Monetary Control Operations: the Bank of England - Coursework Example

Monetary Control Operations: the Bank of England Question 1 ‘The most important function of any Central Bank is to undertake monetary control operations’. Discuss with specific reference to the Bank of England Central Bank is the apex bank of an economy and is responsible for managing financial and economic activities of a country. It regulates the economic activities and is capable of influencing a country’s macro and micro economic factors. The primary aim of Central Bank is to bring financial stability along with economic development. It is widely regarded as the decision cum policy maker of an economy. The primary objectives of Central Banks are given below. It controls the macro-economic activities relating to exchange rate and domestic price level. It develops long term strategies for financial sectors that include improvement of financial infrastructure and efficient payment system. It controls micro-economic activities like deposit insurance and prudential supervision (Asian Development Bank, n.d.). Controlling money related activity is the crucial responsibility of a central bank. In this respect, central bank is responsible for formulating and implementing monetary policies. Central bank uses monetary policy for influencing the economy and money supply in the market. It is an effective economic tool for controlling the interest rate, inflation rate, supply and availability of money. By formulating and implementing monetary policies, central bank influences financial activities. Firstly, it helps to control a country’s money supply. Secondly, it manages bond issues and foreign exchange trade. Thirdly, it helps to determine the short term and long term interest rate. It also influences stock exchange, real estate, banking activities, bond market etc. In this respect, Central Bank can be defined as a ‘nation’s bank’ or ‘banker’s bank’ (Yin, 2009). The monetary policy formulated by the central bank should be forward looking and help achieve long term success. Inflation keeps fluctuating due to undesirable conditions which make it difficult to bring stability in economic growth. Central bank must identify the uncertainties and prepare itself with effective monetary plans. Monetary policy is a slow process and it takes at least two to three years to realize its effects on the economy. In order to have forward looking approach for monetary policies, central bank must forecast the future inflation rate and act accordingly (Mishkin, 2000). Central bank can set the desirable interest rate through open market operations. Interest rate influences investment, trade and business of a country. For example, if government wishes to enhance a particular sector, it offers lower interest rate to it. Lower interest rate encourages investment which is crucial for the growth of business environment. In this process, the repo, reverse repo, government securities like GILTS are crucial instruments. “A repo agreement is a transaction in which one party sells securities to another, and at the same time and as part of the same transaction commits to repurchase identical securities date as a specific price” (Choudhry, 2002, p.93). Specifically, repo rate can be defined as an interest rate at which a central bank lends money to other banks, and reverse repo is the rate at which a central bank borrows from the other banks. Using repo and reverse repo, central bank purchase and sell government securities and influences the money supply. The role of central bank as policymaker for monetary activities has been discussed below in context of Bank of England. The central bank of UK is known as Bank of England. This central bank is responsible for controlling the financial activities of England, Scotland, Northern Ireland and Wales. Bank of England was established in 1694 on March 01. In 1946, it was nationalized. Since 1997, it is operating independently. The primary task of this bank is to ensure financial and monetary stability. “The Bank is committed to promoting and maintaining monetary and financial stability as its contribution to a healthy economy” (Bank of England-a, n.d.). Handling monetary policies is one of the core tasks of this bank. According to Bank of England, two main purposes for formulating monetary policy are to maintain low inflation and consequent stability in the UK currency. Bank of England has developed a Monetary Policy Committee that handles monetary related activities. This committee consists of nine independent members and each of these members is expert in economic and monetary policy. The committee’s approach for monetary policy is forward looking. In order to discuss the interest rate, money supply and exchange rates, the committee holds a meeting on a monthly basis (Bank of England-b, n.d.). Bank of England influences the economic expenditure by changing the official interest rates. It primary focuses on interest rate for controlling the official interest rates that interest rates of the entire commercial