Banks Do Not Adjust their Lending Rates Immediately When the Reserve Bank Reduces the Interest Rate - Essay Example

Banks do not adjust their lending rates immediately when the Reserve Bank reduces the interest rate” Introduction Having the ability to account for several trillions in terms of assets across the world, the banking systems can be described as the single most crucial component that drives and sustains the economy of the entire globe. It is important to understand that banks make up an important component of the financial institutions of the world, being in the same category as insurance companies, investment banks, finance companies and other kinds of institutions that derive their profits and growth from the flow of money across various industries. Banks can be classified as very important and essential financial intermediaries, such that they bridge the gap between borrowers that often need capital for their investments and depositors, who play the role of capital suppliers (Pennington & Thornton 2010, p. 55). Because of the individual wealth in terms of assets and the commerce that the banking sector assists and oversees, banks have become the most heavily and highly regulated business across the world. The need to regulate the functions of banks stems from the fact that they are key to the growth of the Australian economy. In this regard, policy makers and economists try as much as possible to devise policies and regulations that ensure a healthy banking sector that spurs business activities and other forms of investment in the country. By so doing, a country is able to regulate the flow of money as well as other economic activities in the country (Boubakri 2011, p. 35). This process is often achieved by the central or reserve bank implementing various monetary policies such as changing the interest rates. Yet, “Banks do not adjust their lending rates immediately when the Reserve Bank reduces the interest rate.” It is argued by some that banks don’t decrease interest rates because they will reduce their profits in the process. In actual sense, this process is a total disregard of the RBA’s directive of reducing interest rates in order to encourage domestic and international investments in the country. This paper CRITICALLY examines the effectiveness of the Australian Reserve bank to regulate banks to adjust their interest rates that is in the best interest of the Australian economic environment. The first section discusses about RBA and its modes of operation in respect to monetary policies and money markets, the final section of this paper will explain why banks often fail to adjust their interest rates as directed by the Australian Reserve Bank Monetary policies In order to discuss the reasons why other banks do not always adjust their lending rates after the RBA has instructed them to do so, it is important to understand how the bank undertakes monetary policies. In Australia, the Reserve Bank is charged with the duty of implementing monetary policies in the country. Monetary policies, as applied in the banking and larger financial sector involve setting of interest rates on loans, which are to be effected by commercial banks, especially in the respective money markets. By setting interest rates on their lending to commercial banks and other financial institutions in the country, it is expected that the emerging cash rate has the ability to influence the rest of the interest rates in the country’s economy. In this way, it influences the financial behavior of lenders and borrowers and later the rates of inflation in the country. In the process of determining and setting the monetary policies, the bank is expected to effectively maintain the stability of prices, economic prosperity, full employment as well as the general welfare of Australian people. In order to attain these and other major statutory objectives, the Reserve Bank has a specific “target inflation,” making it seek to ensure a consumer inflation rate of about 2% to 3% on the average as well as above the set medium term (Ts, &Tumbarello 2009, p. 42). By controlling the rate of inflation, the bank is able to effectively maintain the value of money in the economy. In so doing, the bank encourages a very string and sustainable level of growth that can go for a very long time. The Federal Reserve Bank’s money markets From the above discussion, it is now evident that commercial banks are supposed to adjust their rates in accordance to the directive of the Reserve bank. This adjustments are the common characteristics of the money markets in Australia; which means that being the main player in the industry, the directives of the RBA are supposed to go unchallenged, making the banks to adjust their rates and implement the given directives from the RBA. In normal instances, commercial banks often borrow or lend some cash reserves from their fellow banks. In such a case, there is often an active and healthy market that exists for reserve loans from inter-banks. This kind of market is often referred to as the federal funds market, since the kind reserves that are often exchange in trade are always available for satisfying the requirements of the reserve bank’s reserves. The rate of the deferral rate is often determined by the prevailing supply demand patterns of the reserves for the particular inter-banks loan market. It is important to realize that the reserve demand is sometimes has a negative relationship to that of the Reserve Bank’s funds rate (Bushby 2011, p. 73). This is because, when the funds rates are low, the banks realize more lending opportunities that are more profitable and become anxious of borrowing the reserves and extending more loans. When the reserve bank has high interest rates for its funds, the banks often end up having few lending opportunities that are