% from 3,5% in September 2007. Managing economic stability of the economy In this situation, the CB is acting as a regulator and at same time supervisor of the economic system through acting as; The Central Bank as the banker’s bank: The CB organises the monetary clearing system, services current inter-bank settlements by refinancing their debt at the prevailing discount rates and actively participates in the inter-bank money market. Their participation on the inter-bank market is by using the monetary policy of open market operations through which central bank engages with financial institutions through the conditional and outright sale or purchase of securities or foreign currency, as well as the issue of own-debt securities. The CB acts as a lender of the last resort to commercial banks in times of crisis. This becomes important, when commercial banks face a sudden financial crunch or become insolvent, the CB upon the request of the commercial bank concerned, can step in to restore confidence in the system via devising various bailout packages for the commercial bank or banks. Effects on mortgages and the prices of bonds in the capital markets by a reduction in base rates A change in the short term interest rates generally can affect the whole economic system. Through a transmission mechanism, changes in the base rate, affects market interest rates such as mortgage and bank deposit rates, the prices of assets, expectations/confidence, and the exchange rate. In this case, only short term interest rates are changed since changes in official short term interest rates do not move in the same direction with long term interest rates. Changes in long term interest rates can go either way since they are influenced by an average and expected future short term rates. (See appendices 3) It can be seen from the above analysis that changes in the base rate are immediately transmitted to other short term whole sale money-market rates and money-market instruments of different maturities and other short term rates interbank deposits. Banks most often are very flexible when such changes occur as they immediately adjust their lending rates by exactly the amount of monetary change which very fast go to affect interest rate banks charge their customers for variable loans and overdrafts and the rates offered to savers to maintain the margin between their deposits and loan rates to offer the investors. Mortgage rates do not feel the changes that fast since their rates change slowly on the market. The above transmission mechanism that occurs as a result in changes in base rates all emanate from changes in monetary policies by the CB. Even though such changes affect the prices of market securities such as bonds and equities, changes in their prices are in the cases inversely related to long term interest rates, meaning that, with a rise in interest rates, prices of bonds and other securities on the security market will fall and vise versa. The rise or fall in the prices of securities in this case can be largely attributed to the fact that expected future returns are normally in this case discounted by a large discount factor making the present value of any stream of future income stream to fall. In conclusion, changes in monetary policies by the CB have far reaching effects depending on what economic situation it intends to resolve. This may imply why CB do not often change their monetary policies even when faced with serious financial crisis. The case in hand is that of the European Central Bank, which even when the world’s economy is suffering due to the credit crunch, they concentrate but on fighting inflation rather than cutting interest rates as the Fed to boost the credit market. Market analysts who can rightly predict CB monetary policies most often benefits a great deal on the market for bonds and securities. References Allen Franklin and Gale Douglas: “Financial Intermediaries and markets”, Econometrica, Vol. 72, (2004) No 4, pp 1023 – 1061, July 2004 Dr. J.O Sanusi, Governor, Central Bank of Nigeria (2002): The importance of financial intermediation in sustaining economic growth and development: The banking sector review. A keynote address delivered at the banking seminar, organised by the institute of directors. Levine Ross: “Bank –based or market-based financial system: Which is better? University of Minnesota, Mimeo. (2001) Martin Redrado, Governor, Central Bank of Argentina (2007): Financial intermediation through Institutions or markets? Opening address at session I on Financial intermediation through Institutions or markets? of the 6th Annual Conference 2007. “Financial system and Macroeconomic Resilience”, Brunnen, 18 June 2007. The transmission Mechanism of monetary policy: the Monetary policy committee, Bank of England. Retrieved from www.bankofengland.co.uk on 16-04-2008 at 17,00pm http://www.hktdc.com/econforum/hkma/hkma041203.htm, retrieved on 16-04-2008 at 18.30pm http://www.investopedia.com/terms/f/financialintermediary.asp, retrieved on 16-04-2008 at 18.00pm Zvi Boddie et al: Investment. McGrawHill, New York. 5th Ed. (2005). Appendices 1 This is the case of most large corporations who have a high rating on the market and can therefore invest directly on the market without the use of loans. (Source: of diagram is self formulation) Appendices 2 This is mostly for firms who do not have good marketing rating or are just simply newly created or new market entrants and consequently do not have enough funds for self financing, therefore resort to using loans from intermediaries to finance their investments on the market. (Source of diagram is self formulation) Appendices 3 Transmission effect of Central Banks monetary policy when base rates change. (Source: transmission Mechanism of monetary policy. Retrieved from www.bankofengland.co.uk) Read More