banks and other financial institution. This also affects the price of financial assets like shares and bonds. The following figure shows the monetary policy of Bank of England. Figure 1: Interest Rate Influencing the Inflation (Source: Bank of England-c, n.d.) The above figure depicts the entire procedure of controlling the interest rate. The repo rate is denoted as the official rate in the above figure. However, the first task of Bank of England starts by setting inflation target which is based on Consumer Price Index (CPI). The inflation set by the Bank of England is 2%. However, it is not possible to keep constant inflation rate every month due to uncertainty and market volatility. The mechanism of monetary policy of Bank of England is transmission process and it is held in open market. Bank of England deals with counterparties like securities dealers, banks etc who are active in money market. Bank of England sells and repurchases the assets based on an agreement rate from counterparties. “The repo rate is the (annualised) rate of interest implied by the difference between the sale and repurchase price in these transactions” (Bank of England-d, n.d.). The agreement assets include gilts, bonds, treasury bills, foreign currency debt etc. In the following figure, the inflation trend of UK indicates the effectiveness of Bank of England in formulating monetary policy. Figure 2: Inflation trend of UK (Source: Monk, 2010) Question 2 a. Discuss the role of banking in business 1. What do bank do? If finance is the blood of business, then banks must be the heart because it regulates circulation of finance from one sector to another. Earlier, the bank’s role was restricted to the collection of capital from the housing sector and its subsequent injection into the corporate houses. In this manner, banks used to assist the increase of capital supply in the economy. With time, the role of banks has become complex and now it is an inevitable part of any economic structure. Today banks provide several value-added activities to its customers. Few of the common activities played by the bank in the business are discussed below: Accepting deposit: To run a business smoothly it is necessary to ensure continuous in-flow as well as outflow of capital. Here comes the role of banks. Instead of making cash payment, business houses can issue cheque. As compared to cash, cheque provide extra float to the business. It takes some time for a cheque to be deposited in the creditors bank account and then to be cleared. As a result the business unit can hold the capital for some more time. Apart from the float, these cheques also ensure safe transaction of fund from one party to another. Similarly, bank can take the responsibility of cheques collection from the clients and transfer the fund to the bank account maintained by the business. This minimises the time taken for collection of cash from clients and thus liquidity position of the bank revives. Many a time banks provided short term loans to the business in the form of bank overdraft. These are flexible loans that are payable on demand (Epstein & Jermakowicz, 2008, p.109). The amount of bank overdraft depends on volume of cash deposit maintained with the bank and the creditworthiness of business. For such services, the business house has to maintain an account in the bank through which transfer of cash can be done. Assuring e-money VIZ. electronic money used on the internet: To make fast and reliable movement of capital, people are relying more on electronic transfer of money. The term ‘e-money’ or e-cash’ refers to digital cash that allows internet transaction of capital. As for example, if a customer makes purchase from a company’s website, he has to make the payment on-line. The customer can make use his debit or credit card where he has the account. Through electronic money transfer process, the cash will be transferred from customer’s bank account to the company’s bank account. Such transaction can never be possible without bank acting as an intermediary. The concept of e-money provides more convenience to the clients as well as to business houses that positively affects the revenue generating capability of the company. Implementing insurance contacts as principle: Companies purchase insurance policies to minimise the risk and this requires payment of premium to the insurance company on a regular basis. For making such payments, the business has to use its bank account. The bank acts as the intermediate of the business and provides guaranty regarding existence of the business. Dealing in investments: Companies often make huge investment for diversifying their existing business. However, extraction of such huge capital hampers the liquidity position of the business. Banks come to rescue then by assisting companies to make investments. Such activities of the bank are known as investment banking. “Investment banks can be described as multifaceted financial institutions that engage in public and private market transactions for corporations, governments and investors