profitable and therefore, they tend to desire a small proportion of the rusting borrowed reserves (Gup 2007, p. 56). The reserve bank has the mandate of controlling the supply of the resulting bank reserves for commercial banks. The reserve bank creates these reserves through buying of the Australian treasury bonds and bills through open market operations. After purchasing the bonds, the bank injects in the economy new reserves for the commercial banks. When the reserve bank sells the bonds, it removes the reserves away from the commercial banks for borrowing. In such a move, the bank reserves’ supply curve is said to be perfectly elastic as shown. This is because, the reserve bank is at liberty to inject any amount of reserves that it wishes for the commercial banks and other financial institutions existing in the banking system. Refer to the graph below: Source (Lau & Liu 2012) Through the process of increasing and decreasing the amounts of reserves available for the commercial banks, the reserve bank can easily raise and lower the rates for the Reserve Bank. For instance, suppose that the reserve bank expects to increase the rate of reserves to a target of about 6%, moving from its current rate of 5.5% (Lau & Liu 2012, p. 65). In order to achieve this, the reserve bank has to sell its bonds in the open market operations, a move that will reduce supply of reserves for the commercial banks, and a move that will push the rate of reserve banks funds upward. Refer to the graph below: Source (Lau & Liu 2012) Why Banks often say no to cut lending rates to increase their profits Many commercial bank executives often insist that they cannot easily reduce the rates on their loans despite the respective official rate cut which is made by the reserve bank; they often explain that the cash conditions are often very tight and the money markets change insignificantly because of the rates reduction by the reserve bank (Paulet 2009, p. 76). However, the insiders of the reserve bank have more than once explained that this observation is simply an excuse that is aimed at making these commercial banks protect their profit margins unscrupulously. The failure of commercial banks to implement the interest rate reduction has effectively diluted both the impacts of monetary policies and equally weakened the push for the government to move fats and unlock credit in a process to spur investments, which is the economic struggle that can help the government in its economic growth and development (Bologna 2010, p. 47). The reserve bank has been trying to provide liquidity, which is much higher compared to that in the banking system. In this perspective, the government expects to influence commercial banks to reduce their lending rates in a bid that will arguably increase credit for people and other business investors in Australia. Banks are expected to ensure that they manage their liabilities and assets in a more efficient and effective manner and not be inflexible in reducing lending rates as proposed by the reserve bank. The reserve bank in Australia is charged with managing the amounts of liquidity present in the market in the process of assisting in the transmission its respective rate decisions. It is expected that when the reserve bank raises the amount of liquidity slightly above what it is providing (Pennington & Thornton 2010, p. 59), then it will be better placed to influence the banks to reduce their current lending rates and thus increase the potential for investments as a result of cheap and affordable credit to individual and other business organizations. Read the Key things that You need to Focus ON and Follow them: A large part of your discussion should consider the profit motive of banks-this part is not clearly addressed in your paper. You focus TOO MUCH on the RBA monetary policy mechanism. You just need to introduce it and NOT GIVE a complete economic analysis of the mechanism. You need to EXPLAIN what the mechanism of cash rate is, when the RBA drops it, WHAT are they trying to achieve and HOW do banks respond to this drop in cash rate. WHAT impact on banks profit does this drop in cash rate and banks interest rates have on bank profits. Follow the Conclusion Below, the previous one was very poor: Conclusion The above discussion considered the following, monetary policies of the RBA and how it manages its money markets in a manner geared towards economic growth and development, the bank reduces its interest rates most often, yet, “Banks do not adjust their lending rates immediately when the Reserve Bank reduces the interest rate”. It is argued by some that banks don’t decrease interest rates because they will reduce their profits. Instead, most of them keep their interest rates above those directed by RBA in the argument that they are trying to keep their businesses afloat amidst high competition. This paper CRITICALLY examined the effectiveness of the Australian Reserve bank to regulate banks to adjust their interest rates that is in the best interest of the Australian economic environment. It has given alternative ways of how banks can remain profitable in their operations, not by failing to adjust interest rates as directed by RBA. From the above, it is evident that the RBA cash rate is effective has not so far been very effective unless commercial banks adhere to the directives given. Banks do not decrease interest rates immediately arguing it affects their profitability; however, it is important to realize that banks have various ways in which they can manage their profitability and growth and not just become inflexible in adjusting their interest rates. The banks need to realize that profit has nothing to do with it failing to adhere to directives by the RBA, by effective management of liabilities and other instruments developed by the management. Read More