and also provide strategic advisory services” (Essvale Corporation Limited, p.2). These transactions are underwriting of securities, mergers and acquisition and divestitures. The role of an investment bank is different from that of a traditional bank. The former maintains a distinct section that solely performs the role of investment bank and this branch is called Investment Banking Division (IBD). Investment banking assists the businesses houses to raise money without disturbing the liquidity. Managing investment: A bank undertakes several activities to manage the investment of a business house. Cash management is one such activity. Along with it, lending and brokerage services are also carried out by banks. Similarly, banks also manage assets and securities to fulfil the specific needs for fund in the investment activity. Merchant banking services of banks assist business to issue equity and raise capital (Subramanyam, 2008, p.8.2). Mortgages: To raise capital, business houses often take loan from the bank through mortgage. Such mortgage loans are called secured loans where the bank provide money on mortgaging any asset of the business whose fair value is equivalent or more than the value of loan amount (Rhodes, 2008, p.65). 2. Negatives and positives of bank Bank provides liquidity to the business; it assures smooth and secured transaction of fund and also provides required assistance in capital market related activities. However, there are certain factors that need to be taken into consideration while availing the banking services. For example, the concept of e-money is not 100 percent secure. Few cases of fraud have been registered where the party conducting electronic transition had lost a lot of money. Often a clash of interest ensues between the investments banking division with other parts of the bank. This might hamper the quality of service provided. Many a time the fees charged by banks for providing value-added services are so high that it affects the profitability of business. 3. What if banks not exist? Banks play a highly diversified role in the present corporate world. Without bank, the circulation of fund in the industry will become problematic. This will have a negative effect on the liquidity as well as solvency state of business, thereby increasing the financial risk. Non-availability of investment assistance provided by bank will restrict growth prospects. This situation will result in poor economic situation and the nation’s financial structure will collapse. (b) Set out the specific role played by Investment Banking and the challenges of corporate governance. With the expansion of trade and business, the role of financial intermediates has increased significantly. These financial intermediates help business organisation by supporting their financial activities. In case of publicly listed companies, the financial process is more complicated as there are many share holders that participate in it. One of the major tasks of these financial intermediates is to acquire funds for organisation from different shareholders. In this respect, investment banks or merchant banks plays very crucial role. Investment bank is an institution that “acts as underwriter or agent for corporations and municipalities issuing securities” (Essvale Corporation Limited, 2006, p.2). Nowadays, the importance of investment banks has increased. Some of the major roles of investment banks are given below. It assists companies in acquisition and mergers. It helps companies to raise capital from market by issuing shares. It helps companies to develop defensive tactics to avoid takeover. It acts as financial advisors to the companies. It also helps to raise capital through loans and by issuing bonds. It also acts as financial analyst and helps its clients by forecasting stock movements. It also helps companies to restructure the financial aspects. Investment bankers make valuable contributions to the growth of corporate world by conducting the above functions. Every individual or organisation must be morally upright in their everyday activities. A business organisation must meet its basic responsibility and hence they should maintain absolute corporate culture. Generally, corporate governance can be defined as “relationship within the firm and between the firm and its environment” and it develops “the systems and processes established by corporate entities for ensuring proper accountability, probity and openness” (Stolt, 2010, p.2). According to OECD ‘Principle of Corporate Governance’, there are six major areas that includes “ensuring the basis for an effective corporate governance framework”, “the rights of shareholders and key ownership functions”, “the equitable treatment of shareholders”, “the role of stakeholders in corporate governance”, “disclosure and transparency” and “the responsibilities of the board” (OECD, 2004). However, there are some challenges in implementing corporate governance. These challenges vary according to different regions and structure of business environment. Some of the challenges are given below. Failure of directors and management to identify risks Difference in cross-cultural aspect Political and government interference in internal issues of organisation Lack of transparency and accountability in organisation Conflicting role of stakeholders and government Failure of internal and external audit Unrealistic and improper objective of corporate governance The collapse of Lehman Brothers is an example of improper corporate governance. This bank did not take any measures to avoid increasing risk, even the board of directors failed to meet their responsibilities. The Financial Crisis of 2007-2008 can defined as an effective of corporate governance failure. Basically, most of the American banks and other lending institutions avoided corporate governance and the entire world economy faced its consequences (Stephanou, 2010). Table 1: Comparison between the banks Citigroup JPMorgan Goldman Sachs Morgan Stanley Bank of America Corporation Market Cap: 119.40B 146.59B 80.89B 37.37B 112.15B Quarterly Rev Growth 29.70% 11.20% -28.00% -20.70% 48.70% Revenue 51.54B 90.08B 43.39B 30.35B 79.48B Operating Margin 6.40% 43.42% 50.34% 25.41% 18.85% Net Income 1.46B 14.30B 10.27B 2.81B -7.18B EPS 0.05 3.59 17.56 2.53 -0.76 P/E 76.11 10.45 9.01 9.75 N/A PEG (5 yr expected): 0.43 1.33 1.46 0.9 1.18 (Source: Yahoo Finance, 2010) The above compares the leading banks of USA that includes Citigroup, JPMorgan, Goldman Sachs, Morgan Stanley and Bank of America Corporation. As per the above table, JP Morgan is the leading bank in terms of market capitalization and net income. In spite of large market sales and high sales revenue, the performance of Bank of England’s has been poor as compared to other banks. Question 3 a. The calculation of the Weighted Average Cost of Capital (WACC) is theoretically simple but practically difficult. Discuss and explain with example- The capital of a business comprises of three types of components. These are common equity, preferred equity and long-term debt. Each of these capital elements has some cost associated with them and the total cost represents the weighted average cost of capital “weighted average cost of capital is the blended cost of the company’s capital structure components, each weighted by the market value of that capital component” (Hitchner, 2006, p.189). For example, a company has $4000 as debt component and equity capital of $6000. Again, the cost of debt is 8 percent per annum, whereas the cost of equity is 15 percent per annum. The weighted average cost of capital incurred by the company for funding can be determined with help of the below given formula. WACC = KE + KD Where, WACC = Weighted Average Cost of Capital KE = Cost of equity = Cost of equity % x proportion of equity KD = Cost of Debt = Cost of debt % x proportion of debt Using this formula, the WACC of the company can be calculated as: WACC= [15%*{6000/(6000+4000)} + 8%*{4000/(6000+4000)}] = 9.00% + 3.20% = 12.20% Therefore, the cost of capital for the company is 12.20 percent per annum. However, in real life, the process of WACC calculation is not that easy because there are several economic factors that affect the cost of capital. For example, while considering the cost of capital, several hidden cost are not taken into account. Few of these hidden costs are loan origination fees, loan covenants that require the company to maintain a compensating balance, pledges for collateral security and also the fee for unused line of credit by the company. Therefore, the cost of debt is actually not as low as it appears at first glance. While determining the real cost of debt, it become quite difficult to ascertain the hidden cost that will be incurred in future and thus WACC fail to reflect the true cost of capital (Hitchner, 2006, p.191). Both cost of debt and cost of equity are opportunity cost and hence it is quite difficult to determine the true valuation. Therefore, any changes in the external environment (such as inflation rate, performance of market and the tax rate) directly affect this cost. In a nutshell, the process of WACC calculation is not as simple as it appears in theory. (b) One-third of the total market value of Jefferson plc consists of loan stock with a cost of 10%. Nelson plc is identical to Jefferson except that its capital structure is all equity and its cost of equity is 16%. According to Modigliani & Miller, ignoring taxation, what would be the cost of equity of Jefferson plc? -1pg-200 Table 2 Jefferson Nelson Equity 2/3 1 Debt 1/3 0 Capital employed 1 1 Cost of equity ? 16% According to the Modigliani & Miller theorem, in the world of ‘no-tax’, the weighted average cost of capital of two identical companies having different leverages is equal. The weighted average cost of capital is the summation of cost of equity and cost of debt. It can be explained as: ‘(Ke + Kd = WACC = Same)’ and ‘(Jefferson = Nelson = WACC)’. As per the table 2, the cost of equity of Nelson is 16%. The weighted average cost of capital of Nelson will also be 16% as there is no debt in its capital structure. The cost of capital of Jefferson is calculated by adding the cost of equity and debt. Therefore, the cost of capital of Jefferson is: =(Ke x 2/3) + (10% x 1/3)’ By comparing the cost of capital of both companies, the following equation has been developed ‘(Ke x 2/3) + (10% x 1/3) = 16%’ By solving the equation, cost of equity has been determined. 2/3Ke = 16% - (10% x 1/3) Ke = 19% (c) Does an optimal capital structure exist? Discuss. As per the traditional approach, a moderate amount of debt does not affect much of the financial risk but such moderate financial leverage enhances the profitability of the firm. The same concept can be derived through static theory of capital structure. According to this theory, “a firm will borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress” (Ross, Westerfield & Jordan, 2008, p.569). The concept of optimum capital structure can be well explained with help of Net Income (NI) approach as well as Net Operating Income (NOI) approach. The NOI approach takes into account the WACC and total value of the firm. NI approach suggests that changes in the debt component of the capital structure always affect the overall cost of capital as well as total valuation of the firm. Even the MM approach supports the NOI approach. NOI approach pointed out that with increase in the debt component in the capital structure, Debt/Equity ratio increases and thus the risk of solvency goes high. This hike in risk motivates the equity shareholders since higher return and as a result cost of equity (Ke) goes increasing. Figure 3: Traditional view of the effect of borrowing on WACC Cost of debt can be both implicit and explicit. The explicit cost is the interest rate charged to be paid. With increase in the debt component in capital structure it remains constant. The implicit cost component is the hidden cost which increases the cost of equity. At initial level, the tax benefit acquired by the debt component nullifies the implicit cost and thus the total cost of debt remains constant. However, with increase in the debt component, the total cost of debt (Kd) starts increasing. Due to change in both these cost element, initial the cost of capital declines and reaches a minimal point, however from onwards it starts increasing. The point where the WACC is lowest represents the optimum capital structure. In practical sense, the concept of optimum capital does not hold true. The assumption of NOI approach states that there must not be any corporate tax and the cost of debt remain constant. In real life a company has to pay corporate tax. Again, in practical situation it has been observed that changing the capital structure does not affect the valuation of the firm. Question 4 a. The primary financial objective of a company is the maximization of the wealth of shareholders … per corporate finance theory. However, this objective is usually replaced by the surrogate objective of maximization of the company’s share price. Discuss how this substitution can be justified. As per the corporate financial theory, a company should focus on maximisation of shareholders wealth. Actually these shareholders are the ones who have invested in the company through shares (mainly the equity share). These shareholders participate in the financial risk associated with the business. Therefore, the main objective of business should be maximisation of their wealth. If a company prefer to enhance its profitability, it can do so by reducing the payments to the creditors and motivating the debtors to make quick payments. In this way, the revenue will be high whereas the operating cost will decline. As a result the net profit will increase but such an action hampers the market image of the company and it fails to acquire a sustainable growth. Therefore, the company should always pay attention towards maximisation of shareholders wealth. Shareholders receive the return in two ways. Firstly, through the dividend distributed by the company, and through the capital gains. Dividend is the part of profit which the company wants to share with its shareholders. Again, capital gain represents the profit earned by the shareholders on selling the shares in the market. Basically, capital gain is the difference between market price of the share and the cost paid by the shareholder while purchasing it. Therefore, higher is the market price of the share, higher will be the capital gain. Again, the market price of the share and the dividend distributed by the company are correlated. Many researchers believe that if the company announces high dividend, it positively affects its market image thereby increasing the share prices. A similar concept has been pointed out by Gordon’s model. This model suggests that dividend policy followed by a firm does affect its value. According to this model, the market value of the company can be calculated by the present value of future streams of dividend distributed by the company. The present value of dividend is the product of future value of the dividend and discounting factor. This discounting factor takes into account the cost of capital, inflation rate and all other risk factors prevailing in the market. As per Gordon’s model, the share price of a company can be derived as future value of the dividend divided by the difference between required rate of return and growth rate in the dividend given by the company. This model assumes that the dividend of the company continues to grow at a fixed rate. Therefore, future value of the dividend can be derived as follows: Future value of the share = Present value of the share (1 – growth rate of the dividend) Similarly, Present value of the share price = Future value of the dividend/(required rate of return – growth rate of dividend) This formula clearly specifies that higher is the growth rate of dividend higher will be the market value of the share price. Therefore, companies pay more attention towards market price of the equity share. They believe that a high share price reflects a healthy growth in the company and as a result the main concern of the company shifts from wealth maximisation towards increasing share price of the company. (b) Explain why maximization of a company’s share is preferred compared to maximization of sales …as a financial objective One of the primary aims of a profit making organisation is to increase the profitability. High profitability indicates high growth of a company along with its financial performance. However, in order to maintain corporate governance, the management of an organisation must focus on maximisation of its share. Maximisation of company’s share increases the wealth of the company and its shareholders. The group of stakeholders also includes shareholders. A company should be committed to the welfare of these stakeholders. In case of shareholders, a company must try to increase their wealth. The financial activities of firm should aim for wealth creation of shareholders. The company cannot grow in long term without including the aim of wealth creation. The concept of profit maximisation is a short term benefit that cannot meet a company’s long term mission and vision. By achieving profit maximisation, a company cannot increase its wealth. Hence, the financial management of an organisation should emphasize on its wealth creation rather than profit maximisation. The reason behind increasing profit may not be good performance of an organisation. Profit can get increased due to several factors. Some of these reasons are discussed below. Lower degree of competition: An industry with lower degree of competition is highly profitable. Players of that industry enjoy large portion of market due to fewer number of competitors. High pricing: Wrong pricing or excess pricing of product may temporary result in high profit but it cannot remain for a long. Acquisition of low cost resources: A company may produce cost-effectively by acquiring low cost suppliers and other raw materials. However, due to uncertainty in an economy, the prices of raw material may go up. In this case, the profit of a company tends to falls. There are also some disadvantages of profit maximisation that affects the value creation of a company. Some major disadvantages of profit maximizations are discussed below. Cash flows are important statement of a company representing its cash strength. High profit may not lead to enhanced cash flows. In case of decision making process, the historical profit statements are not helpful as sales are subjective measures. The maximisation of profit does not consider the time value of money. “The objective of profit maximization is too narrow because it fails to take into consideration the interest of government, workers, society and other persons dealing with the enterprise” (Shah, 2005, p.13). The following figure shows the two primary objective of finance. Figure 4: Objective of Finance (Source: New Age International, n.d.) The above figure shows that the first layer of financial objective should be wealth creation. Wealth maximization is superior objective than profit maximisation as it includes proper allocation of resources, interest of economy and society, consideration of risks etc. Profit maximisation may lead to fatal consequences, for example the collapse of Freddie Mae and Fannie Mae, the popular insurance company. It fell because it wanted to increase profitability without much consideration to risk level. Reference Asian Development Bank. No Date. Role of Central Banks. [Pdf]. Available at: http://www.adb.org/Documents/Books/Central_Banks_Microfinance/Overview/chap_03.pdf. [Accessed on November 26, 2010]. Bank of England-a. No date. About the Bank. [Online]. Available at: http://www.bankofengland.co.uk/about/index.htm#. [Accessed on November 27, 2010]. Bank of England-b. No date. Monetary Policy Committee (MPC). [Online]. Available at: http://www.bankofengland.co.uk/monetarypolicy/overview.htm. [Accessed on November 27, 2010]. Bank of England-c. No date. How Monetary Policy Works. 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